Stocks for the Long Run, Sixth Edition

Jeremy Siegel recently wrote, with Jeremy Schwartz, the sixth edition of his popular book, Stocks for the long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies.  I read the fifth edition nearly a decade ago, and because the book is good enough to reread, this sixth edition gave me the perfect opportunity to read it again.

I won’t repeat comments from my first review.  I’ll stick to material that either I chose not to comment on earlier, or is new in this edition.

Bonds and Inflation

“Yale economist Irving Fisher” has had a “long-held belief that bonds were overrated as safe investments in a world with uncertain inflation.”  Investors learned this lesson the hard way recently as interest rates spiked at a time when long-term bonds paid ultra-low returns.  This created double-digit losses in bond investments, despite the perception that bonds are safe.  Siegel adds “because of the uncertainty of inflation, bonds can be quite risky for long-term investors.”

The lesson here is that inflation-protected bonds offer lower risk, and long-term bonds are riskier than short-term bonds.

Mean Reversion

While stock returns look like a random walk in the short term, Figure 3.2 in the book shows that the long-term volatility of stocks and bonds refutes the random-walk hypothesis.  Over two or three decades, stocks are less risky than the random walk hypothesis would predict, and bonds are riskier.

Professors Robert Stombaugh and Luboš Pástor disagree with this conclusion, claiming that factors such as parameter and model uncertainty make stocks look riskier a priori than they look ex post.  Siegel disagrees with “their analysis because they assume there is a certain, after inflation (i.e., real) risk-free financial instrument that investors can buy to guarantee purchasing power for any date in the future.”  Siegel says that existing securities based on the Consumer Price Index (CPI) have flaws.  CPI is an imperfect measure of inflation, and there is the possibility that future governments will manipulate CPI.

Siegel continues: “Additionally, the same caution about the interpretation of historical risk that applies to stocks also applies to every asset.  All assets are subject to extreme outcomes called tail risks or black swan events.”

Rating Agencies’ Role in the Great Financial Crisis of 2008-2009

Siegel offered a partial defense of rating agencies who failed to see that mortgage-related securities were risky:

“Standard & Poor’s, as well as Moody’s and other ratings agencies, analyzed these historical home price series and performed the standard statistical tests that measure the risk and return of these securities.  Based on these studies, they reported that the probability that collateral behind a nationally diversified portfolio of home mortgages would be violated was virtually zero.  The risk management departments of many investment banks agreed with this conclusion.”

Standard statistical tests are notoriously unreliable when it comes to extreme events.  Flawed math might say an event has probability one in a trillion trillion when its true probability is one in ten thousand.  The world is full of people who use statistical methods they don’t understand, and there are others who use statistics to get the answer they want for personal gain.

Conclusion

I still agree with my conclusion in reviewing the previous edition: This book is very clearly written and offers powerful evidence for the advantages of investing in stocks. I highly recommend it to investors.

Going Infinite Doesn’t Say What People Want to Hear Right Now

Michael Lewis’ latest book Going Infinite: The Rise and Fall of a New Tycoon is an entertaining account of the journey of Sam Bankman-Fried and his cryptocurrency trading firm FTX.  Lewis’ many critics wanted the story to be a deep dive into Sam’s criminal activity and fraud within the cryptocurrency industry, but that’s not the story Lewis is telling.

Relative to social and business norms, Sam is an outlier of huge proportions.  So much so, that his meteoric rise in the cryptocurrency business world would have seemed impossible in advance.  This is the story Lewis told. However, Sam is currently on trial for (allegedly) swindling billions from traders and investors.  Those most interested in this story wanted to learn more details of the swindling.

Some critics accuse Lewis of having been taken in by Sam.  I didn’t get this from the book.  Lewis did discuss Sam’s seeming transgressions, he just didn’t dwell on them because they weren’t central to the story he was telling.  One example of the discussion of a potential crime is “FTX had simply loaned Alameda all of the high-frequency traders’ deposits … for free!”

In another example, Lewis at one point had done some simple accounting and had concluded that billions of dollars were missing.  He tried to press Sam about it, but “Either he didn’t know where the money had gone or he didn’t want to say.”  Note that not knowing where the money had gone is not the same as not knowing it had been taken in the first place.

Readers who don’t care much about cryptocurrencies or Sam’s guilt or innocence will likely find this story entertaining.  Lewis displays his usual skill at evoking vivid and funny images.  At a big media event “Sam emerged, looking as if he had fallen out of a dumpster.”

Going to a meeting with Mitch McConnell, Sam “carried what appeared to be a small pile of old laundry” which turned out to be a suit.  “[Sam] walked up the steps of the private plane and plopped the suit ball onto a spare seat.”  McConnell liked to be addressed as “Leader”, and Sam needed to practice to avoid saying “Dear Leader.”

“He tossed popcorn in his mouth, in a herky-jerky motion that resembled a clumsy layup.  He was shooting around 60 percent, and the popcorn was flying everywhere.”

After reading the book, I was left with the impression that Sam would very likely be convicted of financial crimes.  But the story was really about Sam Bankman-Fried and a cast of other implausible characters doing things that didn’t seem like they should have been possible.  However, it’s understandable if people who lost their life savings in FTX don’t want to hear about Sam’s interesting quirks.

What Experts Get Wrong About the 4% Rule

The origin of the so-called 4% rule is WIlliam Bengen’s 1994 journal paper Determining Withdrawal Rates Using Historical Data.  Experts often criticize this paper saying it doesn’t make sense to keep your retirement withdrawals the same in the face of a portfolio that is either running out of money or is growing wildly.  However, Bengen never said that retirees shouldn’t adjust their withdrawals.  In fact, Bengen discussed the conditions under which it made sense to increase or decrease withdrawals.

Bengen imagined a retiree who withdrew some percentage of their portfolio in the first year of retirement, and adjusted this dollar amount by inflation for withdrawals in future years (ignoring the growth or decline of the portfolio).  He used this approach to find a safe starting percentage for the first year’s withdrawal, but he made it clear that real retirees should adjust their withdrawal amounts in some circumstances.

In his thought experiment, Bengen had 51 retirees, one retiring each year from 1926 to 1976.  He chose a percentage withdrawal for the first year, and calculated how long each retiree’s money lasted based on some fixed asset allocation in U.S. stocks and bonds.  If none of the 51 retirees ran out of money for the desired length of retirement, he called the starting withdrawal percentage safe.

For the specific case of 30-year retirements and stock allocations between 50% and 75%, he found that a starting withdrawal rate of 4% was safe.  This is where we got the “4% rule.”  It’s true that this rule came from a scenario where retirees make no spending adjustments in the face of depleted portfolios or wildly-growing portfolios.  So, he advocated choosing a starting withdrawal percentage where the retiree is unlikely to have to cut withdrawals, but he was clear that retirees should reduce withdrawals in the face of poor investment outcomes.

We can see Benegen’s thinking in two quotes from his paper.  When a portfolio is depleting too fast, a retiree has the “option to improve the situation for the long term, and that is to reduce—even if temporarily—his level of withdrawals.”  When a portfolio’s growth exceeds expectations, “Some increase in withdrawals are probably inevitable.”

So, when experts think they are criticizing Bengen when they say the 4% rule is too inflexible, they are mischaracterizing his paper.  I’m not aware of any serious advocate for blindly following a fixed spending plan in retirement that ignores portfolio growth or decline.

Bengen’s paper has its faults, though.  Here are several articles I’ve written about the 4% rule:

Adjusting the 4% Rule for Portfolio Fees

Revisiting the 4% Rule

A Quiz on the 4% Rule

4% Rule Based on Longevity Statistics

Misleading Retirement Study

Ben Carlson says You Probably Need Less Money Than You Think for Retirement.  His “favorite research on this topic comes from an Employee Benefit Research Institute study in 2018 that analyzed the spending habits of retirees during their first two decades of retirement.”  Unfortunately, this study’s results aren’t what they appear to be.

The study results

Here are the main conclusions from this study:

• Individuals with less than $200,000 in non-housing assets immediately before retirement had spent down (at the median) about one-quarter of their assets.
• Those with between $200,000 and $500,000 immediately before retirement had spent down 27.2 percent.
• Retirees with at least $500,000 immediately before retirement had spent down only 11.8 percent within the first 20 years of retirement at the median.
• About one-third of all sampled retirees had increased their assets over the first 18 years of retirement.

The natural conclusion from these results is that retirees aren’t spending enough, or that they oversaved before retirement.  However, reading these results left me with some questions.  Fortunately, the study's author answered them clearly.

At what moment do we consider someone to be retired?

People’s lives are messy.  Couples don’t always retire at the same time, and some people continue to earn money after leaving their long-term careers.  This study measures retirement spending relative to the assets people have at the moment they retire.  Choosing this moment can make a big difference in measuring spending rates.

From the study:

Definition of Retirement: A primary worker is identified for each household. For couples, the spouse with higher Social Security earnings is the assigned primary worker as he/she has higher average lifetime earnings. Self-reported retirement (month and year) for the primary worker in 2014 (latest survey) is used as the retirement (month and year) for the household.

There is a lot to unpack here.  Let’s begin with the “self-reported retirement” date.  People who leave their long-term careers tend to think of themselves as retired, even if they continue to earn money in some way.  Depending on how much they continue to earn, it is reasonable for their retirement savings either to decline slowly or even increase until they stop earning money.  What first looks like underspending turns out to be reasonable in the sense of seeking smooth consumption over the years.

The next thing to look at is couples who retire at different times.  Consider the hypothetical couple Jim and Kate.  Jim is 6 years older than Kate, and he is deemed to be the “primary worker” according to this study’s definition.  Years ago, Jim left his insurance career and declared himself retired, but he built and repaired fences part time for 12 more years.  Kate worked for 8 years after Jim’s initial retirement.  

Their investments rose from $250,000 to $450,000 over those first 8 years of retirement, declined to $400,000 twelve years after retirement, and returned to $250,000 after 18 years.  Given the lifestyle Jim and Kate are living, this $250,000 amount is about right to cover their remaining years.  Although Jim and Kate have no problem spending their money sensibly, they and others like them skew the study’s results to make it seem like retirees don’t spend enough.

What is included in non-housing assets?

From the study:

Definition of Non-Housing Assets: Non-housing assets include any real estate other than primary residence; net value of vehicles owned; individual retirement accounts (IRAs), stocks and mutual funds, checking, savings and money market accounts, certificates of deposit (CDs), government savings bonds, Treasury bills, bonds and bond funds; and any other source of wealth minus all debt (such as consumer loans).

So cottages and winter homes count as non-housing assets.  This means that a large fraction of many people’s assets is a property that tends to appreciate in value.  Even if they spend down other assets, the rising property value will make it seem like they’re not spending enough.  It is perfectly reasonable for people to prefer to keep their cottages and winter homes rather than sell them and spend the money.  

Consider another hypothetical couple Ted and Mary who have generous pensions that cover their needs and wants.  Their only significant non-housing assets are a cash buffer of $25,000, and a nice trailer in Florida whose value rose from $40,000 when they retired to $200,000 18 years later.  By the methods used in this study, Ted and Mary appear to be continuing to save throughout retirement for no good reason.  In reality they’re not doing anything wrong.  Once again, people like Ted and Mary are skewing the study’s results.

What about an inheritance?

It’s not uncommon for retirees to receive an inheritance from a long-lived family member or close friend of the family.  When the amount of this inheritance is predictable, beneficiaries can account for it in their spending.  However, beneficiaries often don’t know much about when they will get money, how much they will get, or even if they will be named in the final will.  

It’s prudent for retirees to plan for the low end of a possible range.  When they finally get the inheritance, and it turns out to be more than they planned to receive, it might look like they’re underspending when we only compare their assets on retirement day to their assets two decades later.

Conclusion

It’s always possible for nitpickers to quibble with the methodology of any study.  However, it would make a material difference in this study’s results if we were to adjust its methodology to account for working income after retirement, cottages, winter homes, and inheritance.  The study’s conclusions don’t mean anything close to what they appear to mean.  They shed no light on whether retirees are spending reasonably.  We know that there are retirees who spend too much, others that spend well, and those who spend too little.  This study fails to tell us anything about the relative sizes of these three groups.

Party of One

We’ve heard for some time now that China’s rise as an economic superpower is inevitable, and that China will surely surpass the U.S.  Extrapolating from the past few decades, this appears certain.  However, changes made by China’s current leader, Xi Jinping, have cast doubt on China’s ascendancy.  Chun Han Wong has covered China for the Wall Street Journal since 2014 and has written the book Party of One: The Rise of Xi Jinping and China’s Superpower Future.  His descriptions of the massive changes Xi is making lead me to believe that China’s growth will at least slow, if not falter altogether.

My take on China is hardly original, and does not come from a deep understanding of China.  It comes down to the simple observation that for a society to become wealthier over the long term, its most brilliant and driven citizens must have the freedom to innovate.  We can’t know in advance which citizens will make a big impact, so this freedom must be available to most citizens to get the benefits from the few who will do big things.

Until recently, China’s rise has been impressive.  “Deng-era decentralization had unleashed dynamism that helped China boost its gross domestic product by more than fiftyfold from less than $150 billion in 1978 to $8.2 trillion by 2012, and bring more than 600 million people out of poverty.”  After decades of increasing freedoms under previous leaders, Xi has reversed course.  “Where pragmatic innovation once flourished, Xi imposed ‘top-level design.’”

Bureaucracy “has grown even more pervasive under Xi, whose top-down governance has driven officials toward foot-dragging, fraud, and other unproductive practices—so as to satisfy their leaders’ demands and avoid his wrath.”

Xi is using technology to exert greater control.  Citizens were assigned green, yellow, or red codes based on “their potential Covid exposure.”  “What began as a disease-control mechanism became a handy tool for social control, as some security agencies started using health-code data to flush out fugitives and block dissidents from traveling.”

“Xi’s insistence that entrepreneurs serve the party fostered what critics call a ‘hyper-politicized’ business environment, dampening enthusiasm to invest and innovate.”

Under Mao Zedong’s “totalitarian control,” “productivity frequently suffered, as factories were often overstaffed and workers generally content to meet minimum output quotas without concern for the quality or marketability of what they made.”  Although things aren’t this bad in modern-day China, Xi is heading down the same path.

In one example, police detained an entrepreneur, and his daughter stepped in to run the business.  But after more than 18 months, the daughter “made a dramatic plea: inviting the government to run the company and take over its assets.  ‘It’s too bitter and too tough being a Chinese private entrepreneur.’”

Although it has little bearing on China’s future growth, Xi’s sensitivity about his schooling is interesting.  According to “Hu Dehua, a son of former party chief Hu Yaobang,” Xi “attended school only until the first year of junior high.”  According to “one princeling who has known Xi for decades,” “Xi is not cultured.  He was basically an elementary schooler.”  “He’s very sensitive about that.”  Apparently, to compensate, Xi “started raving about his passion for books,” claiming to have read the works of dozens of famous writers.

In an extreme example of the suppression of human rights, “The United Nations human rights agency spent years reviewing” allegations of Beijing “committing cultural genocide against Uyghurs” and concluded that “Chinese authorities there may have committed ‘crimes against humanity.’”

According to “Wang Huning, a party theorist who joined the Politburo Standing Committee in 2017,” “American individualism, hedonism, and democracy would eventually blunt the country’s competitive edge.”  “Rival nations powered by superior values of collectivism, selflessness, and authoritarianism would rise to challenge American Supremacy.”  I think the opposite is true.  Rival nations can only catch up to the U.S. by freeing its people as China did to some degree in the decades leading up to Xi’s control.  Xi’s “top-down control suppressed initiative and flexibility, while encouraging rote compliance and red tape.”

“A decade into the Xi era, the party appears more in control than ever.  It embraces digital authoritarianism and maintains a high-tech security state.  It coerces and surveils its citizens with internet controls, big data, facial recognition, social-credit systems, and other state-of-the-art tools.  Civil society has been all but neutered; activists get imprisoned, muzzled, forced into exile, or coopted by the state.  Dissenting voices face police harassment, jail time, and a ravenous online ‘cancel culture’ fueled by party-backed patriotism.”

I’m not suggesting that China will collapse or that Xi will lose control of China.  China’s impressive economic rise to date could sustain it for decades even if its citizens are tightly controlled.  In a sense, the economy China has built is available to be spent by Xi in whatever way he sees fit.  He could also reverse course again and let capitalism grow its economy further.  As ever, the future is unclear.  What is clear from the evidence presented in this book is that Xi has made a hard break from the policies that fueled China’s rise.