As someone who runs (hahaha) a podcast, I am in awe of how the guys behind the Rational Reminder continue to find interesting topics to review after more than 300 episodes. Someone said that personal finance was a solved problem—sure. Or maybe, even in this small niche, we also amuse ourselves to death.
“how to choose an asset allocation” is a great topic! How come I didn’t think about it? We are going to steal it for our podcast. This is sort of a primer on how I would have (and will) addressed some of the points, the less boring ones. I’ll try to make them less boring.
What is risk?
Risk is not only volatility. If I were a diligent blogger, I would list all the previous posts where I wrote about the shortcomings of framing risk only as volatility, but there are too many. Go read the rest of the blog 😉
Risk profile and behavioural loss tolerance
Behavioural loss tolerance is pretty subjective, psychological. it depends not only on who you are but also on what experiences you had in life and when. Grew up in the 70s? You probably spent your whole life fearing inflation, even if it didn’t manifest itself again for 50 years.
There isn’t much to say about this, other than it is real. How would you know your personal loss tolerance? How do you know if it is a permanent trait or if it changes through time? Would a survey, however clever, ever be able to tell you?
I do not know. My solution to this is: the more you study, the better it is. I do not hold a particular interest in knowing what are my chances of getting colon cancer or what’s the probability I’ll speak with a doctor who doesn’t understand statistics. Yet I do read about these topics because it is too important. At the cost of watching one less NBA game in my life, it is a sacrifice I can make. Like you are doing by reading this (ok, maybe it is not the most efficient or accurate for you…I am sorry; trying my best here :))
Plus you can stick the question on any version of ChatGPT and you would get a reliable reply.
The ability to take risk
That’s your capacity to hold a risky asset without needing to sell in the short term to fund your expenses. I talked about it here. While many look for solutions in their asset allocation, the most effective ones are to eliminate the expense in the first place and/or to grow your salary. Keeping “your burn”, your fixed expenses, low doesn’t mean being frugal: you can easily live a rich life (as Ramit Sethi would call it) while keeping flexibility in your outflows. You can always move to a smaller place to reduce your rent, you cannot reduce your mortgage payment as easily.
Sure, flexibility has a cost. That’s why you pay a premium when you buy an option. But you can fund that flexibility cost by running a more aggressive asset allocation. It is not 100% money in the drain.
Your ability to take risk
My whole blog is dedicated to this topic. Really.
Unless you are a very lucky person, either you took risk in the past and now you do not have anymore (working hard, choosing the right company to work for, progressing in your career is a risky choice) or, most likely, you have to take risk.
They call it ‘ability’, like we have a choice but in some relevant cases, funding your retirement, is a must. I am more convinced so now that I got the opportunity to work on a couple of defined-benefit pension plans. While there are few (no?) companies that offer these plans to their employees, many have to manage legacy plans. One way to remove the issue is to sell the whole bag, assets and liabilities, to an insurance company. A Buy-out, as it is called.
There is an actual market for buy-outs, with several insurance companies competing for deals. Therefore there is a reliable price, which is driven in large amounts by longevity risk. Looking at those prices, the clear conclusion is that longevity risk is fucking expensive to hedge. That’s the technical definition.
Guess who also bears longevity risk? You and me.
As Europeans, we are not used to worrying about that risk because it was customary for public pensions to cover it for their citizens. But a quick scan of French politics will bring you up to speed on who woke up and smelled the coffee: countries are already choked by debt and there is no way they can carry that pension burden anymore. If it is not already your risk officially, it will soon be.
The safest way to hedge longevity risk is to buy an annuity. But as I was saying before, annuities are expensive. And in most cases, you are going to trade longevity risk with inflation risk: most annuities guarantee a nominal perpetual payment, not an inflation-adjusted one.
Even if an annuity allows you to retire without having to worry about market risk, unless you save like a maniac (and leave a big amount of ‘opportunity’ on the table), you have to take market risk in order to accumulate the necessary amount to buy the annuity.
By market risk I mean any type of risk premia you might get by investing in different asset classes.
The other market risk-free alternative is to build a ladder of inflation-linked bonds to achieve liability matching. But this solution requires again maniac level of savings (you are saving 1 today to have 1 of consumption later, your savings do not work in the meantime for you) and leaves the longevity risk open; without mentioning the issue that those inflation-linked bonds might not even be available anymore.
Therefore, yes, market risk.
In this context, market risk is not volatility but permanent loss of capital. You still have the volatility issue, i.e. you chicken out when you see your investments go down and sell, but the main risk is that you will have to sell part of your portfolio to fund your consumption (or to buy the annuity) when its value is down. That’s it, that is the permanent loss.
A geeky note
Imagine you are entering retirement at 65: you have calculated your planned expenses and you have 30 years’ worth of expenses saved, all in cash (let’s assume cash would protect you from inflation, year after year). You only have longevity risk.
Would changing your portfolio to any combination of risky assets increase or decrease your total risk?
Unless your longevity risk has a negative correlation to market risk, moving your portfolio away from 100% cash means you are increasing your total risk. To me, this was not intuitive. Probably because my mind jumped to the conclusion that stocks become less risky the longer you stay invested, making the two risks…negatively correlated?
Are stocks less risky the longer you stay invested?
My issue with the Rational Reminder gang (and my intuition)
Ben Felix during the episode mentions the fact that there is research out there confirming this property of stocks: the longer the horizon, the lesser the risk. Which is the inverse for nominal bonds, btw.
I do not remember who said it in another podcast I listened to recently but the above sentence is not 100% true. Sure, the longer you go, the narrower the stock return dispersion; but if you look at it in terms of terminal value, compounding something at 8% for 30 years is a lot different than 9%. Compared to the spread between -47% and +50% that you can have on any calendar year, sure 8% to 9%, usually the way those figures are presented, feels super tight.
that’s the first image I found on Google to give you the idea
When you use stocks to fund your retirement, that -37% can always be your next year. In other words, you are always exposed to that yearly volatility and related sequence of returns risk. If you need the money, stocks are not less risky; the path matters.
In this context, I do not understand why the RR spent the whole episode with a one-dimensional mindset: do you want to increase your expected returns? Add stocks.
But obviously, only up to 100%.
For a team that reads a gazillion of research papers, I do not understand it. They mention leverage only as something that can add risk but they never concede that a diversified portfolio with leverage can be less risky than a single-asset, unlevered portfolio. For them, leverage is either too expensive or too hard to manage…or both. Considering that a big chunk of their clients are entrepreneurs who had to manage leverage to build a successful business…I do not know…
Now that we have Return Stacking retail products, aren’t they the solution? Cheap leverage and collateral management issues delegated to a pro? According to them, no. And the reason is, if I understood it correctly, their tracking error.
FFS they are financial advisors! Explain to your client what’s going on here. If the potential issue is that your client sees their portfolio going left when the TV tells them everyone is going right, isn’t that YOUR ROLE to explain why this is happening? That tracking error is one of the reasons why the strategy works, you simply (?) have to suck it up. God forbid NTSX or RSST start to outperform SPY and now you have to use that dirty sentence “We are beating the market”. Even if that’s clearly not the way to frame it.
If you just walk the client on the bond-stock efficient frontier, you decrease YOUR risk (as a financial planner): the risk of losing the client. But then, what was the point of reading all those papers?
I guess eventually they say it: evidence-based investing can only go so far. “evidence is like a butt-hole, everyone has one”. At least these days. During the episode, they make a comparison with nutrition, which is wrong. One thing is to say that we are influenced by the most recent fad, one thing is to change a conclusion because we have new evidence.
If God comes to knock at my door tomorrow, I’ll definitely change my mind but I’d not consider my prior convictions wrong.
More data, a better formula, a new insight, there can be many ways in which what we consider today optimal might not be so tomorrow. Maybe there is not enough evidence, as they indirectly argue about factors. Let’s just do a small tilt. I understand the approach. Maybe we will never have definitive evidence.
But is the evidence so weak in regard of a diversified, reasonably levered portfolio for someone who wants to take max risk?
An evidence-based podcast with no evidence?
I came for the asset allocation, I stayed for the mental gymnastics.
Ben starts the episode by assuring the audience that, now that they got bought by a private equity firm, they would not change their opinion about private equity. 40 minutes later, one of them praises the virtues of volatility laundering for very low-risk investments. When confronted with the big issue, it is the exactly same point private credit guys use, he concludes that if helps the client behaviourally, then is good.
Again: that. is. your. role.
Imagine if your client suddenly needs the funds: isn’t it better if they were invested in a liquid instrument? It is your role to hold their hands, not tie their hands behind their back. Then simply allow them to access your investment platform/report once every quarter, job done. Total laundering.
I guess the problem with private investments (equity, credit and venture) is that their risk goes beyond volatility: there is a high chance of a permanent loss and the performance dispersion between each fund is huge.
Still, if the point in favour of volatility laundering is behavioural, then where does evidence go? There is evidence that we, humans, have biases. OK. But then we are also all different, is that still evidence of something? Is it fine to pay an illiquidity premium to correct a bias? What about LowVol, a factor that (should) work because others have a bias towards lottery ticket type of investments and, guess what, distaste for leverage. Shall you recommend it, if the point is to collect a premium? But then what about leverage, shouldn’t they be…right about it?
Shouldn’t the point of evidence based investing to push to stomach volatility and then collect a premium, rather than swipe it under the rug?
Let’s be clear: I understand the conundrum for the RR guys. I am old enough to remember when Ritholtz Wealth was about evidence-based investing. Now the word evidence is nowhere to be found on their website. But their content is full of arguments like “hey, you like high ‘dividends’? then JEPI is a fine product”.
I might accept the logic as long as it keeps you invested from content creators targeting entry-level investors; I have a hard time taking it from financial advisors that cater mainly HNW individuals. But what do I know…
What I am reading now:
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