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Portfolio > Economy & Markets > Fixed Income

Bold Forecasts but Timid Choices

By Bob Seawright

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When I was much younger and new to working in the capital markets, an excellent mentor taught me a market maxim that has served me well. More money has been lost because of four words than at the point of a gun. Those four words are “This time is different.” We are all too ready to view our situation as unique.

I vividly recall a CNBC interview in late 1999 with a geriatric money manager who claimed that in the then current environment, a portfolio with a 100 percent equity allocation was safer for retirees than more traditional investing choices because market inflows from 401(k) contributions and the like provided constant market support. Accordingly, in his view, it was almost impossible for the equity markets to take a major hit.

We all remember how that turned out.

In their great book, This Time is Different, Carmen Reinhart and Kenneth Rogoff examine financial crises throughout history. They document how whenever such crises arise, alleged experts claim that “this time is different” — that the new situation has little in common with past disasters.

Reinhart and Rogoff call this problem the “this-time-is-different syndrome.” According to their analysis, “It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now. We are doing things better, we are smarter, we have learned from past mistakes. The old rules of valuation no longer apply. The current boom, unlike the many booms that preceded catastrophic collapses in the past (even in our country), is built on sound fundamentals, structural reforms, technological innovation, and good policy. Or so the story goes.”

We live in an overconfident, Lake Wobegon world (“where all the women are strong, all the men are good-looking and all the children are above average”). We are only correct about 80 percent of the time when we are “99 percent sure.” Despite the experiences of anyone who has gone to college, fully 94 percent of college professors believe they have above-average teaching skills. Since 80 percent of drivers say that their driving skills are above average, I guess none of them drive on the freeway when I do. While 70 percent of high school students claim to have above-average leadership skills, only 2 percent say they are below average, no doubt taught by above-average math teachers.

In a truly terrifying survey result, 92 percent students said they were of good character and 79 percent said that their character was better than most people even though 27 percent of those same students admitted stealing from a store within the prior year and 60 percent said they had cheated on an exam. Venture capitalists are wildly overconfident in their estimations of how likely their potential ventures are to succeed. In a finding that pretty well sums things up, 85-90 percent of people think that the future will be more pleasant and less painful for them than for the average person.

Our overconfident tendencies are well-known of course and obvious in others if not to ourselves. The odds of playing college sports are long and the chances of an athlete reaching the pros are vanishingly small, yet every weekend astounding numbers of parents can be heard at their kids’ games talking about little Sally or Sam inevitably winning an athletic scholarship. Marketers take advantage of these tendencies too (which explains the success of credit-card teaser rates, for example). Our biases constantly impact our decision-making, obviously. As Daniel Kahneman and Dan Lovallo put it in a 1993 paper, “decision makers are excessively prone to treat problems as unique, neglecting both the statistics of the past and the multiple opportunities of the future.”

On the other hand, we are also highly loss-averse. This aversion is another well-known cognitive bias. Empirical estimates find that losses are felt between two and two-and-a-half times as strongly as gains. Thus the disutility of losing $100 is at least twice the utility of gaining $100. Loss aversion favors inaction over action and the status quo over any alternatives.

Therefore, when it comes time for us to act upon the facts and data we have gathered and the analysis we have undertaken about them, these biases — unjustified optimism and unreasonable risk aversion — conflict. As a consequence, we tend to make bold forecasts but timid choices.

Dealing with these conflicting biases is never easy. But we can start by recognizing the nature and extent of the problem.

These biases go a long way toward explaining what academics call the “annuity puzzle” — the idea that people buy income annuities to guarantee retirement income far less often than good sense says they should. For example, we tend to overestimate the likelihood of good future portfolio returns while underestimating the likelihood of major portfolio drawdowns such that we take no action to deal with longevity risk by purchasing an income annuity. In short, we tend to accept risks when we don’t think we will have to bear them.

This reluctance to take clear and explicit responsibility for potential losses is both costly and powerful. As a result, as shown by political scientist Aaron Wildavsky in his famous book Searching for Safety, we are typically better off engaging in an active search for safety rather than relying upon a passive prevention program. An appropriately active response to longevity risk is to provide a guaranteed income source so that retirees can rest assured that they will not run out of money.

One way to overcome these biases is by framing the decision to be made differently. The “certainty effect” is a sharp discrepancy between the weights that are attached to sure gains and to highly probable gains in the evaluation of prospects. Thus, when an income annuity is positioned as a certain gain of guaranteed income for life rather than as a payment resulting in a loss of control of one’s nest egg in exchange for future payments, it is more likely to be well-received.

We also tend to consider problems one at a time in isolation instead of aggregating the problems and the risks and looking at them together. If the benefits of an income annuity are examined in conjunction with longevity risk, market risk, sequence risk and health risk, it becomes a much more attractive proposition. As Kahneman and Lovallo affirm, “evaluations of single risky prospects neglect the possibilities of pooling risks and are therefore overly timid.”

Similarly, we will often reject a single gamble but will accept multiple plays of that same gamble (for example, a gamble where we will either gain $200 or lose $100). Thus an income annuity framed as a one-time purchase pitting a fixed result against unlimited future possibilities is unlikely to be seen as desirable. Instead, prospect theory recommends broadening the decision frame. Outcomes should be evaluated in terms of final assets rather than gains and losses associated with each choice. For example, research by John Ameriks, Robert Veres, and Mark Warshawsky shows how income annuities need not be an all-or-nothing proposition (ideally they should not be). The authors do not try to find an optimal annuity amount, but they do show how annuitizing a portion of one’s savings can help improve success rates for a 4.5 percent withdrawal rate.

The “annuity puzzle” remains a vexing problem for advisors who are intent upon the best interests of their clients. But if dealt with carefully and communicated fairly and well, the value of guaranteed income can be demonstrated to many consumers.

 

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