An Economist Looks at School, Marriage, Divorce, and Moving in with Your Mom

The financial benefits of attending a prestigious institution turn out to be nearly non-existent, according to research by Alan Krueger and Stacy Dale, the working paper version of which is the mandatory accompaniment to this chapter. Kotlikoff, who teaches at one of those overpriced universities, exhorts students to aggressively comparison shop for price, strongly consider spending their first two years at a community college, take advantage of online offerings from elite universities, and once at school, seek out the professors with the best publication and research track records.

The section on life-cycle investing disappoints somewhat, especially considering the author’s connection to the “Boston school” Samuelson-Merton formulation, which melds human and investment capital. Kotlikoff, for example, uncritically repeats the assertion that, because stock prices follow a random walk, their risk increases with longer holding periods.

It is indeed unambiguously true, as the French mathematician Louis Bachelier showed more than a century ago, that the variance of security prices, and of end wealth, increases linearly with time (and the standard deviation of returns as the square root of time). Moreover, as Zvi Bodie demonstrated in a famous 1995 paper, the cost of purchasing protective options against stock market losses increases over time, a phenomenon that falls directly out of the Black-Scholes formula. Were stocks less risky over longer periods, the opposite should be true.

The problem here is that finance theory glosses over the appropriate definition of risk, choosing instead to equate variance of outcome with risk. But increasing variance with time does not necessarily mean that the frequency of a bad result – say, underperforming the risk-free rate – also increases with time. (Michael Edesess discussed this issue in this 2014 Advisor Perspectives article.)

Moreover, stock prices do not quite follow a random walk. In the first place, they more closely follow a power-law distribution, and not the independent and identically distributed (i.i.d.) one first described by Bachelier. More importantly, equity returns also tend to mean revert over long periods, which serves to decrease the frequency of losses at increasing time horizons. (Bonds, in contrast, do not behave as well as stocks, demonstrating momentum even over very long periods, which can be devastating on the downside, as occurred between 1940 and 1980.)

The most extensive empirical securities time series support the notion that mean reversion does indeed lessen the frequency of bad outcomes over very long holding periods. When Dimson, Marsh, and Staunton examined equity returns in 21 nations between 1900 and 2017, they found that in each and every case, stocks both yielded a positive real return over the 118-year period and, critically, also outperformed both government bonds and bills.

The academic debate over equity risk over time largely ignores a major life-cycle issue. Namely, risk for whom? The above discussion, after all, pertains only to the buy-and-hold investor who neither adds nor withdraws assets. For the retiree who is spending assets, on the other hand, for whom a bad initial sequence can prove deadly, stocks are even more risky than for the buy-and-holder – a fact that Kotlikoff recognizes. Contrariwise, stocks are less risky for the young person with regular periodic savings, who in fact benefits from volatility, especially with a particularly poor initial returns sequence.

Kotlikoff ignores the most descriptive parameter for any retiree: his or her burn rate. Consider, for example, the millions of retirees who have a zero, or even negative one, having enough income from Social Security and an old-style corporate pension to meet or exceed their living expenses and taxes. Their investment portfolio is irrelevant to them personally since it really doesn’t belong to them. Rather, it’s destined for their heirs, charities, and Uncle Sam. The controlling factor in the investment policy of these lucky folks is simply their risk tolerance. If they’ve hung on in the past with 100% stock exposure, then God bless.

The same is also true of retirees who need less than 2% of their portfolio to meet living expenses. Since the dividend flow on their stocks should cover things, and since dividends do not decline very much for very long even in severe bear markets – they briefly fell by half during the Great Depression, and very briefly by less than a quarter after the 2007–2009 crisis – then even a nearly 100% stock allocation with a small sliver of cash for emergencies or a temporary fall in dividends should be adequate.

As that great financial observer, Gloria Steinem, sagely noted, the rich plan three generations ahead; the poor plan for Saturday night. She might well have added that the rich, and their heirs, stay that way by investing in stocks.

Without explicitly saying so, the book is aimed at those with a burn rate in the 3%-6% range, and here it does a fine job, setting as priorities the delay of Social Security until age 70, control of both personal spending and investment and advisory expenses, and a widely diversified global portfolio. Kotlikoff also endorses the reverse-retirement glide path, which makes intuitive sense, since the 90-year-old needs a far smaller liability matching portfolio of safe assets than does the 65-year-old. But the data supporting the reverse glide slope are not all that impressive: The definitive Kitces/Pfau study of the issue demonstrated that in most cases the reverse glide slope strategy had only a few percent success rate advantage over a constant allocation or the standard decreasing equity glide slope.

What of those whose retirement will feature burn rates more than 6%? By age 75 or 80, most will wind up in a parlous financial state. The author quotes the highly respected National Retirement Risk Index (NRRI), which estimates that about half of Americans will see a significant decline in their post-retirement living standards. Left unremarked upon is the NRRI’sunderlying assumption that retirees will reverse mortgage their homes, then combine 100% of that money with 100% of their retirement balances to purchase an annuity. Since only a minuscule minority of retirees will annuitize 100% of both their home equity and retirement accounts, the reality will be even grimmer than the NRRI projects.

These, though, are relatively minor quibbles. Money Magic is aptly titled, a treasure trove of both common-sense advice and deep dives into some of the most vexing problems faced by investors, and especially by their advisors. The general reader should start with the book’s brief, last chapter, which lists his 50 different financial hacks, then scan forward through the book to pick out the areas of interest. Unless you have a photographic memory, the most complex areas, particularly the ones on marriage and divorce, can be safely deferred until the need arises. Over the years, Money Magic will become a well thumbed, highlighted, and post-it strewn presence on advisors’ bookshelves.

William J. Bernstein is a neurologist, co-founder of Efficient Frontier Advisors, an investment management firm, and has written several titles on finance and economic history. He has contributed to the peer-reviewed finance literature and has written for several national publications, including Money Magazine and The Wall Street Journal. He has produced several finance titles, and four volumes of history, The Birth of Plenty, A Splendid Exchange, Masters of the Word, and The Delusions of Crowds about, respectively, the economic growth inflection of the early 19th century, the history of world trade, the effects of access to technology on human relations and politics, and financial and religious mass manias. He was also the 2017 winner of the James R. Vertin Award from CFA Institute.

Read more articles by William Bernstein