The Major Technology Breakthrough to Guide Portfolio Choice
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives
Optimizing retirement outcomes means funding the highest standard of living, both before and after retirement, with a smooth transition in between. Planning for that economics-based outcome, known as “consumption smoothing,” is computationally intensive. But a recent technological breakthrough, which does that smoothing using uncertain asset returns, gives advisors a tool that improves portfolio choice.
Economics-based financial planning differs markedly from conventional financial planning. Economics-based planning is grounded in consumption smoothing – the proposition that households want to have a stable standard of living through time as well across good times and bad times. Why else save for retirement? Why else buy life, homeowners, automobile, medical, or longevity insurance? Why else diversify your portfolio?
Physiology meets economics
The instinct to smooth our living standard over time is physiological. We get satiated. We realize that guarding against rainy days –when we can no longer work, when Joey totals the car and when the market crashes – beats splurging now.1
There are two big things that limit our ability to perfectly smooth consumption. The first is cash constraints. A young, middle-class couple with lots of mouths to feed, a large mortgage to pay, and college costs to cover will need to limit its discretionary spending until they get out from under their bills. The couple’s goal is still to smooth its living standard, but only to the extent possible without going into or taking on more debt.
The second reason is uncertainty. Things change. We lose our jobs, we face unexpected medical bills, or the market tumbles. How do we smooth consumption when our economic world is uncertain? First, we insure against downside risks to the extent possible and affordable. Second, we make our spending and saving decisions based on what we expect to happen, taking into account the potential for uninsured events, like losing our jobs, to happen. What about investing, particularly in the stock market, which offers a high average, but also highly risky return? Here we trade off the risk of a drop in our living standard against the potential for a rise.
Unlike the casino, where the bets are unfair, i.e., where we have a greater than 50-50 chance of losing money, the stock market and certain other risky investments are gambles worth taking – up to a point. That point is determined by our degree of risk aversion, which might better be called our coefficient of satiation. When our risk aversion is very high, we are very concerned about risk because we lose a lot more welfare from seeing our living standard fall by a given amount than by seeing it rise by the same amount.