Five Retirement Processes - an Introduction

"Theories and models are attempts to eliminate time and its consequences, to make the world invariant, so that present and future become one. We need models and theories because of time…You can only be disappointed if you had hoped and desired. To have hoped means to have had preconceptions – models, in short – for how the world should evolve. To have had preconceptions means to have expected a particular future. To be disappointed therefore requires time, desire and a model…You can count yourself lucky if your model of yourself survives its collision with time."

– Emmanuel Derman, Models. Behaving. Badly. [2011] 

Everything changes and nothing stands still…You could not step twice into the same river.

– Heraclitus 

What little I’ve learned about retirement finance so far since 2015, the year I started my blog, tells me that there seems to be no real, perfect spending rule that will save me, except maybe with hindsight, and no such thing (serious academic papers notwithstanding) as a fixed optimal retirement solution, at least not a permanent one anyway. There is only, in the end, what I’ll call “flow.” By flow I mean that retirement is not an object or a thing or a solution or a "number." It is a process, a continuous unfolding-in-the-present of new and unstable circumstances, challenges and changes to which we need to respond anew in each one of those present moments.

Another look at the effects of time on terminal wealth in presence of volatility

I did this before a few weeks ago here.  This is the same thing with a different view. Most of the text is the same but with a different, integrated chart.

The following are mass functions from simulated, empirical frequency distributions (3000 iterations) of terminal wealth after 10 periods under two scenarios:

1. Normally distributed returns with mean = .09 and standard dev = .25 (high risk)

2. Normally distributed returns: (50%) r=.08, sd=.18, (50%) r=.035, sd=.04 (diversified)

This is a little apples and oranges, and the "normal" assumption for returns is for ease of analysis, but I wanted to see the breadth of the distributions vs the modes and try to get a general intuitive sense of likelihood related to "positive" outcomes, however that may be defined. The risk free rate of 3% (arbitrary) is the grey area. Y axis is mass, X is the terminal wealth bins. Note that there is no consumption and there are no fees, taxes, inflation, etc.  I'm just running this out for fun.

Conclusion? Multiplicative, non-ergodic, high vol processes can create vast wealth but otherwise looks like a killer if one were to happen to desire to focus on one's specific goals rather than max wealth.  Note that median terminal wealth is a fair representation of expected geometric returns over time. The mode is instructive, too, though. Take a look at where the mode goes under the two regimes. If I am going to take risk and I have a specific goal at or near t=10+, my attitude towards risk will likely be tempered a bit.

Models, Theories and Time

"Theories and models are attempts to eliminate time and its consequences, to make the world invariant, so that present and future become one. We need models and theories because of time…You can only be disappointed if you had hoped and desired. To have hoped means to have had preconceptions – models, in short – for how the world should evolve. To have had preconceptions means to have expected a particular future. To be disappointed therefore requires time, desire and a model…You can count yourself lucky if your model of yourself survives its collision with time."

– Emmanuel Derman, Models. Behaving. Badly.  [2011]

Nat Gas - part 2

The outfit Optionsellers.com got blown out of the water this month and closed due to unhedged Nat Gas futures positions via naked short calls. That happens to be almost the same trade I had on.  I had a trivial wound from that trade but it certainly was not fatal.  This type of trade is so upside down in risk-return that risk control is the only thing between the seller and Armageddon.  Those guys found Armageddon. They not only lost all the client's money but left them with a 25% debit balance owed to FC stone re the margin calls. Ouch.  I'd put the leaders on suicide watch at this point. I talked to them once a few years ago and didn't like the sound of the offer and didn't trust the principals.  Here is my trade:

I sold calls around 3.20 and exited at about 3.60 based on rules; the horizontal line was the strike and the vertical was the tenure (I thought there was no way (ha) that I'd be anywhere the strike in that timeframe). Optionsellers, on the other hand, got taken all the way and, as I understand it, could not find counterparties to close trades when vol hit 90. Man that has got to hurt.  My strategy is still intact  -- and now warier than it was before -- but at least I didn't die.  On the other hand, my guess is that the probability that over a long enough time frame that I'll get hurt is closer to 1 than it is zero so I'll probably wind down this kind of trading shortly even though the annualized returns are still hovering around 15% even after my wound.  Fanatical risk control saved me on this one, something I have been practicing for over 10 years, but even that won't be enough if I take a really hard hit at the wrong time some day.

RH Links - 11/15/2018

QUOTE OF THE DAY

Mathematics, like medieval Latin, is a medium of disputation in economics wherein those skillful in its use can subdue those who are not, independent of any substantive economic meaning. Elton McGoun

RETIREMENT FINANCE AND PLANNING

So what, we retired at the peak of the bull market? Here are seven reasons why we’re not yet worried… ERN

…it looks like I might become my very own poster child of Sequence Risk. https://earlyretirementnow.com/2018/11/05/retired-at-the-market-peak-still-not-worried/

The New Three-Legged Retirement Stool: You, You, And You, FinancialSamurai

The new three-legged retirement stool now consists of: 1) Personal pre-tax savings (You) 2) Personal after-tax savings (You) 3) Personal hustle (You)  https://www.financialsamurai.com/new-three-legged-stool-for-retirement/

Change is Coming to the Retirement Landscape, Franklin Templeton Investments

This past year we’ve seen heightened buzz in Washington DC about retirement. Issues and proposals have included debate over the definition of “fiduciary,” treatment of multiple employer retirement plans (MEPs), and how to help more Americans better save for retirement, including those saddled with student debt. We think the big takeaway is “Change is coming.” It’s no longer a question of if, but when. https://www.advisorperspectives.com/commentaries/2018/11/02/change-is-coming-to-the-retirement-landscape

How to Determine How Long Your Portfolio Could Last in Retirement, M Milevsky

Heyday contributor, author and professor of finance at York University, Dr. Moshe Milevsky, explains the mathematical equation retirees can use to calculate their portfolio longevity.  https://www.heydayretirement.com/heyday-blogs/how-to-determine-how-long-your-portfolio-could-last-in-retirement

Budgeting for Real-World Situations, Ken Steiner

Because SWPs don’t coordinate with other sources of income and are simply drawdown algorithms, their use is frequently inconsistent with a couple’s (or single individual’s) retirement goals in these real-world situations.  Since SSPs focus on spending and not withdrawals from accumulated savings, they can be tailored to address these real-world situations to better meet retirement objectives. http://howmuchcaniaffordtospendinretirement.blogspot.com/2018/11/budgeting-for-real-world-situations.html

Dirk Cotton on Mean Reversion

In Dirk's recent post Mean Reversion of Equity Returns and Retirement Planning, he addresses some of the issues related to mean reversion in markets and the impact on retirement planning. I think he hit this one on the head from my personal experience.  He says here what I've been thinking and tried unsuccessfully to explain to others:

I've read postings from other researchers who played around with mean reversion in their retirement models until they realized that any risk-reducing effects were swamped by the huge remaining retirement risks. That's one of the reasons I don't bother modeling long-term mean reversion — along with the fact that I don't know if it exists or how powerful it might be, so I'm not sure what I would model.

I believe retirement planners have little to gain by betting that mean reversion exists unless and until research resolves the issue. (The issue has been around for a long time and it could be a thousand years before we have enough data.) There is significantly more downside to incorrectly guessing there is less risk than there is to incorrectly guessing there is more risk.

This saves me a post...

Thucydides on Retirement

Actually, I cribbed these quotes from the WSJ Saturday edition but I feel justified because not so long ago I slogged for over a year through all of the History of the Peloponnesian War. And a slog it was from first page to last. But I was glad when I was done to have had the slog. The voice, by way of the translator no doubt, sounds modern and parts of of the history were more affecting than I had expected, in particular the pathos of the Sicilian campaign and the image of the defeated, captive, abandoned soldiers sweltering in pits. 

This is a stretch on making a retirement connection but what the heck:

On Planning: “Hope is an expensive commodity”

On Spending Retrenchment: “…the usual thing among men is that when they want something they will, without any reflection, leave that to hope, while they will employ the full force of reason in rejecting what they find unpalatable.”

A visualization of multiplicative return generation, terminal wealth and risk over 10 periods

I was doing this exercise for something personal but thought I'd share, assuming I have it right.  The following are frequency distributions (3000 iterations) of terminal wealth after 10 periods under two regimes:

1. Normally distributed returns (sorry) with mean = .09 and standard dev = .25 (high risk)

2. Normally distributed returns: (50%) r=.08, sd=.18, (50%) r=.035, sd=.04 (diversified)

This is a little apples and oranges but I wanted to see the breadth of the distributions vs the modes and try to get a general intuitive sense of likelihood related to "positive" outcomes, however that may be defined. The risk free rate of 3% (arbitrary) is the red dashed line. Y axis is frequency, X is the terminal wealth bins. The overflow bins on top chart are designed to put the X on the same scale in both (otherwise chart 1 is a log-normalish distribution). Note that there is no consumption and there are no fees, taxes, inflation, etc.  Just running it out. 

Conclusion? Chart 1 looks like an expensive exercise in lottery-like thinking if you happen to have any goals you want to achieve at year 10...despite it's higher mean expected return. Multiplicative, non-ergodic processes can create vast wealth but otherwise look like a killer for an otherwise modest retiree.

NG

Being short calls on natural gas futures was not my favorite thing to be this morning. Still unharmed tho.