In a bold attempt to reframe retirement investing, investment firm GMO proposes a new model for portfolio management whose glide path might potentially look “nonsensical,” its authors admit, but which may help retirees minimize the risk of running out of money.
The white paper, written by GMO’s Ben Inker and Martin Tarlie, focuses on two problems in current thinking about retirement portfolios.
First is the assumption held by Modern Portfolio Theory that an investor should seek to maximize return for a given level of risk.
Inker and Tarlie argue that retirement investors particularly are disserved by such an approach because it asks the wrong question, focusing on returns though an investor’s interest is in having a target level of wealth at a predefined period of time.
The authors propose another question: “Which is the portfolio that minimizes the expected shortfall of wealth relative to what’s needed?”
The goal of retirement planning, they write, is “not to put investors into yachts” but to make sure they have enough to live an acceptable lifestyle in retirement.
The authors reject the contemporary emphasis on risk profiling; rather, they suggest it is the investor’s circumstances rather than personality that should dictate the kind of portfolio that is needed. The long time horizon of a younger investor requires more aggressive investing, while the inability to recover from portfolio losses requires a retired investor to invest conservatively.
“Putting the more risk-averse individual in a less volatile portfolio … without making any compensating savings or consumption adjustments, actually increases the wealth risk to that individual in that he is less likely to achieve his wealth needs,” Inker and Tarlie write.
So a young investor who can’t handle volatility may need to regularly save 10 percent of his paycheck, compared to someone of ordinary risk tolerance for whom a 5 percent savings rate would enable a more volatile stock-heavy portfolio.
Based on standard return and volatility assumptions, Inker and Tarlie generate a theoretically optimal weight in stocks for each age that addresses the imperative of minimizing a shortfall in wealth.
But readers needn’t hasten to check the table, because its static view hits a second major problematic assumption of contemporary portfolio management the GMO authors address — namely, the false idea that expected returns are constant over time.
“If you happen to be lucky enough to have lived and saved during the right period when asset returns were high, it doesn’t much matter what your target date allocations were,” the authors write. But unlucky investors who face a poor sequence of returns upon retirement face a rapid depletion of their portfolios.
Or, as the authors put it in simple numbers: “We believe it is the height of folly to assume that a market trading at 45 times normalized earnings, as the S&P 500 was in 2000, can achieve similar returns to one trading at 7 times, as it was in 1982.”
So what’s an investor to do? The answer — to dynamically shift assets in response to market valuations — goes against the grain of buy-and-hold oriented advisors, but it is based on an interesting insight about the predictability of stock returns.
As the GMO authors put it:
“Valuation cannot tell us much about what returns will be over a week or a month or a quarter, but over a period of years the importance of valuation steadily increases.”
In other words, the correlation between valuation and subsequent market return rises over longer stretches of time — only 20 percent at current valuations but 70 percent after 20 years.