Equity versus TIPs & Old "Common" Wisdom
Ok, the book has shaken up my views in a variety of areas, which is good; but some ingrained ideas are hard to shake.
First off, my topic “subject” is a wrong view, as the discussion of asset allocation should not be divorced of the current assets, objectives, future income sources and risk aversion. Still, there are some “pure” discussions in the book about the dangers of long term average returns.
While I can understand the book’s arguments, which weighs more negatively on equities (or at least points out the larger, long term risks); I still have trouble dropping my weightings in a diversified equity positions.
If I am interpreting both the book and my ESP results, the trick to heavy equity investments is to spend way below the project consumption rates. By being aggressive in the risk category (higher average returns, but more volatile investments) but conservative spending (saving during the good years and generally live below the projected ESP consumption numbers) I can then enjoy the benefits of higher returns (later in life) and not risk my future life style if the economy/stock markets/world goes in the tank.
Obviously, one has to have the critical mass or ability to live below the projected smoothed consumption rates.
I believe this is the whole point of Chapter 34 “Beware of Averages” and the tale of two Ruths. But even here, the book still makes it sound that going with the TIPs is a wiser choice; quote the last line:
“Holding stocks can be highly risky in the long run even with very cautious spending.”
And that statement still doesn’t quite sit right with me; especially with conservative spending and a long time investment horizon (which is another discussion point).
RSS
Ooooh! Another opportunity to get feedback on my method of evaluating risk vs reward!
My ESP results have lead me to a very aggressive asset allocation (90/10) even though I'm within less than two years of retiring. As you can imagine, the last year or so of waching the stock market has not been pleasant.
I effectively do what you suggest - invest aggressively and spend less than recommended consumption would be for mean returns, but I do it quantitatively, not guessing at a "fudge factor".
Here, verbatim, is a post I made from last October in the Monte Carlo sectio of the forum. The post below was made before I switched to my current aggressive allocation.
----
I’m not satisfied with eyeballing the “Variability of Living Std†columns in the Monte Carlo report to compare the risk vs. reward of many different asset allocation strategies.
I’ve come up with a process that compares different asset allocation strategies in terms of today’s consumption. Better strategies result in greater recommended current consumption. Worse strategies result in less recommended current consumption.
I’d really like to get feedback from other users of this program (or the developers) on whether they think my process makes sense or not, because the results don’t completely match conventional wisdom. I’ve compared over 30 different lifetime strategies, and the results agree, on a gross level, with the conventional wisdom that I should hold a more aggressive portfolio now, and gradually move to a more conservative portfolio as I age. But the specific numbers are very different from conventional wisdom. My results suggest that I should hold 100% stocks now, just a few years from (an early) retirement, and shift to 100% bond/cash over the next 30 years, holding 100% bonds/cash for the last 15 years of my life.
That’s really why I’d like some feedback – because I don’t want to rely on these unusual results if I’m making a mistake in my approach – so I’m asking you to help me figure out what, if anything, I’m doing wrong. Does my method yield usable results?
I’ve tried posting this before, and haven’t gotten many comments. I’m hoping that by begging you to criticize me -- to find my mistakes -- I’ll get you to respond.
Here’s what I’m doing.
I don’t want to compare strategies based on mean returns, because they don’t encorporate risk. Obviously using mean returns would have me 100% in emerging markets equity. I want to end up with results that compare the risk of variable returns as well as the rewards for taking the risk, and that encorporate it in a way that I can compare numbers, apples to apples.
HERE’S THE HEART OF MY POST. IT MAY TAKE A LITTLE BIT, BUT STICK WITH ME HERE:
The way I’m doing this is to compare a specific “percentile distribution of living standard†instead of comparing the “recommended trajectoryâ€ÂÂ. In other words, if I’m willing to accept a 25% risk that my plan will result in a lower standard of living than I have today, I want to compare the 25th Percentile Distribution of Living Standard for every asset allocation strategy, not the Recommended Trajectory.
So how do I compare them? Ordinarily, the Recommended Trajectory runs across the “Percentile Distribution of Living Standard†chart horizontally, and the 25th percentile slopes downward. So I tell ESP that I'm planning to take a raise each year, by specifying a growth rate in my standard of living, using the "standard of living" tab under economic assumptions. The amount of raise I give myself is enough to tilt the whole "Percentile Distribution of Living Standard" graph counter-clockwise just enough that my desired level of risk runs horizontally across the graph. In other words, if I'm willing to accept a risk that there's a 25% chance my living standard will be lower than planned for, and a 75% chance it will be higher, then I tilt the graph until the 25% line runs horizontal. This approach makes some sense, because if my investments do better than the 25th percentile I’m planning for, I really should be able to give myself a raise each year.
For me personally, 25% is too high and 5%, is to low, so I linearly interpolate between the two to get to my desired level of risk (this is easy, because the output is Excel, so I can add equations to the results sheets).
I can evaluate different portfolios for risk vs reward by implementing a new set of portfolios, running the program, then finding the new standard of living growth rate that tilts the graph to make my desired level of risk horizontal. This allows me to compare the same percentile distribution of living standard between two different asset allocation strategies. If the reward is worth it, the *recommended consumption* will be higher. If the risk is too great, it will be lower, even if the portfolio would return more with mean values. If I were to chose a different level of risk, the results would be different.
So what do you think? Should this result in a reliable way to evaluate different asset allocation strategies for a given level of risk, or am I doing something wrong that leads me to the surprising results? (Please answer quick, before I move my entire portfolio into stocks. Thanks).