by Harold Evensky, CFP®, AIF®
Harold Evensky, CFP®, AIF®, is chairman of Evensky & Katz in Coral Gables, Florida. He is an internationally recognized speaker on investment and financial planning issues and is the author of Wealth Management and co-editor of The Investment Think Tank: Theory, Strategy, and Practice for Advisers.
Once again, welcome to my foray into the world of applied research of interest to financial planning practitioners. Unlike many past contributions, this time it’s not focused on a single subject, but fear not, there are still a few papers that address the ever popular subject of sustainable withdrawal. Other subject areas include behavioral finance, neuroscience, active management, and portfolio tax management. Now, here are the details.
“10 Questions: Daniel Kahneman on the Psychology of Your Clients … Oh, And Your Own Mental Hiccups,” by Christina Nelson, Journal of Financial Planning, October 2012.
Readers of my past columns and my book Wealth Management, know that I consider behavioral economics one of the single most important areas of knowledge for practitioners; so, no surprise that I rank this short but thoughtful interview at the top of my must-read list. With numerous references to his recently published book, Thinking Fast and Slow (another must read), this interview taps Kahneman’s thinking regarding behavioral issues, such as overconfidence, and loss and risk aversion. I particularly enjoyed his dance around the benefits of active management. After starting with the disclaimer that he is neither a financial expert nor has he researched the issue, he mused, “There are examples of people who appear to have skill in understanding large trends in the market, and I wouldn’t bet against that. I will add, though, I don’t know of any research that supports it. The little research that I have seen indicates that people are not strictly good on average tactical allocation.”
“Applying Neuroscience to Financial Planning Practice: A Framework and Review,” by Russell James, Journal of Personal Finance, Volume 10, Issue 2, 2011.
Although this paper is chronologically a little dated for material I would normally cover, I only recently had the opportunity to carefully read it, and I consider it far too important a contribution not to introduce you to it. The author, Russell James, a professor in the Department of Personal Financial Planning at Texas Tech, is on the cutting edge of applying the technological advances in brain imaging to uncovering information about how we make financial decisions. This exhaustive paper first reviews neuroscience methodologies and then introduces a two-system model of human decision making similar to Kahneman’s System 1 and System 2. In James’s system there is the rational “rider” characterized by overconfidence and deficiencies in speed and endurance, and the emotional “elephant” characterized by time preference myopia, emotional market processing, and loss aversion.
The paper then follows with a review of the research findings and concludes with what is probably the most exciting section for practitioners, applications of the framework in financial planning practices.
“Murder on the Orient Express: The Mystery of Underperformance,” by Charles Ellis, Financial Analysts Journal, July/August 2012.
Charles Ellis has been one of my favorite investment gurus ever since I read his Investment Policy: How to Win the Loser’s Game back in the early 1990s. Based on the theme of Agatha Christie’s famous story in which no one suspect was guilty—all were guilty, Ellis studies the long history of underperforming institutional portfolio management and concludes that all the participants—investment managers, fund executives, investment consultants, and investment committees—all contribute to the underperformance. As an example, regarding fund performance, he reports that in random 12-month periods about 60 percent underperform, and when lengthened to 10 years the underperformers rise to about 70 percent. Other research concludes that on a risk-adjusted basis 24 percent of managers fall significantly short of their benchmark, 75 percent roughly match the market, and well under 1 percent have positive returns after costs—an amount that he notes is not statistically different from zero.
After detailing the behavioral traps faced by the participants, Ellis concludes, “… none of the four guilty parties is ready to recognize its own role in the crime. Each participant knows that it is working conscientiously, knows it is working hard, and believes sincerely in its own innocence. Indeed, nobody seems to even recognize that a crime has been committed—nor to realize that until they examine the evidence and recognize their own active roles, however unintentionally performed, the crime of underperformance will continue to be committed.” This is not only a valuable thought piece for practitioners who continue to chase active alpha, but it also may be a useful paper to share with clients.
“Retirement Roundtable: Safe Withdrawal Rates: What Do We Really Know?,” by Michael Kitces, Journal of Financial Planning, October 2012.
I could not possibly do a research column without including something on safe withdrawal rates. In this wide-ranging interview, Michael Kitces (himself a leading authority on the subject) interviewed three of the other most respected gurus on the subject: Bill Bengen, Jon Guyton, and Wade Pfau. Starting with the most obvious question, Kitces asked, “What do you consider to be the safe withdrawal rate?” The responses ranged from Pfau’s, “I wouldn’t be that comfortable going much higher than 3.5 percent at the current time” to Bengen’s, “I’m still using 4.5 percent,” and Guyton’s static, “between 4.5 percent and 5.5 percent,” and when allowing for some adjustments along the way, “between 5.5 percent and 6.5 percent.”
The well-worth-reading interview then covered related subjects, such as the importance of asset allocation, the availability of software tools, the impact of fees and expenses, and the role of annuities. Somewhat to my surprise, both Bengen and Pfau were positive regarding the use of immediate annuities, while Guyton was a bit more skeptical.
“Making Retirement Income Last a Lifetime,” by Stephen Sexauer, Michael Peskin, and Daniel Cassidy, Financial Analysts Journal, January/February 2012.
Although much more limited in scope, this paper is focused on the same safe withdrawal theme. Its major contribution is the design of a decumulation benchmark comprising a laddered portfolio of Treasury Inflation-Protected Securities (TIPS) for the first 20 years and a nominal deferred life annuity purchase with the balance of the assets. In today’s market TIPS would represent 88 percent of available capital with 12 percent allocated to the annuity. The authors propose that this strategy might be used as a direct investment strategy or the benchmark for evaluating other aggressive strategies.
“Two Key Concepts for Wealth Management and Beyond,” by William Reichenstein, William Jennings, and Stephen Horan, Financial Analysts Journal, January/February 2012.
Like the Kitces interview, this is another paper reflecting the thoughts of three preeminent experts on the subject. In this case the subject is tax management. The first key concept is that “a tax-deferred account is analogous to a limited partnership in which the investor is like the general partner and owns (1-tn) of the partnership interest, where tn is the marginal tax rate when the funds are withdrawn.”
As the authors point out, under this conceptual framework the after-tax value of the TDA is tax exempt, not tax-deferred [my emphasis]. The second key concept is that “the government shares in both the risk and return on assets held in taxable accounts.” After introducing the key concepts, the paper goes into detail discussing their implications in determining portfolio optimization and allocations, asset location, selection of saving vehicles, implications for Roth conversions, withdrawal strategies, and estate planning. Serious food for thought.
“Portfolio Diversification: An Ongoing Objective,” a Morgan Stanley, Global Investment Committee Special Report, March 2012 (available on Google Docs).
Although criticisms of modern portfolio theory (MPT) and the importance of diversification have existed since Harry Markowitz published his seminal paper in the Journal of Finance in 1952, they have reached a crescendo post the Great Recession. If you fall into the camp of MPT skeptics, you might find value in this special report from a major brokerage firm. While acknowledging the fact that many correlations have significantly increased during the past two decades (for example, correlations of MSCI US vs. MSCI EAFE in the 1990s was a tad over 0.4 versus approximately 0.8 today), Morgan Stanley research makes a strong case that “portfolio diversification, when properly executed, can improve performance by smoothing out the bumps that occur in very difficult investment environments.” As a bonus, the report includes the firm’s projected 20-year returns for a wide variety of asset classes and styles.
“Modern Fool’s Gold: Alpha in Recessions,” by Shaun Pfeiffer and Harold Evensky, Journal of Investing, Fall 2012.
You might guess from the author listing that I’m a bit biased regarding this paper, so I’ll simply provide you with a few excerpts from our conclusion in the hope you find it of enough interest to read the full piece.
“Using 20 years of monthly data, we find active portfolio management fails to add value above the higher cost it imposes on investors. These findings are relevant to both expansions and recessions.… We also find weak persistence in performance across business cycles.… Specifically, the correlation between performance ranks across business cycles is less than 10 percent in all scenarios examined…. Income, the lack of aggregate active portfolio management performance across business cycles, and risk associated with repeat performance should be considered when determining whether a passive or active fund manager is appropriate for the investor.”
I hope you enjoyed this month’s column, and even more important, I hope you find elements in these papers that help you improve the quality of the advice you provide your clients.