How reducing exposure to a catastrophic event, such as running out of money during retirement, is a better strategy than trying to accurately predict a catastrophic event.
In this episode you’ll learn:
- How repeated exposures to low probability events can lead to ruin.
- How bonds have outperformed stocks over long stretches of time .
- How the success of retirement spending rules depend on the market environment and why a flexible approach to retirement spending makes the most sense given the wide variety of risk factors.
Stock Market Charts You Never Saw by Edward F. McQuarrie
The First Eighty Years of the US Bond Market: Investor Total Return from 1793, Combining Federal, Municipal, and Corporate Bonds by Edward F. McQuarrie
Evaluating Gambles Using Dynamics by O. Peters and M. Gell-Mann
Antifragile: Things That Gain from Disorder (Incerto) by Nassim Nicholas Taleb
Skin in the Game: Hidden Asymmetries in Daily Life by Nassim Nicholas Taleb
Living Off Your Money: The Modern Mechanics of Investing During Retirement with Stock and Bond by Michael H McClung
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David takes listeners back to the root of his investment strategy with one simple investment rule in this exciting 250th episode of Money For the Rest Of Us! What truly matters when considering how to diversify your portfolio and save for retirement is avoiding what will ruin you. Author and investor, Nassim Nicholas Taleb, said that “I effectively have organized all my life around the point that sequence matters and the presence of ruin disqualifies cost-benefit analysis.” How does recognizing that life is lived along the sequence of time influence investment decisions?
Modifying your exposure to fit the risk and avoid ruin
David shares the story of a friend who was diagnosed with an aortic aneurysm. The big decision facing his friend was whether or not to endure an open-heart surgery to fix the aorta. When he considered the statistics, he was informed that he risked a 7% chance in any given year that the aorta would dissect. If it did, the risk of death is extremely high. Open heart surgery, on the other hand, carries a 1% risk of death during procedure, but the risk of dying after a successful surgery decreases. David explains that if you were to keep having the surgery every day, then you’d eventually die from it—just as you would from an untreated, dissected aorta. But life is lived out through time, and catastrophic events—such as a dissected aorta—must be avoided as much as possible, leaving the open-heart surgery as the better option.
Investing is much like the medical decision that David’s friend had to make. Modifying your exposure to unnecessary risk should be the driving force behind your investment decisions. While not all investment decisions will be lucrative—or even prove safe in the long-run—you have control over continued exposure. Just like a medical tragedy, there is no going back in time to fix poor exposure. The key is to fix negative exposure before it can cause further damage—or any damage to begin with.
Conditions to look for when deciding between bonds and stocks
David considers the history of trading in the U.S. with stocks and bonds. Referencing charts from 1926 that show the return on a dollar invested over time through both mediums, the results are rather surprising. In many scenarios, bonds outperformed stocks over extended periods, even 30-year periods—about the time we tend to save for retirement. In the long run, stocks outdid bonds, but in the short-to-intermediate term, the results varied depending on the period. Theoretically, stocks should always outperform bonds—but this is obviously not always the case. Why is this, and what can you look for when trying to decide which option will prove more profitable—without excessive risk?
It all depends on the conditions. The driving factors behind stocks are cash flow as reflected by dividends, how dividends and earnings growth over time, and the value that investors place upon the cash flow. Bonds, however, are simply driven by cash flow—and sometimes by changes in interest rates. It’s important to understand where we are today in terms of dividend yield. The dividend yield on U.S. stock is below 2%, whereas global stocks are expected to have a higher return due to a higher dividend yield. With bonds, it’s currently the opposite, with higher yields in U.S. bonds than global. David encourages listeners to simply be aware of what is happening in the economy right now so that they can make the best, low-risk decisions to best prepare for the future.
Spending rules to consider when living off retirement
There are several investment rules when it comes to spending in retirement. David unpacks a few of them, following the experimentation of Michael McClung in his book, Living Off Your Money. While the traditional strategy is to spend 4% of your retirement nest egg and increase or decrease that amount based upon inflation in future years, there are other options. McClung recognizes that there are risks to living off retirement, and he takes different strategies and considers their historical performance.
What is the maximum withdrawal rate in any given strategy? In the best-case scenario, you could spend 4.4% of your nest egg in the initial year and not run out over the next three decades. That wasn’t the case in all strategies, however. Some maximum withdrawal rates ran rather low at 2.2% in the UK. An important aspect of McClung’s work is that he then went on to consider what the maximum withdrawal rate could be without taking into consideration the 10% worst-case scenarios. The rate rose dramatically. David explores why this is perhaps not a wise way to approach retirement spending, however. What if one of those worst-case scenarios were to happen? The number one rule is to avoid ruin. A better way to approach retirement spending is to evaluate how your portfolio is performing every year and adjust when necessary to promote the longevity of your retirement savings. Be sure to listen to the entire episode for further insight into other spending rules and considerations.
Avoiding ruin should be the foundational investing rule of your investment strategy
David explains that while one can study case scenarios and try different strategies, there is only one shot that we have at life and retirement. We live along the sequence of time, and we cannot make financial decisions outside the space of time that will not in some way affect us and our future. Ways to help modify the risk are to keep your portfolio diversity, balance your investments, and create redundancies. Being flexible in your approach to your portfolio can help keep you from sticking with unnecessary exposure. Have buffers, and create a retirement plan that won’t lead you into potential ruin.
- [0:20] Celebrating 250 episodes – thank you for listening!
- [1:51] Three individuals who have greatly influenced David’s passion for good investing.
- [2:37] The sequence of life – and how you are affected by it – matters.
- [9:21] Defining risk and modifying exposure.
- [9:53] Case study: bonds vs. stocks.
- [15:34] The conditions for premium dividend yield.
- [18:00] Spending rules for retirement.
- [23:04] Considering worst-case scenarios.
- [26:10] Best strategies for retirement planning.
Welcome to Money For the Rest of Us. This is a personal finance show on money, how it works, how to invest, and how to live without worrying about it. I’m your host, David Stein. Today is episode 250. 250 episodes! It’s titled, “Rule Number One—Avoid Ruin.” Next month, May 2019, will be my fifth anniversary of the podcast. I’ve recorded over 250 episodes. This is numbered episode 250. The show has had over 10 million downloads. There are a thousand premium subscribers who are members of Money For the Rest of Us Plus. They get the ad-free version of the podcast plus additional content. There are over 220 Q&A plus episodes, dozens and dozens of monthly investment conditions reports, model portfolios, so I’m producing a lot of content. By doing so, I get better. That’s what I’ve learned about doing the show or doing anything for some length of time. It’s that way with investing, it’s that way with audio, it’s that way for video. I record a weekly video or most weeks on YouTube, I’m getting better.
There are things I know about audio recording now that I didn’t know five years ago that didn’t even occur to me, small nuances. I do the show because it helps me learn, but it also helps me to improve on my craft. Thank you for listening. For many of you who listened from the beginning, thank you for sharing the podcast with others. That, I really, really appreciate. Just to note, Money For the Rest of Us Plus usually is closed to new members but it’s now open for spring 2019 enrollment. You can check that out at moneyfortherestofus.com.
There are three individuals that I have learned the most from when it comes to investing. They influenced how I manage money as an investment advisor and they influenced how I manage money today. The first is Seth Klarman who runs the Hedge Fund Baupost Group. He used to manage or still manages money for one of my former clients. I spend a lot of time—or some time with him. Certainly, many hours reading his annual letters but also spent some in-person time with him over the years.
The second is Ned Davis of Ned Davis Research. I have subscribed to their service for over 15 years and I’ve learned an incredible amount from him and his colleagues at Ned Davis Research. The third person is Nassim Nicholas Taleb. One of his teachings I want to share today, it’s from Skin in the Game. From that, I derived the number one rule of investing, which we’re going to talk about. That number one rule is avoid ruin. Here’s what Taleb wrote, “I effectively have organized all my life around the point that sequence matters and the presence of ruin disqualifies cost-benefit analysis.” What does that mean that “sequence matters and the presence of ruin disqualifies cost-benefit analysis?”
The sequence of life matters
This past week I was visiting with a friend. He was recently diagnosed with an aortic aneurysm. An aortic aneurysm is “an abnormal bulge in the wall of a major blood vessel,” the aorta that carries blood from your heart to your body. That’s from the Mayo Clinic describing that. It’s the same condition that I have. I’ve mentioned it on the show, but I don’t mention it very often because mine is fairly benign. I have it checked every two years by the Cleveland Clinic. It hasn’t changed.
His is much more severe and the risk of dissection, effectively the aorta tears, is much higher for him, so he’s contemplating open-heart surgery to replace this section of the aorta that has the bulge with a fabric graft. The doctors tell him right now untreated, he has a 7% risk of dissection in any given year. I looked it up and found that about 20% of patients with the aortic dissection, essentially it tears, die before reaching the hospital. Without treatment, mortality rate is about 30% in the first week, 80% after two weeks and 90% after one year. The hospital mortality rate, if you go in and you’re treated, mortality is 30%. When I researched this, probably been 10 years or so since I was diagnosed, one quote I remember, it was—you do not want the surgery. The mortality rates at the time were over 5%. I searched not knowing anything about this—who am I going to go to for help? I ended up choosing the Cleveland Clinic because they published the statistics of their outcomes. I shared the statistics with my friend.
Cleveland Clinic does 500 to 600 elective ascending aorta repair surgeries per year. The mortality rate has averaged 1.2% per year for the past five years, 2.7% risk of stroke during operation. My friend is in his late 40s. A healthy individual in his late 40s has about a 0.4% probability of dying that year. This is according to the Social Security Administration. Here’s the decision to make. There’s a 1% chance of probability of dying during the operation based on the statistics at the Cleveland Clinic, but there’s a 7% probability of dissection of the aorta, in which case the risk of dying increases. You can’t compare the 1% probability of surgery death to the 7% probability of dissection. These probabilities are across an entire population, which means seven out of a hundred individuals with a severe aortic aneurysm will die this year. If each year there is a 7% probability you will die from an aortic dissection, then as time passes your probability of dying approaches 100%. You’ll die sooner rather than later but that’s different for the surgery.
Well, in some ways it’s the same. If you had this surgery every year and there’s 1% to 2% chance of dying, eventually it wouldn’t work out and you would die. In his case, he just needs to do the surgery once and by doing so, his probability of dying in any given year will fall significantly. What Taleb means that sequence matters is that we live through time, that we are changed by events as time passes. If there is an event that can ruin us, can kill us, bankrupt us, particularly with repeated exposure such as the case with my friend, he has repeated exposure to the probability of his aorta dissecting. If we have that repeated exposure then it’s better to reduce it rather than trying to get better at forecasting probabilities, it’s better to just reduce that exposure.
There’s a paper by Ole Peters and M. Gell-Mann called, Evaluating Gambles Using Dynamics. They write, “Gambles are often treated in economics as so-called one-shot games, meaning they are not part of any dynamic and are assumed to reside outside of time.”
A Monte Carlo Simulation where you run 5,000 iterations on a particular portfolio, that takes place out of time. We’re not living through that. It’s a statistical analysis, but in life we are changed by the events. We just get one shot and we’re going through time. We’re not calculating probabilities outside of time. They continue. “If we lose our house, we cannot bet the house again. The typical decision problem only makes sense in the context of a notion of irreversible time in dynamics. We cannot go back in time after the gamble and our future will be affected by the decisions we make today.” When we talk about avoiding ruin, the reason why is because once it’s here, we can’t go back in time and so it’s better to do things now to avoid it. Taleb writes an antifragile, “the payoff, what happens to you, (i.e., the benefits or harm from it) is always the most important thing, not the event itself.”
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