The beauty of a rationally irrational investment approach
Our investment strategy needs to take psychology into account.
Money is fungible (a £ is a £ wherever it is) so we should consider our investments as a single integrated portfolio. This portfolio has an accumulation phase (saving while we work) and a drawdown phase (spending in retirement). History lets us calculate a ‘safe withdrawal rate’: the percentage of our portfolio we can spend each year in retirement without risk of running out of money.
Equities outperform over the longer term if we’re prepared to stay the course and ignore short term volatility — we should stay invested at least 75% in equity markets over the long term in a way that minimises costs. We should regularly rebalance our portfolio to maintain our risk profile. A faith in markets and financial theory can help us get the highest return from our money if only we can overcome our behavioural biases.
Gurus of the financial independence world make it all sound so easy, don’t they?
The behavioural finance app MyBe tells me that I’m in the extreme tail of rationally-oriented individuals, in theory amongst the least prone in the population to financial behavioural biases (you can hear more about behavioural biases in Pete Matthew’s interview with the app’s creator Neil Bage on The Meaningful Money Podcast.)
It’s the least I could hope for after years of training as a mathematician and actuary, and a career working in a financially-related field. I understand the theory and have a detailed understanding of the historical data. I should be able to invest in the theoretically optimal way, resilient enough to resist the siren calls of self-damaging investor behaviour. But I don’t. And as markets tumble (the time of writing is late February 2020, in the middle of the COVID-induced market meltdown) I’m glad I don’t, because if I were ‘optimally’ invested, I don’t think I’d be as calm as I am.
How rational am I really?
This issue is particularly relevant to me because at the time of writing I’m soon to retire from PwC, where I’ve been fortunate to have a highly enjoyable career for 24 years. I’ve decided to renew myself in a different career and to enable a different lifestyle for our family, exchanging money for time. I’m not yet sure exactly what that’s going to mean. What I‘m finding is that this is an exciting yet daunting period. Life is full of questions and uncertainty. Have I done the right thing, moving on when I’m at the peak of a challenging and well-paid career at PwC? Will I be able to make a success of the future? What do we really want to make of our lives in this next phase? What’s the right next step?
But one thing’’s for sure: my income is going to plummet. So the performance of our investment portfolio will become more relevant than ever. And the last thing we need is to be anxious about money as we start this new venture.
A mountain of research based on history tells us that people in our position looking to draw an income from their investments over a period of decades would almost always have been better off if they remained fully or largely invested in equities throughout their life as opposed to investing in a mix of equities and safer assets such as bonds (OK, there are some time periods when up to 25% in bonds would have been better but only by a minuscule amount). Invested this way they can withdraw a steady inflation-linked 3% to 4% of their initial portfolio — the so-called safe withdrawal rate. J L Collins provides an easy-to-read summary of this based on US data in The Simple Path to Wealth. Abraham Okusanya provides a more technical and UK-oriented analysis in Beyond the 4% Rule, which if you like data and analysis is a must-read on retirement income planning.
So as a supposedly super-rational investor what do I do? Rather than being fully invested in equities we’ve only got around two thirds of our assets in this class, with the remainder in a mix of Index Linked Gilts (with a current real yield of –2.5% pa, am I mad?) and cash, with some gold and fixed income bonds for diversification. Rather than thinking of our portfolio as a single fungible whole, we think about it in distinct buckets. And so far we’ve never rebalanced between them.
What’s going on?
The importance of psychology
Our approach may well cost us financially over the long term. Potentially a lot — I’ve modelled it. So if I know this why do we do it?
For the following reasons:
- Remaining fully or largely invested in equities requires you to be able to withstand high levels of volatility while staying the course. That’s all very well while you’re earning and not touching your assets. But when you are entering the period where you are starting to spend your assets rather than adding to them, the thought of a significantly falling asset pot is suddenly a lot more nerve racking, even if you know that in past periods it would always have worked out fine.
- This time really could be different. Historically equities have outperformed risk-free assets such as government bonds to an extent that isn’t easy to justify. In part this has been the result of a unique set of circumstances driven by extraordinary economic growth and the rise of America over the last two centuries — a winner’s premium — in turn driven by a probably unsustainable boost from fossil fuel consumption. With the various headwinds caused by climate change and demographics, this time genuinely could be different (even it would have to be very different to make our index-linked gilts look good value).
- Sequence of returns risk is a real issue. This means if you have very bad returns at the start of the period where you are drawing down on assets to fund your expenditure your pot can deplete scarily quickly. Markets might turn in your favour in time to stop your assets running out (in the past they always have) but then again they might not. Abraham Okusanya shows that aggregate retirement income is disproportionately affected by investment returns in the first decade. This is because if your investments are falling, you are pulling out an increasing proportion of your assets, leaving less money to benefit when market returns pick up again.
Looking at the historical data on the rational, optimal investment approach these risks are all manageable, but they incur a psychological cost.
Kicking the bucket
So as we approach this new phase in our lives I’ve found it much easier to think in terms of buckets, of which we’ve got three:
- Short-term bucket — this is very low-risk cash-like assets to cover several years of expenditure.
- Long-term security bucket — this is largely a set of long-dated, index-linked gilts that provide a minimum level of income beyond age 70, which may not be ideal but means we can have what we’d consider a satisfactory minimum standard of living for our lifetime.
- Growth bucket — this is our equities, most of which we’ll be holding for at least a decade before we need them, and which all being well will fund the lifestyle we want to have, over and above the minimum.
Each bucket plays a specific role. The short-term bucket is particularly important because we don’t want to be worrying about what we’re spending in the first period of our new life when we’re young(ish) and healthy and have lots we want to do. I know that if we were fully invested in equities as markets plummet in response to the coronavirus, then I’d be feeling that we had to pull back our expenditure to avoid depleting assets too quickly, even if history might say this was unnecessary. But this is a period in our life when that’s exactly what we don’t want to be doing. Being arguably over-invested in cash enables us to relax about the immediate future and enjoy the first years of our new life, and, importantly, not to allow financial worries to distract us as we go through our life transition.
The long-term security bucket tells me that — short of a UK government default — we’ll never be impoverished in old age. The index-linked gilts, even with their value-destroying negative real returns, will keeping dripping out enough over the years to keep us afloat. So even if this time really is different and we face a massive and sustained meltdown in equities, we’ll survive.
Our short-term bucket and long-term security bucket now enable us to take advantage of our inherent myopia by leaving the growth bucket alone. Because the immediate future is sorted and the long term future is protected as well as possible (neutering our loss-aversion), our natural short-termism enables us to defer any concerns about our equities. These will do what they will do, happily ignored by us for up to a decade (which probably means markets recovering, even if they’ve further to fall in the short term).
We never rebalance between the buckets — why would we? The short-term and long-term securities buckets each need to be big enough to fulfil their intended role and the growth bucket becomes the balancing item. This is an example of Richard Thaler’s ‘mental accounting’ — not always rational, but in my experience extremely soothing. Of course as we move through time we’ll need to refill the short-term bucket somewhat, supported by our equity returns, quietly delivering value for us, unobserved and undisturbed. But we’ll be available to avoid selling those equities in down-markets, quietly taking profits when markets are up.
Our suboptimal approach will almost certainly cost us financially in the long term, maybe by a lot. If we could tame our psychology we could have more money in the future — perhaps 20% more. But our approach brings psychological benefits today:
- We’re not at all concerned about the impact of recent market falls on our portfolio. It’s not something we lost any sleep over or even considered reacting to — nor will we even if we’re on the cusp of a bear market. We’re neither tempted to bail out of our equities nor facing the anxiety of rebalancing from our low risk assets into a falling equity market.
- We’re not feeling the need to tighten our belts or reduce our expenditure plans for the next decade because of financial concerns about what the future holds for markets.
- We don’t feel any concern about whether I’ve made a mistake in moving out of a well-paid job at a relatively early age — we don’t have financial anxiety tempering our happy anticipation of leading a different and freer (even though much less remunerative) life.
We modelled our investment strategy based on a series of thought experiments, imagining that at the start of our new life we faced very severe stock market falls. We tried to visualise in detail how we would feel about our financial security in a range of very real scenarios. How might we respond and how might we feel about the decisions we’d made? We then picked the strategy that best managed the tradeoff between the lifestyle we want to have and the anxiety we want to avoid. Our goal was not to maximise our long-term wealth but to ensure we would have enough while minimising our financial anxiety so we could enjoy the new life we’ve chosen.
The transition from earning to not earning (or at least earning much less) is a time of significant potential worry where major market movements could cause huge anxiety: history and theory may tell us the risks are small, but we only have one financial life. Our buckets approach helps us convince ourselves we’ll be OK and so sit out the noise in a way that otherwise we might not be able to.
What price is this worth paying in terms of lost returns? It’s almost priceless in terms of the sense of financial freedom created by an approach that fits our psychology. Even the most rational of us are psychologically frail. You need know your own personality and what it can withstand. It’s completely worthless to have a theoretically optimal investment strategy that is shipwrecked on the rocks of your psychology when a market storm comes. Our approach is right for us and is proving its worth to us right now. You need to figure out what’s best for you. The important point is that the theoretically optimal investment strategy is not always psychologically the best.
It’s rational to allow for your irrationality.
This blog first appeared on LinkedIn in February 2020 as markets fell dramatically.