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ataloss
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PostPosted: Sat Sep 20, 2003 6:41 am    Post subject: Tossing coins Reply with quote

I won't post on hocus' board but since a particular post has been discussed I thought I should say something about it for those who don't have or want TMF access. Hocus has made a point about retaining a copyright to what he posts so I have paraphrased. (Not that he will like that either) Laughing

In June of 02 a poster at another board mentioned that she had a portfolio decline of 1/3 and had then sold all of her stock. Galeno got a large number of recs for accusing her of the classic investor's mistake of buying high and selling low.

MHtyler said
Quote:
For someone with a 3M nest egg living on 1%, a 33% loss means you've got 2 million left and your next years W/D is what...2%? What about the guy with 1M who was W/D 4% and who's nest egg is now 600 thou???

RE philosophy starts looking ridiculously abstract at that point


(So I took this to mean that he was suggesting that a 1% withdrawal rate is safer than a 4% withdrawal rate) Wink

Anyway, Hocus cited this post and said it was the second most important post on that board.

He gave a mental exercise to consider. You are offered a bet on a fair coin flip. If you lose you pay $100,000 if you win you get $200,000. Is the wisdom of accepting such a bet different for a person with a $1 million dollar portfolio vs a $10 million portfolio. What if the offer is a series of 10 such bets. What would you do if you accepted and then lost several consecutive bets? The presumption is that the person with the larger portfolio would not "need" the winnings much and would give them to charity.

Although it may seem obvious that an investor with a larger portfolio can better tolerate a $100,000 non-diversified investment, I think hocus was really onto something. Many investors probably misunderstood the risks of the market and overestimated their risk tolerance. Understandable when their only experience with markets was highly positive and a couple of brothers were promoting the idea that it was easy for amateur investors to "double the dow."


Hocus said that the REHP study is "theoretical" and "abstract" and doesn't consider the fact that typical investors will not behave as the study presumes (ie continue to hold the same allocation.) He didn't really seem to specify how to fix this. He also says that with intercst's large portfolio his swr may be 4% although hocus' would not be. I think he meant that the consequences of a shortfall in returns would be greater for the person with the smaller portfolio but I have difficulty understanding what hocus means when he talks about swr since he seems to have a unique definition for the term. Wink

I have condensed this to 1/6 of the length of the original post so it is possible that some nuances have been lost.



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hocus
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PostPosted: Sat Sep 20, 2003 7:09 am    Post subject: Reply with quote

Here's a link to the REHP board thread:

http://boards.fool.com/Message.asp?mid=17389587&sort=whole


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therealchips
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PostPosted: Sat Sep 20, 2003 10:11 am    Post subject: On coin tossing, the value of money, and the year 1738 Reply with quote

Suppose you are offered the following game: We will toss an honest two-sided coin until the first head shows up. You will win 2^n dollars where n is the number of tosses that gets you to that first head. So, if the sequence is H (the very first toss is a head), you win $2; if it is TH (i.e., you toss first a Tail, then a Head) you win $4. TTH is worth $8, etc. What would you pay to play the game? The expected winnings are the sum of an unlimited number of terms, each showing the probability of a particular sequence times the payoff for that sequence:

(0.5 * 2) + (0.25 * 4) + (0.125 * 8 ) + . . . (an unlimited number of terms)

which equals

1 + 1 + 1 + . . . (also an unlimited number of terms)
or, in short, the expected winnings are infinite. No one, of course, would be willing to pay an infinite amount to play this game.

Is any of this news? Well, no. This is the famous St. Petersburg Paradox, much discussed and resolved the better part of three hundred years ago. Here is another description of the game, maybe better written:
Quote:
The expected utility hypothesis stems from Daniel Bernoulli's (1738) solution to the famous St. Petersburg Paradox posed in 1713 by his cousin Nicholas Bernoulli (it is common to note that Gabriel Cramer, another Swiss mathematician, also provided effectively the same solution ten years before Bernoulli). The Paradox challenges the old idea that people value random ventures according to its expected return. The Paradox posed the following situation: a fair coin will be tossed until a head appears; if the first head appears on the nth toss, then the payoff is 2n ducats. How much should one pay to play this game? The paradox, of course, is that the expected return is infinite. . .Yet while the expected payoff is infinite, one would not suppose, at least intuitively, that real-world people would be willing to pay an infinite amount of money to play this!

Daniel Bernoulli's solution involved two ideas that have since revolutionized economics: firstly, that people's utility from wealth, u(w), is not linearly related to wealth (w) but rather increases at a decreasing rate - the famous idea of diminishing marginal utility, (Chips: here it gives some expressions using the notation of the calculus with the intuitive meaning that each additional dollar contributes something to the owner's utility, but that the increase is less for each subsequent dollar) ; (ii) that a person's valuation of a risky venture is not the expected return of that venture, but rather the expected utility from that venture.


I make it a point to mention the age of this problem and its solution because I have seen some implausible claims of originality in FIRE posts. I make no such claim. My material comes from classes I took decades ago.

I have posted my arguments based on utility theory and life expectancy in another thread here at NFB's FIRE Board. I have not posted these ideas at Hocus' board even though he suggested that the ideas I raised would be appropriately discussed over there. If he thinks so, I have not made myself sufficiently clear. What I am suggesting is subversive to the entire notion of safe withdrawal rates as usually defined. I want instead to derive mathematically a schedule of withdrawals over many years that maximizes the expected total utility of the withdrawals. The expectation depends on the owner's life expectancy as we show by making explicit use of mortality tables. The utility depends on the planners' current level of wealth and, to be plausible, must grow at a declining rate. (The logarithmic utility function satisfies these requirements. That's the one I have used in my experiments.)

Withdrawal schedules set up in the "conventional way" aim at avoiding bankruptcy for a specified number of years while taking annual withdrawals with fixed purchasing power. This is not likely to maximize the total utility of the withdrawals, depending on what utility function the planner uses. Further, this approach pays too little attention to the planner's not knowing how long he will live. Hocus can and, I suppose, should see these ideas as disruptive to his SWR research and therefore quite appropriately kept off his board. I have posted occasionally on that board, but only when I think my comments are not at all controversial or disruptive. He has a right to pursue his goals in peace; I just don't happen to share them.

I am glad to hear that posts at TMF have considered that the risk in an investment is less significant for someone with ample FIRE assets than it is for someone with marginal FIRE assets. However, the basic idea (the utility of the next ducat diminishes with the number of ducats already owned) is approaching three centuries in age. I would not be surprised to find that there have been mentions of Bernoulli and St. Petersburg over there at TMF too. I would like to see some posts that mention (and use) standard mortality tables as somehow significant in FIRE planning. As ataloss put it, a 50-year old man with a million dollars is somehow richer than a 100-year old man with a million dollars.

(Editted after the fact to fix an error spotted by Wise and Lucky and Perceptive: The line in the quotation that reads " if the first head appears on the nth toss, then the payoff is 2n ducats." should read " if the first head appears on the nth toss, then the payoff is 2^n ducats." I won't pretend that I copied it correctly in the first place.)



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Last edited by therealchips on Sun Sep 21, 2003 1:16 pm; edited 1 time in total
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hocus
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PostPosted: Sat Sep 20, 2003 12:14 pm    Post subject: Reply with quote

I am glad to hear that posts at TMF have considered that the risk in an investment is less significant for someone with ample FIRE assets than it is for someone with marginal FIRE assets. However, the basic idea (the utility of the next ducat diminishes with the number of ducats already owned) is approaching three centuries in age.

Chips:

You make some good points in this post. However, you are misunderstanding what is new about the approach to SWRs that I proposed on May 13, 2003, and then developed in subsequent posts put up during the course of The Great Debate about SWRs.

I am not saying that no one ever before put forward the idea that the utility of money diminishes as one comes to possess more of it. What I am saying is that the SWR that applies to one's portfolio changes as the amount of assets held in the portfolio increases. I am giving the insight application in the SWR context. That had never been done before the discussions that followed in the wake of my May 13, 2002 post, so far as I know.

In order for the intercst SWR numbers to be accurate, his assumption that the investor will sell no stocks even in the event of a worst-case scenario also needs to be accurate. The historical data indicates that this assumption rarely is accurate. The few times in which it might be accurate are in those cases in which the investor has so much in the way of assets that the losses sustained in a worst-case scenario have no practical consequence. In all other circumstances, his conclusions can be objectively demonstrated to be wrong. It is not "safe" to presume that the results obtained by stock investors of the future will be entirely unlike any that have ever been obtained by stock investors of the past.

It is important for aspiring early retirees to know that, and that is an insight that I explained to the FIRE community with my "Coin Toss" post. It was my explanation of this sort of insight, and the community's enthusiastic response to the insights offered in the early days of the Great Debate that caused intercst to flip his lid and inititate the smear campaign against me. Intercst had been one of my biggest fans prior to the days when dozens of community members came forward and thanked me for my SWR posts. It was only when it was becoming clear to much of the board community that intercst had gotten the numbers wildly wrong in his study that intercst announced that the "board culture" at the REHP board demanded "ridicule" of anyone reporting the truth about SWRs (anyone posting "irrational" and "loony" ideas was the phrase that intercst used).

It helps to understand the way that the smear campaign began in order to put the smear campaign into context. The problerm is not that the REHP board was not interested in knowing the realities of SWRs or that the community was not convinced of the merits of my claims. The entire problem was that the community there was too interested in the subject matter for intercst's taste and over time was becoming increasingly convinced of the merits of my case. He liked it better when people did not understand what the data said because in those days many community members considered his SWR claims plausible ones. When poster after poster came forward thanking me for my contributions in this area, intercst began engaging in the prohibited posting practices that drove most effective posters out of that community and brought the REHP board to the state that it is in today

I don't say my posts are not influenced by many ideas that have been around for a long time. I hope that they are; the oldest ideas are often the best ideas. What I say is that I post in an informed and honest way on SWRs and that intercst does not. The insights discussed in the "Coin Toss" post reveal that intercst got the number wrong in his study. It's important for aspiring early retirees to know that because the study offers advice on a money question. Anyone thinking that the historical data supported a 4 percent SWR at the top of the bubble is living in a dream world, and needs to be apprised that the historical data does not support a number anywhere in that neighborhood. This is real life, Chips, we are not playing a game on these boards. People who retired in the year 2000 thinking that intercst had accurately reported what the historical data says were setting themselves up for some serious life setbacks. It is the responsibility of anyone who has gained from participation on a FIRE board to point out the flaws in the intercst claims and thereby protect fellow community members from the natural consequences of his deceptions.

My job is to help people achieve financial independence early in life. I have never done better work than in the work that I have done in pointing out the deceptions contained in the intercst SWR claims. So I take strong exception to claims that my pre-SWR posts are in some sense better than my SWR posts. I am proud of a good number of my pre-SWR posts. But none of them ranks in importance with the best of my SWR posts, in my opinion. The pre-SWR posts were a lot easier to write too. It is a lot easier to develop a post when everyone is telling you how great you are than it is when people are making death threats against any poster who dares to put forward an informed and honest post. I showed the courage to continue posting in the face of the threats of physcial violence that were made against Information Seekers posting at that board. Few others did. I'm proud of that fact, <b<>Chips. If you had been in my shoes, I am confident that you would have been too. No message board poster should be required to pay that sort of price for wanting to inform fellow aspiring early retirees of the errors made in a study of an important investing question, in my view.

For more detail on why I consider my posts on the realities of SWRs so important, please take a look at the "About This Board" post at the SWR Research Group board. That post gives a general sense of the sort of damage that could be sustained by an investor placing confidence in the intercst claims. It also gives an idea of how much sooner investors using a data-based SWR can expect to achieve their dreams of early retirement.

What I am suggesting is subversive to the entire notion of safe withdrawal rates as usually defined. I want instead to derive mathematically a schedule of withdrawals over many years that maximizes the expected total utility of the withdrawals.

I think you are wrong in your belief that your idea here is subversive of the SWR concept, Chips. I believe that you are making a mistake that many others have made before you, confusing the concept of a SWR with the concept of a Personal Withdrawal Rate (PWR).

I see no reason why one could not use the SWR concept as the first step in the process of determining a PWR in accord with your goal of maximizing the utility of withdrawals over the course of a retirement. You need to begin with a validly calculated SWR, I don't see how you can get anywhere without that. But I see no reason why it would not be possible to develop a changing PWR rooted in the investment realities revealed in the valid SWR analysis but also incorporating additional data re your utility of money concerns.

I'm no numbers wiz, so it is not for me to say for sure. But what you are seeking here strikes me as no more ambitious than a few of the other issues that we are expecting to struggle with at the SWR board over the course of the next few years. You might want to check with JWR1945 and see whether he agrees that it is possible to do constructive work towards dealing with the question you are raising. In the event that he agrees that it is possible, i think you should go ahead and put this one on the table over there.

I don't think you should expect any immediate breakthroughs. We have lots of other stuff on the table at the SWR board, and few posters to handle the workload. But we have achieved some amazing breakthroughs in the short life of that board. I think that over time you might be pleasantly surprised if you give the community that congrergates there a chance to tackle your question.

Withdrawal schedules set up in the "conventional way" aim at avoiding bankruptcy for a specified number of years while taking annual withdrawals with fixed purchasing power. This is not likely to maximize the total utility of the withdrawals, depending on what utility function the planner uses.

The issue of withdrawal schedules is an issue that comes up primarily in the application of a Retire Early plan, not in the calculation of a SWR. There is a big difference between the two. The calculation of the SWR is an objective numbers-based exercise. That is why I can say that intercst got the number wrong. His number simply does not match the number you get when you look at the historical data. Implemetation of a plan is a subjective exercise, however. It is not right or wrong for a particular investor to take a particular PWR, it is a matter of indivdual choice. I see no reason why you should not explore the idea of taking a PWR that would be in accord with your ideas re utiliity of money.

Hocus can and, I suppose, should see these ideas as disruptive to his SWR research and therefore quite appropriately kept off his board. I have posted occasionally on that board, but only when I think my comments are not at all controversial or disruptive. He has a right to pursue his goals in peace; I just don't happen to share them.

I don't see your ideas as disruptive to my SWR project in any way, shape, or form, Chips. I do appreciate that you have avoided disruption in your posting at the SWR board, and I also appreciate your thought that people with whom you disagree have a right to pursue their ideas in peace. I wish that some others would take that notion to heart.

That said, there is no need to agree with me on SWRs to post at the SWR board. The two big no-nos are to offer word game posts or ridicule posts. Those will get you shut down. Anything else that is at least remotely connected with the subject matter is welcomed. I hope that we see your screen-name again at the SWR board again soon, whether on the utility of money question or on some other aspect of the board's project.

The bottom line, Chips, is that subversives are welcomed at the SWR board. It is hard for me to imagine anyone putting up anything over there even remotely as subversive as the May 13, 2002, post that I put up at the REHP board. I would love to see somebody give it a good try, however!


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peteyperson
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PostPosted: Sat Sep 20, 2003 12:48 pm    Post subject: Re: On coin tossing, the value of money, and the year 1738 Reply with quote

Chipperoo,

You're the fried full-flavor fry! (chips are Brit for fries here)

Wonderful stuff. I was wondering where you get it. While my equations and knowledge of economics is limited to date, I would be interested to consider any books you recommend. I have an interest in old civilisations, the way money was managed before and these kind of quotes from you are gold. I particularly enjoy learning where economic precepts originated from and how far they go back.

Petey
therealchips wrote:
Is any of this news? Well, no. This is the famous St. Petersburg Paradox, much discussed and resolved the better part of three hundred years ago. Here is another description of the game, maybe better written:
Quote:
The expected utility hypothesis stems from Daniel Bernoulli's (1738) solution to the famous St. Petersburg Paradox posed in 1713 by his cousin Nicholas Bernoulli (it is common to note that Gabriel Cramer, another Swiss mathematician, also provided effectively the same solution ten years before Bernoulli). The Paradox challenges the old idea that people value random ventures according to its expected return. The Paradox posed the following situation: a fair coin will be tossed until a head appears; if the first head appears on the nth toss, then the payoff is 2n ducats. How much should one pay to play this game? The paradox, of course, is that the expected return is infinite. . .Yet while the expected payoff is infinite, one would not suppose, at least intuitively, that real-world people would be willing to pay an infinite amount of money to play this!

Daniel Bernoulli's solution involved two ideas that have since revolutionized economics: firstly, that people's utility from wealth, u(w), is not linearly related to wealth (w) but rather increases at a decreasing rate - the famous idea of diminishing marginal utility, (Chips: here it gives some expressions using the notation of the calculus with the intuitive meaning that each additional dollar contributes something to the owner's utility, but that the increase is less for each subsequent dollar) ; (ii) that a person's valuation of a risky venture is not the expected return of that venture, but rather the expected utility from that venture.



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ataloss
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PostPosted: Sat Sep 20, 2003 12:53 pm    Post subject: Reply with quote

I see myself agreeing strongly with hocus that the idea of a SWR as usually defined is "purely theoretical." I think that real people would alter their behavior rather than (for example) let their portfolio go to zero. OTOH, I think intercst makes a good point in response to hocus:
Quote:
What is the safe withdrawal rate for "people who jump in and out of asset classes"? Most of the research I've seen shows they get much lower returns.


SWR (using intercst, trinity, raddr etc) gives one a ballpark estimate of the portfolio needed. Using gummy's SWR is more practical Smile
http://home.golden.net/~pjponzo/sensible_withdrawals.htm



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peteyperson
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PostPosted: Sat Sep 20, 2003 1:23 pm    Post subject: Re: On coin tossing, the value of money, and the year 1738 Reply with quote

Chips,

Do you have a link to the previous discussions you mention?

If someone needs say $500,000 in order to cover essential expenses. While they are accumulating the money, do you think they are already going through the law of marginal utility on wealth building even though they may have $100,000 and be nowhere near being able to quit their job? To me, $100,000 doesn't get the job done and so isn't worth much. It may help compounding gradually up to $500,000 with significant additional new funds & additional years, but in and of itself I wouldn't feel wealthy, independent or about to FIRE. That would be like completing one lap of a 4 lap race, not valuable unless you complete it and get the medal.

I can see that once you reach the essential expenses net worth point, then as you add more to cover non-essentials like better home, more travel, more nights out etc you're going down the curve of marginal utility then.

Thoughts?

Petey
therealchips wrote:
I have posted my arguments based on utility theory and life expectancy in another thread here at NFB's FIRE Board. I have not posted these ideas at Hocus' board even though he suggested that the ideas I raised would be appropriately discussed over there. If he thinks so, I have not made myself sufficiently clear. What I am suggesting is subversive to the entire notion of safe withdrawal rates as usually defined. I want instead to derive mathematically a schedule of withdrawals over many years that maximizes the expected total utility of the withdrawals. The expectation depends on the owner's life expectancy as we show by making explicit use of mortality tables. The utility depends on the planners' current level of wealth and, to be plausible, must grow at a declining rate. (The logarithmic utility function satisfies these requirements. That's the one I have used in my experiments.)


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therealchips
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PostPosted: Sat Sep 20, 2003 6:16 pm    Post subject: Topic: The Utility of Money and Personal Life Expectancy Reply with quote

Thanks for the responses, all of you. I will respond more later, but first I answer the easiest of the questions.

I had said "I have posted my arguments based on utility theory and life expectancy in another thread here at NFB's FIRE Board."

Petey then asked "Do you have a link to the previous discussions you mention?"

Here it is: Topic: The Utility of Money and Personal Life Expectancy
started Friday, May 30, 2003 on the FIRE board. Its latest post was June 4, 2003.

The URL for the start of this thread is
http://www.nofeeboards.com/boards/viewtopic.php?t=956.



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[KenM]
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PostPosted: Sun Sep 21, 2003 1:58 am    Post subject: Reply with quote

In terms of how retirees consider big "losses" I suggest that there are two different scenarios.
The first is similar to Chips
Quote:
Here are my actual, year-end results in my IRA since I retired in 1993 -- with no trading, no market timing, no hassle, no worry, no personal effort on my part, and, of course, no taxes.

Year, Value of IRA relative to Starting Year of 1993

1993 100%
1994 100%
1995 137%
1996 168%
1997 223%
1998 287%
1999 355%
2000 324%
2001 281%
2002 221%
2003 258% (as of last Friday)
He has "lost" approx 30% since 1999 but as he is still ahead of the start value of his stash then he's OK with the situation.

The second scenario is perhaps similar to MHTyler's situation which, as I understand it, was that he invested a large cash lump sum in stocks at the very top of the market in 1999, lost 30% and then cut his losses by selling everything.

Any thoughts on behaviour really need to take into account the way an investor puts money in the market and whether he/she is making profit or loss on the original investment.



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WiseNLucky
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PostPosted: Sun Sep 21, 2003 3:30 am    Post subject: Reply with quote

Chips,

I had to read your example a few times before I could figure out why I had a problem.

Your example uses a return of 2^n which provides the return of 1 at each level. The quoted example (Bernoulli's) gives a return of 2n which would be substantially lower (in the third iteration the return would be 0.125 X 6 which is only 0.75 ducats).

Am I missing something?



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PostPosted: Sun Sep 21, 2003 3:32 am    Post subject: Reply with quote

KenM wrote:
...He has "lost" approx 30% since 1999 but as he is still ahead of the start value of his stash then he's OK with the situation.

The second scenario is perhaps similar to MHTyler's situation which, as I understand it, was that he invested a large cash lump sum in stocks at the very top of the market in 1999, lost 30% and then cut his losses by selling everything.

Any thoughts on behaviour really need to take into account the way an investor puts money in the market and whether he/she is making profit or loss on the original investment.


This is why diversification is so critical. You can sustain a big loss in later years of retirement if you had good gains early on. However, a big loss right off the the bat can have devastating consequences to a retirement portfolio. If you make a big bet on a single asset class at the beginning of the withdrawal phase, in this case LcG, and it gets clobbered early then you better lower your withdrawal rate or face likely disaster.

If, however, you spread your equity risk amongst classes with low correlations to each other you increase your chances of a smooth ride in retirement and can probably withdraw more from your portfolio.


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ataloss
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PostPosted: Sun Sep 21, 2003 4:00 am    Post subject: Reply with quote

I think that the original hocus post is good but perhaps in a sort of kyosakian sense. Smile

per John T Reed:
Quote:
The odd thing is that each person has a different version of what the point of Kiyosaki's book is - and it is never something I recall reading in the book.


http://www.johntreed.com/Kiyosaki.html

but hocus keeps saying things like:
Quote:
In order for the intercst SWR numbers to be accurate, his assumption that the investor will sell no stocks even in the event of a worst-case scenario also needs to be accurate.


Without any explanation of how intercst (or anyone else) could have done
this. You can either have a have a study of the maximal surviving withdrawal rate for a given historical period or you can have a study of investor behaviour but I don't see how you can combine the two. (And I don't see where hocus or jwr have done this.)

Some clear thinking about risk before investing can minimize regret, poorly timed reallocation, and overreaction. I think that this was absent in some readers of rehp and the hocus post was useful in that respect.



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peteyperson
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PostPosted: Sun Sep 21, 2003 4:45 am    Post subject: Reply with quote

Hello Ken,

KenM wrote:
Any thoughts on behaviour really need to take into account the way an investor puts money in the market and whether he/she is making profit or loss on the original investment.
____________
KenM


It is nice to be able to reply to you for a change!

If you're talking the sale of a business and receiving a taxable lumpsum upon sale which takes you into FIRE from zero personal savings, then it is tricky. Usually people recommended DCA over the course of a year (which won't necessarily avoid buying at the top). If it were me I would want to research the history of the markets (and other asset classes besides) to determine how they operate, what the returns have been and see how they are valued at present. I would not, for instance, look completely favorably on investing in Gold right now. It is at a 7 year high, information easily available if you read gold mutual fund reports available from Merrill Lynch UK fund and I'm sure American too. I would DCA into asset classes that are fairly valued and DCA into others when their valuation comes down. This is the same strategy I plan to use as I invest, the asset allocation not being as important initially as buying in low. With such a lump sum, I would not be concerned about dumping it all in a money market account, paying the taxes and learning what I'm doing before doing anything meaningful. A fool and his money etc..

In 1999 and 2000 I was caught up in the excitement of the internet boom and was talking about buying while it was easy to make money. I never actually moved forward on that but it was an interesting lesson looking back at my lack of insight into the markets, what booms and busts were about and how people had lost complete sight of company valuation fundamentals in place of temporary insanity/lack of logic in pricing. At the time it was a case of what I didn't know. So I use that inactivity which could have been expensive, to teach. As such I think ' market timing ' gets a bad rap that covers everything. You can see when an asset class is overvalued and looks like it will not deliver well until it corrects or just will deliver poorly for several years, as raddr has determined and allocated accordingly. That then is a choice to buy low and get good value with more units of a chosen fund or no of shares. I now see timing as trying to guess the market in the short-term, very different from a confidence that long term American or British or Global markets will prosper and initially selecting fairly valued markets with a view to investing in all as and when they come down to appealing valuations. Warren Buffett operates much the same way with his purchases, admiring well run companies but usually only buying when they're on sale. American Express is one example of that. I think this kind of strategy one that favors buying at a good price over the initial asset allocation, not often spoken of due to it being not really for the beginner investor, will work out more profitably as did buying your UK properties in a down market at cheaper prices and holding them did for you, Ken.

Understanding the risk involved, particularly the yearly short-term volatility of your investments is crucial. I've seen many people on the UK Fool complain that their ISA tracker (index fund) is down from when they bought it a year ago. Whilst that is a fair complaint, beneath a lot of these comments is a lack of understanding what that kind of investment can do, knowing what you're buying, buy it, sit on it, don't sell. Again as Buffett says, the markets could close for 20 years and he wouldn't care. If the business is sound, why would we wish to sell? I feel investors need to take a similar long term view of the business environment with investing. Not understanding the fundamentals causes people to load up on an overvalued market and then not know what to do when it drops back 30% to fair value shortly after. By deciding on a balanced asset allocation and investing in each fairly valued asset class in turn, you avoid that problem. Many retirees didn't realise this and went back to work when their portfolios lost 30%. If they had done some research before putting money down they would have known that a) the market does drop 30% and will come back up if it started from a fair valuation and b) use a total portfolio number that re-adjusts to fair value so you're not kidding yourself that you're worth more than you are long-term, otherwise that is like wearing a big pair of sneakers with a chunky heel and telling yourself you're taller than you are. You need to be smarter than that.

I may be a bit off your topic but I thought a discussion of some larger issues might be useful for other readers who lurk more than post!

Petey




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PostPosted: Sun Sep 21, 2003 4:51 am    Post subject: Reply with quote

Excellent post, raddr.

What I think would be useful would be a discussion on what asset classes are correlated to each other or not-correlated. I've seen precious little on that with any investment books read to date including Bernstein. Gillette Edmunds's book, Retire Early and Live Well touches on it in various places but I still would have liked to have seen more on this crucial issue.

According to Edmunds, Emerging Market stocks are often not very correlated to US/UK Markets even though their currencies are often linked to the US$. Property can sometimes not be correlated. To expand that theme, we have three property mutual funds in the UK. Two invest 60% in freehold properties, 20% in property stocks and 20% cash ready to deploy in new property purchases. A third mutual fund invests 100% in property stocks. I would be more inclined to invest in the two that focus more on direct property management even if they underperform the 100% stock focused fund because of the lack of correlation to the stock market which is a large part of my planned portfolio. My planned allocation takes this into account with 30% in property.

Petey
raddr wrote:
This is why diversification is so critical. You can sustain a big loss in later years of retirement if you had good gains early on. However, a big loss right off the the bat can have devastating consequences to a retirement portfolio. If you make a big bet on a single asset class at the beginning of the withdrawal phase, in this case LcG, and it gets clobbered early then you better lower your withdrawal rate or face likely disaster.

If, however, you spread your equity risk amongst classes with low correlations to each other you increase your chances of a smooth ride in retirement and can probably withdraw more from your portfolio.




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PostPosted: Sun Sep 21, 2003 5:27 am    Post subject: Reply with quote

Hey Ataloss,
ataloss wrote:
Without any explanation of how intercst (or anyone else) could have done this. You can either have a have a study of the maximal surviving withdrawal rate for a given historical period or you can have a study of investor behaviour but I don't see how you can combine the two. (And I don't see where hocus or jwr have done this.)

Some clear thinking about risk before investing can minimize regret, poorly timed reallocation, and overreaction. I think that this was absent in some readers of rehp and the hocus post was useful in that respect.


I think the reason is that it is very difficult to review something like investor behaviour. You cannot boil that down to a s/w number!

I do think the problem is more basic: Many Americans don't travel out of the country. They seem to have an attitude that America is the whole world. This is also shown in the allocations with investing where there is little foreign investing unless future domestic returns look dire. This has been borne out in the latest American new mutual fund money going more to international than US-located funds. The motivation doesn't appear to be an asset allocation that would allow you to sell stocks from different countries during distribution phase but chasing performance. Investors swing from one asset class to another as they become over invested. An internationally-balanced approach would allow a sell-off of emerging market stocks when American markets are down and you're living off your investments. Few advisors have actually lived off their investments nor the journalists who pen articles on FIRE investing. So you get an unbalanced approach which doesn't really work too well. Further diversification into real estate and other asset classes will benefit this still further.

However until Americans stop having such an insular attitude to other countries and culture, this won't really change all that much. You see this when travelling where there are many other nationalities in the town but few if any Americans. The line is usually, " No, there's no Americans. They don't travel out this far. They usually don't get much past Maine. " This is also borne out in the Merrill Lynch World Wealth Report which compared international asset allocations globally and found Americans allocated most to the US, whereas those in Asia and Europe distributed more evenly globally and their wealth has weathered the last 5 years in much better fashion. Americans much more into the US markets didn't. This may work during accumulation phase but during distribution you want to smooth out the returns which only goes to show that the regular American asset allocation is completely wrong for the task. It is an interesting problem, considerable success causing an insular attitude and overconfidence. Possibly good for accumulation but lousy to avoid the emotional problems associated with a portfolio focused in America and not selling off in a panic when you're down for 3 years running. The London stock market is down to what it was 8 years ago! Try that for size. When you have that mindset, you can easily see the need for more international diversification. We're not a minnow either, we're something like the 5th or 6th largest development economy in the world. But there is a need to properly diversify before you're 8 years down and thinking, " Err, maybe I should have invested more internationally.. "

An unhelpful addendum to this is that international mutual funds are highlighted as high risk and domestic as medium risk. As we know, diversification even into markets that add currency risk and other additonal risk can in fact reduce your portofolio risk overall, particularly when living off your investments. The information supplied to investors does not show this and conveys quite the opposite impression. I've been recently thinking about what percentage I would allocate to global emerging markets vs UK (my own currency) vs. Europe, vs. USA. Tipping the balance too far will take the focus away from my own currency & make me more susceptible to currency fluctuations, investing too much at home does the opposite. I'm considering 50% stocks, 30% UK REITS & 20% UK Treasure inflation-protected bonds & Cash. From the stock allocation of 50%, I plan something like 15% in the UK, 35% spread globally. While this weights me low on the UK market, it brings my exposure to UK domestic investments to over 50% due to the UK REIT and Bonds. This all acts as a counterbalance with a mix of international / non-correlated asset to smooth the way. Buy in when each asset class is at a sensible valuation and place buying low over the inital asset allocation with a view to have a good return over time because of that focus. This is a balancing the risk of being over-allocated in only a handful of markets early on vs. the benefits of not buying the S&P at current valuations if at all possible. A more sophisticated approach than most investors would know to try.

Petey




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PostPosted: Sun Sep 21, 2003 6:00 am    Post subject: Reply with quote

Petey,

Nice post!
Quote:
I do think the problem is more basic: Many Americans don't travel out of the country. They seem to have an attitude that America is the whole world.


This is so true. We Americans are so insular. I think that we have a little too much of an air of superiority towards the rest of the world. This carries over into investing where there seems to be an attitude that since we are the greatest country we must have superior markets and there is little reason to diversify outside of our narrow little slice of the world. BTW, if you've read Jim Rogers' books he agrees with your point of view. He should know since he's travelled around the world both by motorcycle and by car and probably has a better feel for how Americans are perceived abroad vs. how we perceive ourselves than just about anyone. I think that we have a little too high opinion of ourselves.

There's a fine line between patriotic pride and hubris. No matter where you live, exclude the rest of the world when you invest at your own peril. Wink


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PostPosted: Sun Sep 21, 2003 6:17 am    Post subject: How do we show superscripts or exponentiation here? Reply with quote

Wise and Lucky writes:
Quote:
Chips,

I had to read your example a few times before I could figure out why I had a problem.

Your example uses a return of 2^n which provides the return of 1 at each level. The quoted example (Bernoulli's) gives a return of 2n which would be substantially lower (in the third iteration the return would be 0.125 X 6 which is only 0.75 ducats).

Am I missing something?


Thanks for reading carefully, and sorry about the error.

Short answer: You aren't missing anything. The problem is that the superposition of the "n" was lost when I simply cut and pasted the quotation. The expression 2^n is correct; 2n is incorrect.

Long answer: In my earlier post, I seem to have omitted a reference URL. Here it is:
http://cepa.newschool.edu/het/essays/uncert/bernoulhyp.htm. If you look there, you will see the problem stated using symbols that I cannot reproduce here. (Maybe someone can show me how.) The important line reads
Quote:
if the first head appears on the nth toss, then the payoff is 2n ducats.
when I cut and paste it, but the "n" appears above the line in the original, meaning 2 to the nth power. 2 to the nth is correct; 2n is not. I expressed the exponentiation, 2 to the nth power, as 2^n. Exponentiation is also expressed sometimes with double asterisks, thus:
Quote:
2**n
for 2 to the nth power.

<whine> Cut-and-paste should not CHANGE things! </whine>



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PostPosted: Sun Sep 21, 2003 7:01 am    Post subject: Reply with quote

hocus says
Quote:
In order for the intercst SWR numbers to be accurate, his assumption that the investor will sell no stocks even in the event of a worst-case scenario also needs to be accurate. The historical data indicates that this assumption rarely is accurate. The few times in which it might be accurate are in those cases in which the investor has so much in the way of assets that the losses sustained in a worst-case scenario have no practical consequence. In all other circumstances, his conclusions can be objectively demonstrated to be wrong. It is not "safe" to presume that the results obtained by stock investors of the future will be entirely unlike any that have ever been obtained by stock investors of the past.


For what it is worth, my personal history provides evidence that someone might not sell anything even when the market turns against him. I quit trading years ago. In the sharp decline of 1987, I sold nothing and just continued with my dollar-cost-averaging monthly investments in an S&P 500 index fund within a 401k.
Quote:
http://hnn.us/articles/895.html In the days between October 14 and October 19, 1987, major indexes of market valuation in the United States dropped 30 percent or more. On October 19, 1987, a date that subsequently became known as "Black Monday," the Dow Jones Industrial Average plummeted 508 points, losing 22.6% of its total value. The S&P 500 dropped 20.4%, falling from 282.7 to 225.06. This was the greatest loss Wall Street had ever suffered on a single day. . . Unlike 1929, however, the market rallied immediately after the crash, posting a record one-day gain of 102.27 the very next day and 186.64 points on Thursday October 22. It took only two years for the Dow to recover completely; by September of 1989, the market had regained all of the value it had lost in the '87 crash.

The author says "only two years" but during that period, we didn't know how long it would take to recover from that stunning one-day loss. It is easier to be calm about that period in retrospect, knowing how it would come out, than it was living through it without such knowledge. This may not be the worst case that hocus had in mind, but the crash of 1987 is the worst day I have seen personally as an investor for forty years.

How did other people respond to the 1987 crash? Shiller wrote a paper on the subject called Investor Behavior in the October 1987 Stock Market Crash: Survey Evidence, but unfortunately, I cannot find it online. Here is an abstract of it:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=227115
Quote:
Questionnaires were sent out at the time of the October 19, 1987 stock market crash to both individual and institutional investors inquiring about their behavior during the crash. Nearly 1,000 responses were received.
The survey results show that: 1. No news story or rumor appearing on the 19th or over the preceding weekend was responsible for investor behavior, 2. Investors' importance rating of news appearing over the preceding week showed only a slight relation to decisions to buy or sell, 3. There was a great deal of investor talk and anxiety around October 19, much more than suggested by the volume of trade, 4. Many investors thought that they could predict the market, 5. Both buyers and sellers generally thought before the crash that the market was overvalued, 6. Most investors interpreted the crash as due to the psychology of other investors, 8. Portfolio insurance is only a small part of predetermined stop-loss behavior, and 9. Some investors changed their investment strategy before the crash.
This does not tell us how much company I had in my calm reaction to the 1987 crash. As I said, I sold nothing and just continued with my DCA.
Quote:
Hocus: The few times in which it might be accurate are in those cases in which the investor has so much in the way of assets that the losses sustained in a worst-case scenario have no practical consequence.
In 1987 my calm reaction had its basis more in my retirement stash being fairly small at the time rather than quite large and my expectation that I would have additional years of accumulation. I knew my industry was flaky, but I didn't foresee in 1987 that my accumulation phase would end just six years later. In any case, someone's retirement stash is large or small relative primarily to his spending level, I think, rather than some absolute number of dollars. I refer to ideas such as Prodigious Accumulator of Wealth or PAW from Millionaire Next Door.
Quote:
It is not "safe" to presume that the results obtained by stock investors of the future will be entirely unlike any that have ever been obtained by stock investors of the past.
The market has had an average real return around 7% in the past. I would be highly pleased with results like that in coming decades. However, few people expect the future, at least the near-term future, to be so good. So, evidently, it is also not "safe" to presume that the results obtained by stock investors of the future will be entirely like any that have ever been obtained by stock investors of the past.



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PostPosted: Sun Sep 21, 2003 9:12 am    Post subject: Is the S&P 500 actually two asset classes, LcG and LcV? Reply with quote

raddr:
Quote:
If you make a big bet on a single asset class at the beginning of the withdrawal phase, in this case LcG, and it gets clobbered early then you better lower your withdrawal rate or face likely disaster.


If I read this correctly, raddr is referring to me and to my S&P 500 index dominated investments as a single asset class and more specifically, to the S&P 500 as Large Capitalization Growth stocks. I may not have been adequately diversified from raddr's point of view, but referring to the S&P 500 Index as a single asset class strikes me as strange. Aren't both Large Capitalization Growth and Large Capitalization Value, by definition, half the value of the S&P 500? (That's not a rhetorical question. I'm somewhat in the dark since I don't do slice and dice. Your comments are welcome. ) As I understand it, my S&P 500 investment is half LcG and half LcV. As I see it, I made a big bet on these two asset classes, comprising more than 80% of the total value in the US stock market.

I certainly agree with raddr on the idea of lowering the withdrawal rate in the face of a decline in value of the retirement stash. As I've said before, I raise or lower my withdrawals at about half the percentage change in that value. 10% gain or loss in the market produces about a 5% gain or loss in my withdrawals. That number comes from a mathematical optimization with the objective of stabilizing the purchasing power of the retirement stash as closely as possible over the next thirty odd years, given a constant after-tax standard of living from here on. I didn't just make up the result. It seems that this sensitivity at one half is that low for two reasons: 1. Part of my income is a corporate pension and will be social security soon, neither of them affected by market volatility. 2. The graduated income tax assures that my tax bill falls or rises faster than my ordinary income.



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PostPosted: Sun Sep 21, 2003 9:23 am    Post subject: Reply with quote

Hi raddr,

Thx for the compliment. I knew the post was long but I was hoping there was something good in there.

I would say that most people internationally view you (Americans) with a mixture of hubris, jealousy and annoyance at the level of arrogance displayed towards other nations. I understand Americans sufficiently to realise that the arrogance is not intended and is institutionalized. I recall a dot com millionaire who dropped it all to travel widely. He visited Fiji and realised there was just so much out there to explore (how he felt and I feel regarding foreign travel). Paul Terhorst also mentions this a little and was particularly insightful in his book when he said you shouldn't complain when abroad and embrace the culture (Brits go to Brit-populised parts of Spain and expect English breakfast and grumble when the Spanish cannot do it right). I'm giving languages my first go in almost 20 years with a beginner course in Spanish early next month with a view to enrich my experience travelling (Spanish is seems to be just about the most frequently spoken language outside of English and is used in many European destinations including many FIRE locations..) If that proves successful then I may go further with more advanced courses and consider learning French and Italian.

Watched a show on house swapping, a cheap way for people to go abroad and skip the hotel costs (particularly cheaper for families). Most people seem to go with high expectations and don't seem to embrace the differences. The last show had a woman in her 50s, mansion in the deep south and a couple of kids. Not one had ever left American shores. It just makes your mind boggle! My grandmother used to have the same attitude towards food, nothing "messed about with". Such attitudes lead to a limited, unadventureous and often dull life I feel. Of course we all have history and culture and sights to see but it just not the same experience. This is different however from those who write in personal ads: " Well travelled. " which often translates to " Have sat on a beach in Spain and spoke English which there. " which is a bit of a cop out and not the same thing at all!

It is regrettable that events like 911 enhance the lack of desire to travel in Americans. Also unlike what some Americans might think, Americans are welcomed abroad. There isn't the universal hatred that people might at first think. Anyone who comes across as arrogant is disliked which privately I do feel is part of the cause of the terrorist actions in general, it makes you a target. No one likes the teacher's pet sort of thing, but I think you have to see that in context. I also say that in the knowledge that London is a very likely terrorist target (where I live) because we are America's supporter.

P.S. I'm pleased you know me well enough to not think my post was America-bashing.

Petey
raddr wrote:
Petey,

Nice post!
Quote:
I do think the problem is more basic: Many Americans don't travel out of the country. They seem to have an attitude that America is the whole world.


This is so true. We Americans are so insular. I think that we have a little too much of an air of superiority towards the rest of the world. This carries over into investing where there seems to be an attitude that since we are the greatest country we must have superior markets and there is little reason to diversify outside of our narrow little slice of the world. BTW, if you've read Jim Rogers' books he agrees with your point of view. He should know since he's travelled around the world both by motorcycle and by car and probably has a better feel for how Americans are perceived abroad vs. how we perceive ourselves than just about anyone. I think that we have a little too high opinion of ourselves.

There's a fine line between patriotic pride and hubris. No matter where you live, exclude the rest of the world when you invest at your own peril. Wink


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