From the April 2012 issue of Research Magazine • Subscribe!

Evidence Over Ideology

In the words of the great Benjamin Graham, an “investor’s chief problem – and even his worst enemy – is likely to be himself.” We all like to think that we make decisions based upon a careful weighing of the evidence. But that is rarely what happens, as the behavioral research now establishes beyond doubt.

Our overriding tendency is to concoct belief systems based upon incomplete evidence or even out of whole cloth and then to set out looking for evidence to confirm what we have already decided. Moreover, we are not anything like objective. We interpret the evidence we do examine in ways that tend to be supportive of our prior commitments. We are ideologues through and through. 

For example, the March 2012 issue of Money magazine rightly honors Jack Bogle as a hero on account of his having preached the benefits of low-cost and indexed investing and for making those objectives widely available as the founder of The Vanguard Group.  Money follows that up with a puff piece on the “Bogleheads,” devotees of Bogle with a variety of publishing ventures including a popular website (www.bogleheads.org) that – by-and-large – offers pertinent and helpful information for individual do-it-yourselfers from experts (such as the excellent Larry Swedroe of The Buckingham Family of Financial Services) and from interested amateurs.

However, even a few random visits to the Bogleheads forum reveals evidence of ideology run amok. Many there suggest that using a financial professional is always wasteful foolishness, no matter an individual’s ability and interest in learning the fundamentals of investment management and behavioral economics as well as the perils they bring, since financial advisors are deemed generally incompetent and to care only about separating you from your money. Moreover, well-supported and non-controversial research on financial topics other than indexing (such as the judicious use of income annuities to deal with longevity and sequence risk) is often attacked by regulars as part of a conspiracy on the part of big corporations out to exploit investors. Accordingly, it can be difficult to ascertain where the good and well-supported advice stops and the ideological nonsense begins.

The same issue of Money includes an interesting interview with MIT’s Andrew Lo wherein Prof. Lo (rightly, in my view) criticizes the efficient market hypothesis and advocates for his adaptive market hypothesis, positing that markets adapt over time to the biases and foibles of investors, bringing about inordinate risks, bubbles and crises. But he then flatly states that “buy-and-hold doesn’t work anymore.” That sounds like an ideological commitment to me.

To be fair, the interview includes Prof. Lo’s admission that our industry has not developed “good alternatives” to that approach and expresses concern less with the long-term returns of a traditional, diversified and rebalanced portfolio than with the behavioral pressures that cause so many to be their own worst enemies on account of maddening volatility. This idea is consistent with research findings by Morningstar showing that volatile funds tend to have the greatest discrepancies between time-weighted and dollar-weighted returns: “Volatile funds may entice investors on the upswing, but spook them into withdrawing during rough patches.” Thus “investors in volatile funds can unwittingly end up buying high and selling low.”  

But Prof. Lo’s bald proclamation can readily be used (and similar statements are being used) by ideologues (and salespeople!) to justify all kinds of nonsense, whether it be hedge fund and related strategies that fail by any reasonable measure (Simon Lack’s recent book, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good To Be True, shows how Treasury bills have achieved twice the returns of hedge funds overall and hedge fund replication funds have had notoriously poor performance records since their inception), overpriced funds of any sort, or market-timing efforts that are doomed to failure.

A recent Financial Planning Association survey of its membership revealed that 50% follow a systematic withdrawal strategy for retirement income and a special report on retirement income planning in the December 2011 issue of The Journal of Financial Planning included an article by Jonathan Guyton showing that the mean initial sustainable withdrawal rate recommended by financial planners is 4.17 percent. These findings are consistent with a common rule of thumb that a 4 percent retirement withdrawal rate, adjusted annually for inflation, ought to be “safe” for traditional portfolios. As I have noted in this space before, this “rule” is largely based upon research by William Bengen and others showing that the lowest sustainable withdrawal rate historically from a standard portfolio to this point has been about 4 percent.

Yet financial services advertising typically includes a disclaimer something like “past performance is not indicative of future results” for very good reason. If nothing else, the 2008-2009 financial crisis taught that just because something has not happened or is highly unlikely to happen does not mean it cannot or will not happen. The 4 percent “rule” is based upon far too narrow a swath of data to be normative. Moreover, as recent research by my friend Wade Pfau has shown (in the Winter 2011 issue of The Journal of Investing and elsewhere), there is very good reason to think that sustainable withdrawal rates since 2000 have decreased dramatically. Indeed, for 2008 retirees, Prof. Pfau estimates a maximum sustainable withdrawal rate of only 1.5 percent. Blind faith in historical return levels going forward for these investors is likely misguided. Therefore, assuming that something like a 4 percent withdrawal rate is somehow “safe” can only be based upon an ideological commitment rather than a careful weighing of the evidence.

Accordingly, the need for assured income – most efficiently provided by a simple income annuity – is affirmed and remains the best choice for most retirees. It is the nearly unanimous choice of academics and other unbiased experts even though it is routinely rejected by advisors and consumers.

In the Bucks blog at The New York Times last summer, the typically outstanding Carl Richards made a plea for investors to “stay the course” in tough times based upon faith. “This act of faith is most evident when it comes to the stock market.…The core question becomes this: Do you still believe that stocks will continue to do better than bonds, and bonds will continue to do better than cash, just like they always have?”

I do not necessarily accept the premise of the question in that bonds have outperformed stocks over significant periods of time. Moreover, we do not have anything like enough data to be terribly confident about any alleged trend going forward. However, to the extent that this question is a valid one, my answer is “probably not” with respect to the intermediate term and “I have no idea” with respect to the longer term. I agree that it is foolish to ignore history. But history should not be turned into ideology. I choose to remain skeptical going forward.

Edwards thinks that investing requires faith of a sort – an ideology. But I remain an investing agnostic. I believe only in what can be shown to work. I also recognize that what works today will not necessarily work tomorrow. Therefore, all financial plans must be evaluated and constantly re-evaluated in light of these facts.

In the world of investing, I only believe in what works.

Bob Seawright is chief investment and information officer for Madison Avenue Securities in San Diego.

 

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