In the financial advisory business, one of the most pressing and controversial topics is how much money people need to save during their working years in order to provide for long-term retirement income. The research on this topic has evolved quite a lot in recent years, and a recent issue of Money magazine features a series of articles representing the current view on this critical topic. These articles, based around interviews with a number of the current thought leaders on this topic, deserve to be widely read and discussed.
The series of articles in Money kicks off with perspectives by Wade Pfau. Pfau’s introductory piece suggests a difficult future for American workers. A traditional rule-of-thumb in retirement planning is called the 4% rule. This rule states that a retiree can plan to draw annual income equal to 4% of the value of her portfolio in the first year of retirement and increase this amount each year to keep up with inflation. Someone who retires with a $1 Million portfolio could draw $40,000 in income in the first year of retirement and then increase that by 2.5%-3% per year, and have a high level of confidence that the portfolio will last thirty years. It is assumed that the portfolio is invested in 60%-70% stocks and 30%-40% bonds. The 4% rule was originally derived based on the long-term historical returns and risks for stocks and bonds. The problem that Pfau has noted, however, is that both stocks and bonds are fairly expensive today relative to their values over the period of time used to calculate the 4% rule. For bonds, this means that yields are well below their historical averages and historical yields are a good predictor of the future return from bonds. The expected return from stocks is partly determined by the average price-to-earnings (P/E) ratio, and the P/E for stocks is currently well-above the long-term historical average. High P/E tends to predict lower future returns for stocks, and vice versa. For a detailed discussion of these relationships, see this paper. In light of current prices of stocks and bonds, Pfau concludes that the 4% rule is far too optimistic and proposes that investors plan for something closer to a 3% draw rate from their portfolios in retirement. I also explored this topic in an article last year.
One of the most interesting market stories in the last week is the big drop in the Japanese stock market. Japan is the third-largest economy in the world, ranked by GDP. The values of the Japanese stock market, as measured by the Nikkei 225 index, dropped by 7.3% on May 23rd, and then suffered another fairly dramatic one-day decline of 3.2% on May 27th.
Over the last five sessions, the iShares MSCI Index ETF, EWJ, has dropped by almost 10% (see chart below). Continue reading →
Vanguard has just reduced the expense ratios of 24 of its ETFs. The reductions are fairly substantial. What I noticed, in particular, is that the reductions include sector-specific ETFs.
The Vanguard Energy ETF (VDE), the Vanguard Information Technology ETF (VGT), the Vanguard Telecom ETF (VOX), and the Vanguard Utility ETF (VPU) each now have 0.14% expense ratios vs. 0.19% previously. While the expense ratios of these funds were already low, the new expenses are 26% lower than before. Continue reading →
Moronic question, right? Of course we don’t. The S&P 500 sits at about the same level it did five years ago. Bond interest rates have never been lower, and the Fed says it’s planning to keep them that way through mid-2015.
Turn on any financial channel and you’ll find as many gloomy predictions as you care to sit through: debt-fueled implosion in Europe, the next flash crash, the shrinking dollar, a stagnant labor market, Great Depression 2.0 (or is it 3.0 by now?). Continue reading →
In Part 1 of this series, I set the stage for a discussion of behavioral finance and game theory as they pertain to how market participants behave. In Part 2, I expand upon some of ways that individuals and institutions behave in ways that can be explored from this perspective.
Giving People What They Want
One of the most striking features of the capital markets of the recent year or two has been the ‘Las Vegas’ feeling to much of the action in the markets. There has been tremendous excitement around IPOs of companies including Zynga (ZNGA), Groupon (GRPN), and most notably Facebook (FB). The hoopla around the Facebook IPO, in particular, is without precedent. Why do the financial media and corporate management work together to create this frenzy? The answer is simple: people buy it. If investors ignored the carnival atmosphere around these firms, we wouldn’t see this kind of media. If people say that they want to invest in solid well-run profitable firms, but clearly signal that what they are actually buying is shares in IPOs of companies with enormous dreams but untested business models, we know what Wall Street will provide. If investors seem to be seeking investments that behave like lottery tickets, it is perfectly rational for venture capitalists to fund such companies and to rapidly take them public. I view the marketing of Facebook’s IPO as perfectly executed to exploit behavioral biases. I am not a conspiracy theorist, but even the trading delay on the day of the IPO helped to bring the frenzy to own shares to a fever pitch. The Facebook IPO and others like it suggest that Wall Street is very effectively playing a game that many investors do not really understand. Continue reading →
Watching the market this year has been like observing an exercise in game theory and behavioral finance, and the two fields are closely related. Game theory is the study of how a rational person makes decisions in uncertain situations. As the name suggests, game theory was developed with the intent of developing optimal strategies in games in which chance or the decisions of an opponent play a role in your outcome. Game theory focuses on how rational players can make the best decisions to maximize their satisfaction. Behavioral finance adds the nuance that, in real life, people do not necessarily have all available information and, even if they do, they often make decisions that are inconsistent with those made by a perfectly-rational and fully-informed decision maker. Continue reading →
The market rally of the past twelve months may appear somewhat baffling in light of the fact that individual investors have been pulling money out of the market. The S&P 500 is up 22.5% in the last year, while September marks the 17th consecutive month during which investors took money out of equity mutual funds. The outflows from equity mutual funds are not simply due to investors moving from mutual funds to ETFs. A recent analysis by Bianco Research demonstrates that including ETF flows does not change the results. Continue reading →