QUOTE OF THE DAY
RETIREMENT FINANCE AND PLANNING
Sequence Risk: Managing Retiree Exposure to Sequence RiskThrough Probability of Failure Based Decision Rules; Frank and Blanchett [2011]
The hypothesis for this exploration is that POF based
decision rules can be developed to warn a retiree that his retirement
withdrawals during adverse returns sequences may put his distributions at risk
of depletion within his lifetime. With such a warning, these same decision
rules may suggest a method to adjust either the portfolio allocation and/or
withdrawal amount to avoid running out of money before death. The point of
reference for Guyton-type decision rules is based on an initial withdrawal
rate. This is, by definition, a time reference to some point in the past. But
what time point is relevant for this decision? This paper will shift the point
of reference for decision rules into the future by using a future oriented
reference point for the time function. This paper will also use current
withdrawal rates as opposed to initial withdrawal rates… Changing asset allocation
as a stand-alone strategy to address sequence risk is not effective. In other words, changing portfolio allocation in response to
sequence risk in ineffective… Arguably, no predictive metric may be available.
However, Probability of Failure appears to be an effective management tool as a
response to exposure to sequence risk.
The Dynamic Implications of Sequence Risk on a Distribution Portfolio. Executive Summary; Frank and Blanchett [June 2010 - Journal of Financial
Planning]
"sequence risk is always [emphasis added] present
in the short term, and can be measured indirectly through the current [i.e., as
measured or sampled in the unfolding future "present" moment]
probability of failure of the current withdrawal rate over the remaining
distribution period…the current year is the first year in the time sequence,
regardless of how many years remain in the sequence or how many years may have
passed." [I have blogged on this
fairly often before. I am surprised by how
infrequently I see this concept of an explicitly continuous retirement
discussed like this]
The Pitfalls of 'Sequential Risk', Dimitry Mindlin
The objectives and risks should reflect the best interests
of the stakeholders of
investment programs in the most straightforward manner. For
example, if the
primary objective is to fund a pre-determined level of
post-retirement spending,
then the primary risk should be defined as “a failure to
fund a pre-determined
level of post-retirement spending.” All scenarios that may
lead to this failure
should be considered. Doing otherwise may lead to
sub-optimal investment
solutions and be a disservice to the program’s stakeholders.
Commitment Driven Investing: The Essentials, Mindlin [2014]
The design of optimal policy portfolios can be put in a much
more expansive theoretical framework of game theory. The investor and his
ageing "clones" that make future asset allocation decisions can be
viewed as "players" that have objectives, actions, and preferences.
Under common rationality assumptions, an optimal policy portfolio should
represent a Nash Equilibrium (NE) strategy – one of the key concepts of game
theory. In general, Nash equilibrium policy portfolios are not stationary.
Thus, the CDI framework justifies evolving policy portfolios.4 … CDI is related to Liability Driven Investing
(LDI) – a much publicized framework for managing pension plan liabilities that
offers a range of liability driven investment strategies. CDI and LDI have the
same starting point – both frameworks are based on the objective to fund
pension benefits. The key difference is in the next step. In LDI, the next step
is the definition of a deterministic present value of pension benefits called
"liability." The investment objectives are specified next. The
"liability" plays a major role in the investment objectives – it actually
"drives" pension investing, as advertized in the title. LDI imposes
the following "order of operations": to define the
"liability" first and specify investment objectives next.
Furthermore, LDI promotes asset-"liability" matching as a proxy for
the funding objective. As discussed earlier, the "order of
operations" in CDI is exactly the opposite: to specify investment
objectives first and select the appropriate present values next. CDI
incorporates the funding objective directly without any proxy. The assumptions
in CDI are less restrictive than in LDI, therefore CDI is a generalization of
LDI.5
Regrettably, the proponents of LDI have skipped over certain
vital aspects in the development of a comprehensive approach to asset
allocation LDI is proclaimed to be. Somewhere between LDI’s origins and its
practical recommendations, certain shortcuts have been taken; certain corners
have been cut; certain unnecessary impractical assumptions have been made… While
LDI asserts that there is the single dominant measurement of the commitment –
the "liability," – CDI maintains that the multitude of challenges
retirement plans face require a multitude of measurements. Conceptually, LDI
and CDI are at odds… no accounting “liability” behaves exactly like a portfolio
of tradable bonds…. The claim that there exists a measurement of the commitment
(“liability”) that is superior to any other measurement and, therefore, must
“drive” retirement investing defies common sense. Virtually any object has a
multitude of measurements, and such a multifaceted object as a financial
commitment is no exception. The best measurement always depends on the purpose
of the measurement – the purpose comes first, the right measurement for the
purpose is selected next. In LDI, this "order of operations" is
reversed – a measurement is given first, purpose is given later (if ever).
Cash reserve buffers, withdrawal rates and old wives’ fables for retirement portfolios, Abraham Okusanya
So it makes sense to replace the bond allocation with a
little bit of cash. The key here though is not to overdo it. I have heard tales
of advisers holding five years’ worth of cash (by reducing equity allocation).
This approach doesn’t work unless you increase the equity allocation
significantly in the rest of the portfolio to compensate for the cash drag. In
any case, replenishing the cash reserve through systematic rebalancing will
likely result in poorer outcome than a fully invested portfolio. I examined the
results using UK
equities and UK
bonds instead of the global equities and bonds, and the key findings are
consistent. The point here is, if you’re going to implement a cash reserve
buffer, take it from your bond allocation. Equities aren’t the enemy!
The Misconceptions of Retirement Risks - Society of
Actuaries
- The key messages of this article are the following. The utilization of “low-risk” discount rates to discount “low risk” financial commitments is a choice, not a requirement supported by a sound economic theory. The claim that there exists “the only appropriate way to calculate the present value” is little more than an attempt to apply certain principles of finance beyond the scope of their applicability.
- The primary risks embedded in bond pricing and actuarial valuations are fundamentally different. The financial health of the bond issuer is at the heart of bond pricing. In contrast, the financial health of the pension plan – not necessarily the plan sponsor – is at the heart of a typical actuarial valuation.
- The uncritical application of the principles of bond pricing to pension funding is another example of a valid concept that becomes inapplicable when taken out of its proper context.
- The economic foundation for the requirement that pension benefits must be priced similar to tradable assets is shaky at best and probably non-existent.
- It is
hard to find an object that has one measurement that is clearly superior
to all other measurements. Virtually all objects have multiple attributes
that require multiple measurements. Yet, the proponents of “the only appropriate way
to calculate the present value”
essentially have designated pension benefits as an object that is uniquely
different.
A relevant portfolio is specified first; its return(s) and
related discount rate(s) are specified next… Traditionally, pension actuaries
calculate present values of pension commitments and the contributions required
to fund (not necessarily to price) these commitments. Yet the practice note is
virtually silent about traditional actuarial work… present values can be
calculated without discount rates. A discount rate is a choice, not a
necessity [emphasis added]
MARKETS AND INVESTING
When Michaud Optimization Fails, Michaud and Esch
The Markowitz and Usmen (MU) (2003) simulation study
reported Michaud (1998) mean-variance (MV) portfolio optimization superior to
Markowitz (1952, 1959) out-of-sample on average in each of thirty cases
examined. However, a simplified replication of the MU test found thirty percent
failures of Michaud relative to Markowitz. Instances of Michaud failures were
associated with asset risk and return characteristics inconsistent with
diversified portfolio risk management. Risk-return properties in professional
asset allocations and large universe portfolio optimizations may often be similarly
perverse. The simulation framework in Michaud (1998) can be a valuable
diagnostic for risk-return estimate diversification perversity when
appropriately applied. Our results underscore the necessity of investment sense
oversight and validation for successful application of quantitative methods. [not
read. This is here as a placeholder for future reading because I have read
other pieces of his work]
The Currency Conundrum. Damodaran
There is perhaps no more mangled nor misunderstood part of
financial analysis than the handling of currencies, and globalization has only
made the problems worse. From the laziness of assuming that government bond
rate in a currency is always the risk free rate in that currency, to
nonsensical notions like a global risk free rate, to bad practices like
discounting peso cash flows with dollar discount rates, the list of currency
sins is long. In this post, I look at three of the most common misconceptions
related to currencies and use them to update currency related numbers at the
start of 2018.
ALTERNATIVE RISK
Overconfidence in personal beliefs and inattention to new
trends are widespread in financial markets. If specific behavioural biases
become common across investors they constitute sources of mispricing and –
hence – return factors. Indeed, overconfidence and inattention can be
quantified as factors to an equity market pricing model and seem to capture a
wide range of pricing anomalies. This suggests that detecting sources of
behavioural biases, such as attachment to ideological views or laziness in the
analysis of data, offers opportunities for systematic returns.
Complexity Bias and Trend-following, Mark Rzepczynski
A manager comes into an office and talks about his use of
complex tools for extract unique and special signals and many will be jumping
across the table to invest. Another manager in the extreme says, "I don't
try to predict, I follow trends and buy what is going up and sell what is
falling" and it is a short meeting as you usher him to the elevator.
Why Does Momentum Investing Work? www.pragcap.com
The primary reason why this works so well is because it is a
systematic way of aligning yourself with the success of corporate America
over time. Corporate America ,
after all, is a big momentum machine that systematically kicks out inefficient
entities so that newer more efficient entities can take their place. As
consumers we tend to spend a little bit more money each year in a systematic
manner and that growing monetary pool gets spent across an ever changing group
of companies who compete for that money. This shows up in corporate profits in
what looks like a big stream of profits with ever increasing momentum.
SOCIETY AND CAPITAL
Contribute to Society…or else…, Andrew Ross Sorkin NYT
Textiles: Your Clothes are Pollutants, Tim Taylor
"[T]he way we design, produce, and use clothes has
drawbacks that are becoming increasingly clear. The textiles system operates in
an almost completely linear way: large amounts of non-renewable resources are
extracted to produce clothes that are often used for only a short time, after
which the materials are mostly sent to landfill or incinerated. More than USD
500 billion of value is lost every year due to clothing underutilisation and
the lack of recycling. Furthermore, this take-make-dispose model has numerous
negative environmental and societal impacts. For instance, total greenhouse gas
emissions from textiles production, at 1.2 billion tonnes annually, are more
than those of all international flights and maritime shipping combined.
Hazardous substances affect the health of both textile workers and wearers of
clothes, and they escape into the environment. When washed, some garments
release plastic microfibres, of which around half a million tonnes every year
contribute to ocean pollution – 16 times more than plastic microbeads from
cosmetics. Trends point to these negative impacts rising inexorably ..."
When Nudges are Forever: Inertia in the Swedish Premium Pension Plan, Cronqvist, Thaler, Yu.
To inform economists and policy makers about whether the
effects of nudges are persistent in one specific context, we study the choice
architecture of the Swedish Premium Pension Plan. The data we study consist of
all initial choices and subsequent rebalancing activities by the entire
population of 7.3 million retirement savers in Sweden
during the period 2000 to 2016. Based on our analysis of these data, we
conclude that the effects of nudging in this case were surprisingly persistent
and seem to last nearly two decades, if not forever. [beware of nudges. Depending on how one defines it it can be a
soft form of coercion that can be a foot in the door for other coersions…]
I find that the number of years a teacher must work before
she is eligible for her full pension benefit is the major driver of variation
in pension wealth. This specification has the benefit of a flexible baseline
hazard that can easily capture the sharp incentives driving a teacher’s
retirement decision that are dependent on her proximity to retirement
eligibility, and can flexibly account for differences driven by local labor
market conditions. These analyses highlight important unintended effects
Bitcoin and Illegal Activity, Tim Taylor
"We find that illegal activity accounts for a
substantial proportion of the users and trading activity in bitcoin. For
example, approximately one-quarter of all users (25%) and close to one-half of
bitcoin transactions (44%) are associated with illegal activity. Furthermore,
approximately one-fifth (20%) of the total dollar value of transactions and
approximately one-half of bitcoin holdings (51%) through time are associated
with illegal activity. Our estimates suggest that in the most recent part of
our sample (April 2017), there are an estimated 24 million bitcoin market
participants that use bitcoin primarily for illegal purposes. These users
annually conduct around 36 million transactions, with a value of around $72
billion, and collectively hold around $8 billion worth of bitcoin.
How Gender Diversity Enhances the Bottom Line, visual
capitalist
There are many arguments that can be made for closing this
gender gap, but the most compelling one is very simple: there’s a growing body
of research that shows that gender diverse companies make more money.
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