David Macchia: There’s a lot at stake for people as they approach retirement, many with arguably insufficient assets, or certainly not the optimum amount of assets. Making that money last as long as possible and protecting it as well as possible is an important goal. I’m wondering how you look at how the financial industry may respond as the financial need changes for millions of people — from accumulating retirement assets to generating durable, and hopefully, inflation-adjusted retirement income.Well, I’m very optimistic for the following reason. Sometimes a need arises, an important need or a social need or economic need arises, like global warming, and we don’t have the technology yet to address that need. But, in this area, namely the idea, the need for products, investment products, savings products, that offer adequate protection, there’s a huge need, but there’s also an available technology.
I mean, the last 30 years have seen a revolution in the science of financial risk management. Not just a science, but also the technology of financial risk management. The lives of derivatives markets, swaps markets, options markets, these are all, right at the moment, these are all markets where institutions are active, buying and creating risk management mechanisms, large banks, and so forth. But that technology is ripe and ready to be employed at the retail level, at the level of individuals. And so, I think that within the next year we’re going to see the rapid evolution of financial products that combine downsize guarantees against market risks with participation in the upside, or at least potential for upside growth. I’ve called those the consumer products, the financial consumer products of the future. But they’re actually here in many places. I mean, as you probably know, an example, a fairly simple version of such a product, is a mass market product over in Europe, and that’s the equity participation note.
It’s like a convertible bond. Basically, it guarantees you that you’re going to have, at the end, at least the value of your money back, maybe with some interest, and on the up side, you can get significant participation in the appreciation of underlying equities. So that, to my mind, is sort of the prototype for the consumer product of the future, and it’s even here in the present. It’s this entirely feasible technology. We see that these products are starting to be rolled out now in the retirement market. And the number of companies that are offering principal protection even with inflation protection, including rollover products for IRAs, will increase. In fact, at [Boston University], at my urging, we’ve adopted for our employees a class of rollover products that are available through www.incomesolutions.com. A retiree can go and get competitive bids on inflation-protected lifetime income from AA rated insurance companies, and you actually get to see apples-to-apples comparison between the picks. That makes me very optimistic.
I think that’s very important, and I know that you know of my interest in structured products. In fact, you recently provided me an opportunity to speak to your MBA class.That’s right. You did a great job.
Well, thank you. I’d like to get some of your vision about how you see the marketplace in the future changing, especially in the context of the debut of structured products in the retail market, which, I think, we both believe is going to happen on a broad scale, and probably will make a big impact.Well, let’s just take an example of how you can have standardization, transparency and a good deal of choice and customization in structured products. And, again, I like to use the principal protected note with equity participation as an example, because it’s very simple to understand. You can decompose it into a bond and a fraction of a call option so that it could be analyzed easily. That’s great for clients we’re teaching, but it’s also great for explaining it to ordinary people, as I do.
This is a chapter in Worry Free Investing, where I talk about these products. The beauty of it is this: Let’s say we’re standardizing, we’re saying what you’re going to get back is the minimum of your principal. OK? So you put up $100,000, or $10,000, or $1,000, and, at the maturity date — and you can choose the maturity date, let’s say it’s five years from now — the least you’re going to have is you’re going to get your principal back. Then there’s some standard equity index, let’s take the best known probably in the investments field, and that’s the S&P 500, domestic equity. There’s something we call the participation rate, which is, at the maturity date, what fraction of the increase in that index [you are] entitled to. Now, just like with the inflation-protected annuities that you can compare, it’s all apples to apples. You can compare the terms you’re getting on this investment because, you know, you’re getting downside protection. So you know exactly how much you had, the maximum you can lose, abstracting of course from the default risk. We need to somehow have a way of correcting for that, but let’s say these are all AA or AAA issuers, which typically they are with firms like Merrill Lynch, others. With banks this could even be FDIC-insured on the downside.
On the upside, you are promised some participation rate, let’s say it’s 90 percent of the appreciation in the S&P 500, right? So if the S&P 500 doubles, it’s twice what it was, at the maturity date, twice what it was when you put your money in five years earlier. You’re going to get 190 percent of your money back. That’s an investment product that is very easy to understand, especially if you compare it to, say, a target-date mutual fund or a value-oriented mutual fund, or a growth-oriented mutual fund. None of those descriptions of mutual fund strategy mean much to the average consumer. There’s a reason for that, and that’s because the mutual fund isn’t really promising anything. It’s trying to characterize the nature of the investments it’s going to hold, but even if you buy a target-date fund, say, with a target date of 2020, what exactly are you being promised in the year 2020? And the answer is nothing.
Or best efforts.Well, it’s not even best efforts. What they’re going to be doing is following a predetermined asset allocation strategy, the outcome of which is unpredictable. So it’d be like you’re buying a car, and they’re telling you here’s what the car is going to be composed of. It’s going to have these inputs, but we can’t guarantee that you’ll be able to even drive down the street in it because we’re not issuing any performance guarantee.
Well, you bring up another important point. In the course of my own experience of developing retirement income solutions since 2003, we’ve trained a lot of financial advisors, and we see that their tendencies are to try to port over accumulation logic into the distribution phase. And we see mutual fund complexes that are trying to maintain the accumulation mindset in distribution-era product development. How do you see that playing out?Well, I think the accumulation logic was wrong to begin with.
Does that make it doubly wrong in retirement?All of that was fallacious, the notion that all you have to do is hold on long enough and the risk goes away.
Okay, so, now here you have structured products emerging with a value proposition that is extraordinarily compelling — protection combined with upside growth potential.Yeah. Well, that logic applies whether you’re talking about the accumulation phase or the payout phase.
Right. But, you know, I saw the power of that with the equity-indexed annuity, which debuted in 1995, and although, regrettably, the indexed annuity business fumbled the ball through progressively ever more inferior product development, the underlying value proposition was so compelling it drove almost $30 billion worth of sales at the high point.Yes, that’s right. But the problem is cost. I mean the challenge for the industry, the big challenge for the industry, is to mass-produce these products, allowing some degree of customization, while maintaining transparency. They have to be sold for what they are and not hyped. We’ve got to do it through direct sales through plan sponsors to cut out the high selling expenses. Again, an analogy — automobiles for people in the upper income brackets were around for many, many years before automobiles became a mass market. You look at some of those early automobiles from the early part of the 20th Century, or even before that, and they are masterpieces, they are just gorgeous. That is the equivalent of private wealth management. Some of the most sophisticated financial engineering goes into solving the problems, the wealth management problems of multi-millionaires today. The trick is to find the model T that’s going to make this affordable for the masses.
And I believe that will happen.Oh, I’m convinced it will happen. And I do agree that it’s going to happen when the boomers retire, because that’s when they’re going to have to reckon with the fact that if they’ve got losses in their portfolio, they’re real losses. What happened in 2000, 2001 and 2002 is that boomers just stopped opening their statements, which is the equivalent of burying their head in the sand. It didn’t affect their standard of a living. But once you retire, it does affect your standard of living if you’re living off that income. So I agree with you, that is what is going to be the trigger.
I made the point at your class that technology has created an ever more transparent world and products that are opaque create friction. I do think that the boomers will not tolerate anything but transparent structured products and I think it’s likely that structured products will enjoy phenomenal growth, and it won’t take long.Right, and there’s also the advent of the Internet where it’s so much easier for people to compare, for consumers to compare. I mean now they talk about consumer empowerment; it’s still in its infancy, but it’s clear what way the trend is going.
Could you talk about your life, where you grew up, how it began for you?Sure. Well, I grew up in Brooklyn, was born into a working-class family. Both my parents were born in the United States. They were first generation, and their parents had come from Eastern Europe as immigrants. Actually in the 1800s from Russia and Hungary. I guess the best way to put it is to say that it was very similar to the upbringing that has been depicted in Woody Allen’s movies. But, you know, there are so many well known movies about growing up in families of Jewish immigrants, so it’s that kind of a background. My grandfather, who was really the most cultured member of the family, I mean, no one had gone to college, not my parents, not my grandparents. My grandfather, though, was a producer/director/actor in the Yiddish Theater. He had a repertory company in the early part of the 20th Century. His company toured all over North America, wherever there was an immigrant Jewish community, a Yiddish speaking community of any size. They performed plays and repertory, including a lot of Shakespeare. My grandfather knew all of Shakespeare’s major plays by heart, in Yiddish translation.
My grandfather was already retired when I was born. He was born in 1879, and he died at age 90, in 1969. He was an enormous influence on me, very theatrical, as you might imagine. He was a fascinating guy. My father was a plumber, and I, as a young person, would work with him on weekends. During the summers I was a plumber’s helper. And, so I grew up very much understanding the situation of working class people, having been one. We were never poor, but we were, never even remotely rich. I mean, my father never took a vacation. Never.
Actually, I do remember one. One summer we went away for two weeks, and that was the only vacation that I remember growing up. I even remember where we went. It was in the Berkshires, in Pittsfield, Massachusetts. Every time we’d drive past that lake I’d point out to my kids where we stayed. Anyhow, at age 13 or thereabouts, I got involved in a group. I was born in ’43, so this would’ve been 1956. I got involved with a Zionist group, and its orientation was towards getting Jewish youth to settle on the Kibbutz in Israel. And I was attracted to that. I just liked the idea of a cause, and, of course, when you’re that age, you think that socialism is the answer to all of man’s problems. You know, brotherhood. And, of course, a hypothetical society always works better than an actual society. So, I got involved in that for a number of years. Then, when I graduated in 1960, I went for a year to visit Israel, spending part of my time on the Kibbutz. I resolved that I was going to come back some day and settle there.
At that time I was 17 or 18, and a true believer. When I returned from that year in Israel my dad had a heart attack and died. All of a sudden things changed. I had a younger sister, who was only 8 years old. Mom was about 49 at the time. So I went to work. I had started college, and I worked and went to college at the same time. For about a year I really didn’t have much time for anything else. Then, my mother remarried. I got involved once again in the Zionist movement, and eventually, I settled in my Kibbutz in Israel, I was 23. By this time I was going with a steady girlfriend who also was involved in the Zionist movement. She was two years younger than me. She is now my wife of 40 years.
So, we’re living on the Kibbutz, and she got along just fine. But I became disillusioned with socialism for a variety of reasons. Well, with the Kibbutz, anyhow, which I guess is as good as socialism gets. It was a very democratic society, but people are people, and I just realized that living that life was not what I wanted to do.
So I went back to school. I went to the Hebrew University in Jerusalem and got a masters degree in Economics. I then went on for a doctorate in economics. By that time, I had gotten married, and we had our first child. In 1970, we came back to the states so I could work on my Ph.D. in economics at MIT. I arrived there at exactly the right time because, in 1970, MIT was the center of the new discoveries in financial economics.
Bob Merton had just finished his thesis under the direction of Paul Samuelson. They had already written their landmark papers of 1969 on Lifecycle Consumption and Investment Decisions over time, which are still sort of the watershed articles. Merton accepted a teaching position at the Sloan School at MIT, and I was in the very first class that he taught as a graduate student. I was 27, he was 25. So, I was sort of an older student among the graduate students. At that time Myron Scholes was on the faculty and Fischer Black was consulting, but he participated. He was working with Myron Scholes on the famous Black-Scholes paper, as well as other papers, and he was participating regularly in the finance seminar at MIT. Talk about being there, you know, at the right time.
And of course Franco Modigliani was there and also Stewart Meyers. They were in actually in the early stages of their careers. Not Franco though, Franco was a senior person, but, you know, this was 1970. Paul Samuelson said that he was younger than I am now. I mean he was in his 50′s. So it was quite an exciting place to be, and that is what sort of shaped, my, shall we say, introduction into the world of finance. I really considered that period the critical turning point in the development of finance as a science.
At what point in this process did you decide that you wanted to spend your life teaching others?Well, that happened a lot earlier. That happened even when I was on the Kibbutz. I worked as a teacher for a while. I was actually teaching science to kids who were in the high school. I always wanted to be a teacher. I loved being a student. I had gone to the best public schools. I had gone to Brooklyn Technical High School, which is one of the finest high schools in the country. It’s an exam school with free tuition, and then I went to Brooklyn College, which was part of the University of the City of New York which is also a very, very good school, and free.
So, I got a free public education and a very fine one, and had been an outstanding student. I had won all sorts of awards as a high school student, and I knew I wanted to be a teacher. That was a given from a very early age. I should say, even when I was in the Masters Program at The Hebrew University in Jerusalem studying economics, I was teaching economics in English to students who were visiting from abroad.
Was there something special about that MIT environment that made you a different individual today?Without a doubt, in terms of my intellectual development. The person who had the greatest influence on me, and there were a number of them among the senior group including Paul Samuelson and Franco Modigliani. But Bob Merton and Stan Fischer were my two thesis advisors, and those guys had a powerful influence as well, particularly Bob Merton. But Stan Fischer, who later went on to become the Vice-Chairman of the IMF, and now the governor of the Bank of Israel, was an important influence, too, and my principal thesis advisor. My thesis, which I completed it in 1975, was on the topic of hedging against inflation. Very much a finance topic that was linked to what was going on in the real world, because the early 70s was a period when, in the U.S., inflation reared its ugly head for the first time in a long time.
That period was called a period of stagflation, during the Carter era of 1976 to 1980. In the 70′s, there was something called the misery index, which was the sum of the unemployment rate and the inflation rate. The inflation rate, as measured by the CPI, was in the double-digits. Unemployment had been in the normal unemployment rate but was ratcheting up, and by the end of the decade, most of the economists were saying 6 percent is sort of the normal level of unemployment that we should expect. So, of course, everyone was surprised when it came back down to 4 percent some years later.
I remember that when I came to Boston in 1970, that that was the low point in the economic history of Boston, because that was exactly when the big turnaround occurred. New England in general, and Boston in particular, had seen its traditional shoe manufacturing and other manufacturing industries bought out, and it was before high tech developments in medicine and in computers starting taking off. It was the beginning of what later became known as the Massachusetts Miracle. Remember when Dukakis ran for President in ’88, and he was Mr. Massachusetts Miracle? So I do remember that.
I quote from Nassim Taleb’s book “The Black Swan:” “Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief. The turkey reminds me how so often the past is used to project a vision of the future that no one can guarantee. Yet this tendency to project drives so much behavior in terms of how people invest their money. You know what I’m getting at.Oh, I do know what you’re getting at. And it’s one of the hardest issues, not just in finance, by the way, not just in investing, but it’s true in general. It’s how we deal with uncertainty.
Let me elaborate on it in theme, because there’s a very, very, very important distinction that I would draw between my approach and the approach of Nassim Taleb. Nassim, I would characterize as a kind of nihilistic figure. He’s rejecting everything more or less. In fact, if you look at the list of people who are in line for very rough treatment from him, it includes Paul Samuelson and all the Nobel Prize winners. I mean, virtually, all of them. I, on the other hand, believe in the progress of science, particularly in the field of economics. And so, all of those guys are my heroes, and they came to be Nobel Prize winners. Now, that doesn’t mean that the work they did is the final work, and that the Black Swan is not, if you will, a real phenomenon. Let me give you an example, okay? Let me give you the counter example that, at the same time, makes his point and makes my point.
Suppose you are studying really the basics of probability. Take something that we’re all familiar with, which is coin flipping. Now, you know, on each toss of the coin, we say, the probability of heads is zero point five. Right? Now, that may or may not be exactly correct, because any particular coin you pick may be out of balance.
But let’s say it’s in perfect balance, you make the abstraction that we got from the coin, then we can study the outcomes. In particular, you know, you can study binomial processes by coin flipping. In fact, I do this with my students in class. So in the very first class, I have every student pick out a coin and flip it ten times. And, then, they report how many heads came up. The number of heads has to be between 0 and 10. And what you’ll see, you should get a probability distribution that looks very much like the normal distribution. Okay?
But the zero and ten have very low frequency and the most common outcome is going to be five, right?
Now, all that can be studied, and has been studied scientifically. It is the basis for much of the science of and the laws of probability, without which we would not have made much progress in other fields of science. Now, it is possible for you to flip a coin and it lands, not on heads or tails, but because it’s got a third dimension, it actually winds up standing on edge. Okay?
Your Black Swan.Right. Now, would you therefore reject everything else about what we’ve learned about the coin flipping?
You would not reject binomial distribution, and a normal distribution. Of course not. Depending on the purpose, I mean, if you want to study rare events, then you’d want to study that phenomenon and understand it better. But frankly, it’s going to be very, very difficult to model. And one reason it’s going to be difficult to model is because, really, at the abstract level, you didn’t even want that to be a possibility. You would have liked the coin to be not three dimensional, but two dimensional.
But, of course, in the real world, you never get exactly what you want. Just like when Galileo was dropping objects from the leaning tower of Pisa, they weren’t going to hit at exactly the same moment, the feather and the steel ball, because he didn’t have a perfect vacuum. Do you see what I’m saying?
So what’s the point of what Nassim Taleb is trying to say? I don’t see that anything really spectacular comes out of that, except for something that we all knew even before he wrote his book, which is – who was it who said this – our former secretary of defense: “There are the things we don’t know we don’t know.”
The unknown unknown. And that’s why, if you’re ever going to run a financial firm, you’ve got to have some reserve capital there to back up the promises you make, because stuff happens.
But we all know that. I mean, it’s not as if the scientists don’t know that. But we build our models so that we can make progress, not so that we can reject everything. Now, having said all that, most of the arguments that I have made, which run counter to conventional wisdom, and probably the best known of those in the practitioner community, is my claim that it is fallacious to believe that stocks become less risky in the long run than they are in the short run. What could run more counter to conventional wisdom that that?
But that point is actually well established in the scientific community. You know, when I say that to a fellow professor of finance, they say, “You mean practitioners really believe that?”
In my experience, virtually all practitioners believe that. And it might be helpful to practitioners to understand the research or evidence that shows that the belief is not well founded.Okay. So, first of all, my first exposure to the proof that that is a fallacy was as a student of Paul Samuelson at MIT. He had written a number of papers. The one that was specifically targeted at this was his 1969 paper on lifecycle investing. Where he himself said, you know, he thought he modeled that (stocks become less risky over time) right? And he thought he was going to find that when he solved for the optimal investment strategy, he would find that the longer one’s time until retirement, the more the individual would get out of stocks and into fixed income.
But making some very reasonable assumptions about the nature of stock market uncertainty, namely random law, and making the assumption that people have very plausible, rational preferences, he discovered that independent of one’s age, one would always want to have the same proportional exposure to stocks, when you look at the individual’s total wealth, in other words, include human capital in wealth.
Now, Samuelson proved it, theoretically, making very plausible assumptions. So, you know, as far as most academics are concerned, we’re done. Okay. He’s proved that it’s a fallacy. Now, he rewrote that article in various forms consistently over the years. I mean I can send you a version of it that he wrote in the late 90′s, for the first issue of Bloomberg Personal Finance Magazine. And, again, you know, it was the fallacy of time, diversification, etc. But he was ignored. I did not ignore him, and, in fact, I took it very much to heart unlike most academics. But I think what is somewhat different about me, and if I had to single out what is my distinguishing trait as an academic, it’s that I really pay careful attention to what practitioners are saying and try to reconcile conflicts between the results of academic research, or scientific research, and the advice being offered from practitioners.