Looking around, one can see an old parting of ways that is becoming relevant again. On the one hand, there is a view that flourishes in the physics of the 19th century. It sees the world as a mechanism with root causes and effects that can be optimized at will. Plato would have felt at home here. On the other hand, there is a view that grows from biology. It sees the world as a complex system with muddled origins and obstinate redundancies. Aristotle would have liked it here. One view believes in optimization. The other believes in resilience. The distinction becomes more pressing in stressful times when optimized solutions reveal their brittleness.
Optimization is the story of investment accumulation. It can be nice when things go well. When it reaches limits, it does not degrade gracefully. Resilience is the story of retirement income. It can feel muffled when things go well. When times are rough, it is more likely than not to survive yet another day.
Interestingly, worldviews and the retirement crisis are discussed in environments other than the financial industry, including — of all things — a video-game-oriented blog written by Sean Malstrom. That such discussions take place outside of our industry should not be much of a surprise if you read Steve Johnson’s 2005 book titled Everything Bad is Good for You. One of his key points is that the economics of repeatability (think TV series on DVD as opposed to live TV shows) encourages cognitive complexity. According to Johnson, gamers as well as couch potatoes (who knew!) benefit from more complex plots with sophisticated social mapping, increasing ambiguity and the need to keep long-term goals in mind while facing mind-blowing scenes. Does this not sound like the financial industry in the last few months?
Johnson’s thinking brings us back to one of the key ideas in Nicholas Nassim Taleb’s book The Black Swan: The economics of repeatability help us develop “skeptical empiricism” rather than submit to the consensus “Platonist” narrative. The bottom line is: The business ecology that we live in — being driven like video games by the economics of repeatability because FAs expect to service clients year after year — is getting more complex and our skills need to match the increasing complexity.
Gamers may be showing us the way in matching and navigating this increasing complexity. They construct complicated hierarchies of tasks and move through them in proper sequence. How can ADHD-like gamers spend so much focused time on delayed gratification, doing difficult tasks that we find so hard to do? The answer may be found in a particularly important aspect of video game (product?) design: Keeping the players feeling in control and notified of the potential rewards just ahead of them. What keeps the gamer going is having a sense of control and a desire to see the next thing. Let’s remember this idea: Giving the investor a sense of control and a desire to experience the expected outcome.
If your clients have opened their financial statements for 2008, it should be clear to them that the complexity of the times is marked by the appearance of unusual disorder. A financial blogger writing under the pen-name of Ironman gave us permission to use (www.politicalcalculations.blogspot.com ) a very nice chart (see preceeding page) to show that we are indeed living in a time of unusual disorder.
This graph maps, on a per-share basis, the trailing year dividends (x-axis) by the S&P 500 index value (y-axis) on a monthly basis. Linking the monthly observations, you can clearly see periods of ordered growth where linear trend lines can be fitted. You can also see two periods of disorder that look like uncontrolled geysers rising above and below the ordered trend line. One such geyser of disorder was the dot-com boom; the other is the current period. These look like mirror images of one another.
What can we control to ensure that retirement incomes meet our expectations when valuations and returns are unusually disordered? Taking a step back, we can see that there are several generic ways to work with wealth in order to create income, including: (1) coercive transfers, including taxes; (2) market-driven inter-generational transfers; (3) market trades based on holding preferences; (4) market and/or coercive poolings of risks including mortality risk.
For instance, Sean, the video-game blogger, believes that our current crisis comes from the fact that too many people are seeking an annuity (by which he seems to also mean “entitlement”) and that too few will be working to create the excess production and profit necessary to pay for those annuities. What happens when the coercive parasite and its “zombified” patronage get bigger than the productive host?
There is another aspect of coercive transfers that Tim Harford describes in his book The Undercover Economist. Because market transactions are optional (participants are not forced to trade) market prices reveal a greater measure of truth. They reveal useful information about the participants’ true preferences.
On the other hand, coercive transfers reveal a lesser measure of trust and are akin to lies. They do not reveal useful information about the participants’ true preferences because there is no choice. For instance, what “services” requiring ever-rising coercive takings do you really care about? Which “services” would you rather do without? As a retirement income investor, would you seek to become more or less dependent upon coercive transfers to create your future stream of retirement income?
Here are some other quesetions we may explore in future articles: Because darkness is fullest before dawn and there is always the promise of another day, where will positive cash flows come from as we pull out of this crisis?
Because the fundamental engine of wealth is productivity growth — being able to do more with less, year after year — where will future productivity growth and innovation come from?
Are we reaching the limits of what income can be generated through intergenerational wealth transfer because the subsequent demographic cohorts are smaller than the boomers?
Looking at the returns of risky assets in 2008, have we reached a limit of what income can be generated from returns on wealth invested in risky assets on the basis of other investors having different holding preferences?
Given the health status and the level of healthcare available to boomers, what are the income opportunities that can be created from investing a portion of our wealth in mortality pools?
Will the most effective retirement income solutions be big solutions (mandatory and government-driven) or small solutions (optional and under an individual’s control)?
At a more fundamental level: Who sees the world as a clock? Who sees the world as a garden? Are you a clock-maker running the risk of catastrophic failures? Are you a gardener trying to guess which crop will do best this season? It is basic beliefs such as these that will drive answers to the questions. What are your answers?