Fixing the REHP Study

Research on Safe Withdrawal Rates

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hocus2004
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Fixing the REHP Study

Post by hocus2004 »

The REHP study reports inaccurately what the historical data says re what withdrawal rate is safe. Intercst's refusal to either acknoweldge or correct the errors in the study has caused great damage to the various FIRE/Passion Saving/Retire Early discussion board communities. All responsible community members should be doing what they can to see that the errors are corrected as quickly as possible so that their fellow community members do not suffer further financial losses as a result of the inaccurate claims that have been put forward.

I had been planning to start a thread on "Fixing the REHP Study" at some later date. However, the issue surfaced today in a post put forward by JWR1945 on the "Dead Posts File" thread, so I thought I should go ahead and open this thread now and move the discussion initiated by JWR1945 over here. I'll put forward some sketchy thoughts of my own now and add more detail to them at a later date.

To gain a full understanding of the context in which the JWR1945 post was put forward, you need to look at the discussion that takes place in the "SWR as a Tool" thread. JWR makes the point there that the 4 percent number reported as safe in the REHP study in fact is not safe according to the historical data. SalaryGuru put up a word game post in an apparent effort to trick community members who have not been following the debate closely into thinking that this is not so. I deleted the word game post from that thread, and placed the text of the deleted post (as well as an explanation of why it was deleted) in a new thread called "Dead Posts File."

JWR1945 offered the following comments in response to my thread-starting post:
I composed this earlier this morning and then found the original post missing:
The Historical Database Rates of the past were generally bounded by 3.9% or 4.0% (over 30 years and with 50% to 80% stocks).

We draw a sharp distinction on this board between Historical Database Rates, which tell us what would have survived in the past, and Safe Withdrawal Rates, which are mathematically calculated estimates of what will be safe in the future.

I think that it was a good decision to separate this from the original thread.
If I am not mistaken, Hocus is beginning to use the phrase Historical Database Survivability Withdrawal Rate (HDSWR) as a descriptive replacement for the older phrase Historical Database Rate (HDBR).

Have fun.

John R.
I don't want us to discuss issues of substance in the "Dead Posts File" thread. That thread is reserved for the posting of the words of deleted posts and discussions of why the deletions were made. When I finish this post, I will put up a post on the "Dead Posts File" thread asking that discussions of the points raised by JWR1945 be moved here.

JWR1945 says in his post that "Hocus is beginning to use the phrase Historical Database Survivability Withdrawal Rate (HDSWR)...." Actually, the phrase that I use to describe the number reported in the REHP study is "historical surviving withdrawal rate (HSWR)." I am of course open to the use of any phrase that accurately describes the number reported in that study and other conventional methodology studies.

There are two points that must be conveyed by a phrase for it to be accurate:

1) It must be made clear to readers of the study that the methodology used in the REHP study was not designed to give us an indication of what withdrawal rate is likely to survive in the future. Since the study ignores a factor that has always in the past played a key role in the determination of what withdrawal rate is safe, there is no reason to believe that the number reported in the study is safe for retirements beginning today. I use a phrase including the word "historical" to alert readers to this critical limitation of the study.

2) It must be made clear to readers of the study that the methodology used in the REHP study was not designed to reveal the withdrawal rate that was safe at any time-period. The methodology employed identifies a withdrawal rate that in a hypothetical sense would have survived in earlier time-periods. It does not tell us whether the surviving withdrawal rate reported was a safe withdrawal rate at the beginning of any of the particular historical sequences examined. The reality is that, in some of the sequences examined, the 4 percent number survived the hypothetical test because it was safe (or even more than safe) while in others, it survived because it was lucky. It is not reasonable to presume that because a number survived once or twice for a historical sequence beginning from a specified valuation level that it is a safe withdrawal rate to use for other 30-year sequences of returns beginning from similar valuation levels. The study examines only the question of whether a withdrawal rate survived or not. It does not consider whether the rate survived because it was a safe number at the valuation levels that applied at the beginning of the retirement or whether it survived because it was a lucky number in one or two particular historical sequences examined.

Another approach to fixing the REHP study would be to add language pointing readers to the work that has been put forward discrediting it. In the event that intercst continues to this day to believe that his study provides an accurate report of what the historical data reveals re what withdrawal rate is safe , he is under an obligation to his readers to make them aware of the case that has been raised discrediting the study and of his reasons for not being persuaded by the case that has been made.

If this is the approach used to fix the study, he needs to include references to the claims made by William Bernstein that the conventional studies are misleading at times of high valuation and to Bernstein's determination that the REHP study was off the mark by a full two percentage points in the number it reported as safe at the top of the bubble. He also needs to make reference to the work that has been done at the various discussion boards, especially the work done at this board. Finally, he needs to discuss the claims that have been put forward by such experts as Rob Arnott, Robert Shiller, Andrew Smithers and others taking exception to the root assumption of the REHP study, that changes in valuation have zero effect on long-term returns and thus that no adjustment for changes in valuation is needed in a reasoned analysis of what withdrawal rate is safe.
hocus2004
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Post by hocus2004 »

The study published at RetireEarlyHomePage.com contains language in its Disclaimer section stating that "while every effort has been made to offer the most current and correct information possible...."￾

Here is a link to my "What Bernstein Says" post. This post was put to the Motley Fool board on August 27, 2002.

http://boards.fool.com/Message.asp?mid=17744487

Here is the full text:

I do not believe that it is possible to guess the direction in which the stock market is going to move in the next week, the next month, or the next year. My skepticism regarding this practice, a practice I refer to as "timing,"￾ is shared by many knowledgeable investment analysts. For example, William Bernstein, author of "The Intelligent Asset Allocator,"￾ says in his most recent book, "The Four Pillars of Investing,"￾ that "the pattern of annual stock returns is almost totally random and unpredictable."

Does that mean that Bernstein agrees that a portfolio with an 80 percent stock allocation has a 100 percent certainty of generating a 4 percent safe withdrawal rate for a retirement commencing on Aug. 1, 2000, the day I said goodbye to the world of ties and offices and regular paychecks? It does not. Bernstein says (page 234) "current retirees may not be entirely safe withdrawing more than 2 percent of the real starting values of their portfolios each year."￾ That is in accord with my own assessment.

How can he say such a thing? Doesn't Bernstein, an expert on efficient market theory, know what the historical data says? Of course. Bernstein's books are filled with charts showing what the historical data reveals. But while Bernstein views it as almost impossible to predict short-term changes in market prices, he also understands a point which he says (page 12) "cannot be made too forcefully or too often: high previous returns usually indicate low future returns, and low past returns usually mean high future returns."￾

Thus, for example, "the recent very high stock prices in the United States would not have been possible without the chaos of the 19th Century and the prolonged fall in prices that occurred in the wake of the Great Depression."￾ Prices must fall in ways similar to (but not exactly the same as) the ways they have fallen before if stocks are in the future to be the attractive investment class that they have been in the past.

Bernstein points out (page 108) that "It is easy to obtain the monthly or annual returns of various classes of stock assets, feed them into a spreadsheet or a device called a "mean variance optimizer"￾ and determine precisely what combinations of these assets worked the best. But we can only do this in the past tense; it tells us nearly nothing about future portfolio strategy. If anyone tells you that he knows the future's best allocation, nod slowly, slide back several steps, turn, and run like hell."￾

But does Bernstein not believe that stocks are the best asset class? He thinks they are a very good asset class indeed, as do I. But he sees some downside too.

For one thing (page 116), "Millions of investors in the 1920s and 1960s thought (my emphasis) that they could tolerate a high exposure to stocks. In both cases, the crashes that followed drove most of them from the equity markets for almost a generation."￾ He observes that (page 152), "there will always be speculative markets in which the old rules seem (my emphasis) to go out the window."￾

For another (page 56), "Stocks have had an incredible run the past few decades. Their prices have been bid up dramatically, so that their future returns will be commensurately lower."￾
His advice? Be skeptical of researchers claiming levels of certainty unattainable in investment decision-making: "I'm amused when financial planners and academics talk about methods that predict a 40-year success rate of, oh, say, 95 percent."￾

And don't forget to factor in the fact that the safe withdrawal rate for stocks is not a stable number, but changes with stock price levels. He says of one study (page 231) that "the scariest thing about their results was that the period they studied had real stock returns of 7 percent. Future stock returns are likely to be lower, which means that even their 4 percent to 5 percent withdrawal rate may be overly optimistic."￾

How can Bernstein say that safe withdrawal rates change over time if he does not believe in timing? He believes (page 43) that "the historical returns we studied in the last chapter are invaluable, but these data can, at times, be misleading. The prudent investor requires a more accurate estimate of future returns for stocks and bonds than simply looking at the past."￾

And what would that be? The discounted dividend model, "which allows the investor to easily estimate the expected return of stocks and bonds with far more accuracy than the study of historical returns."￾ What does that model say about the level of overvaluation in the market at the top of the most recent bull market peak? "At least twice in this century U.S. investors indeed did demand a 15 percent discount rate."￾ And what sort of DOW are we looking at if the discount rate goes to 15 percent again? DOW 1400 (page 53). (To be sure, Bernstein does not predict DOW 1400, and, to be sure, neither do I.)

Add it all up, huge bull markets giving optimistic predictions of future stock performance more credence in many investors' eyes than they would normally possess, an overvalued market permitting a safe withdrawal rate of only half of what is normal, and an historical record of investors with high stock allocations leaving that investment class for decades after being burned by the consequences of their excessive optimism, and you have an account that says to me, "hocus, you were not necessarily loony to go with a stock allocation of less than 80 percent when you commenced early retirement on August 1, 2000."￾

But how will I know when it is time to up my stock allocation? That's an entirely different question, of course. If you are going to lower your stock allocation at any time, you do need to think about what the historical data indicates is the best way of getting that allocation back up again at some later date. That's a question that I would very much like to see this board address.

But it needn't be discussed today. It can't be discussed today. Determining the answer to that question requires taking a serious look at the historical data to see what strategies are likely to be most effective. It's too soon for this board to move to that question, with a good number still professing in the most heated terms confidence in a 4 percent withdrawal rate from stocks at any valuation level. Until consensus (or at least a willingness to be agreeable while remaining in disagreement) is reached on that point, any effort to discover the best way to increase a stock allocation when times of extreme overvaluation pass will head off in chase of a dozen uninteresting and unimportant semantic distinctions.

For now, try not to think about any of that. Focus on one thing, what Bernstein says. The man is a serious student of efficient market theory. He says the safe withdrawal rate is not 4 percent, but something less. A lot less. When the board achieves some measure of acceptance of that point, then will be the time for constructive discussions of what to do about it.
JWR1945
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Post by JWR1945 »

hocus2004 wrote:Here is a link to my "What Bernstein Says" post. This post was put to the Motley Fool board on August 27, 2002.
I had to double check the date. I had to make sure that is wasn't this morning.

Have fun.

John R.
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