Swedroe's Paradox and Kahneman's Boundary

[cowboyhat]

Harry Browne's investment idea was that you should put the money you can't afford to lose into a super safe portfolio, and that you should only speculate with money you can afford to lose. But how much, exactly, or even approximately, can you afford to lose?

Larry Swedroe frames this question as a paradox. Because risk and return are negatively correlated, Swedroe notes that investors who are most able to take risk are those with lots of capital, and are therefore are those who have the least need to take risk. And unfortunately, investors who most need to take risk are those with little capital, who can least afford risk. But he doesn't say where to draw the line between lots of capital and little.

These are different ways of thinking about similar things, but neither one offers a specific number. And it's hard to interpret a Monte Carlo simulation without an investment objective.

Do I NEED to maintain my current income in retirement? That seems ambitious (but probably what a percentage-of-assets-invested-fee adviser would suggest). Do I NEED to maintain my current lifestyle? That sounds like nice, but not like need. How much does a retired person need? How about enough money to be happy? How much is that? In dollars per year?

Amazingly enough, Daniel Kahneman has found the general solution, at least for the "average American family." If you haven't watched this talk it is worth 20 minutes of your time. Be sure to stay to the end and hear the question.

http://www.ted.com/talks/daniel_kahnema ... emory.html.

Kahneman discovered that you can't maximize happiness based on memory, but found that you can maximize immediate experiential happiness. And even better, he puts a reasonable dollar figure on this kind of happiness. In 2010, $60,000 bought a certain kind of happiness for the average American family. That is Kahneman's boundary.

Swedroe's logic is that if income from your investments in retirement will fall below Kahneman's boundary then you should take on as much risk as time allows to push yourself over the line. Browne's logic is the reverse. You should play it safe and try to save your way across the line. Passing game or running game, your choice. I have a temperament inclined toward Browne's view, but I want to know where Kahneman's Boundary is for a retired American.

[Bongleur]

$60k   I need to spend more then...  I'd appreciate being able to buy better happiness...

[cowboyhat]

Saving money is a trade off between maximizing happiness now when you are definitely alive and able to be happy, and maximizing happiness later when you or a loved one may or may not be around.

Harry Browne talked about this. He said that you should have a fund of money that you blow after your meet your budget. You have to enjoy life today. The problem I'm struggling with is where to draw the line and I think Kahneman has drawn it, at least in principle.

But his $60,000 comes from a survey that includes money people spend on debt service, rent or mortgage payments, income taxes, health insurance, etc for their entire household. I don't see a retired person needing so much, especially if they have paid off their house, don't have any credit card debts, and avoided expansive hobbies like golf or driving an RV.

[Wonk]

Great topic Cowboyhat, thanks for the link.  Kahneman talks about the $60K level around the 18m mark and my impression was that it was $60K per person, not $60K per family.  Am I off base on that?

From what I can see, the $60K/person level looks about right as far as the law of diminishing returns and Pareto's Principle.  That would be $120K for a household of 2 and in the US, would buy an upper middle class lifestyle in most areas of the country after taxes are applied.

[stone]

I thought a survey had found that "enough money to be content" was always 1.5x what you currently have and that that relationship extends across several orders of magnitude of wealthiness. Also that risk and reward trade off is baseless isn't it? What would have less risk than the PP? 100% cash has great risk from inflation. Craigr was told by his accountant that not one of the accountant's clients outdid Craigr's PP. Of course the Ranaissance Technologies Medalion fund etc do much better but they probably also are lower risk than the PP too. They just take an army of rocket scientists to operate and have a small capacity within the market and that capacity is already full. Am I in a mudle about this?

[MachineGhost]

Last time I looked hapinesss was at >30K, but >60K could be equally as applicable nowadays.  Just on a gander, what would have less risk than the PP would be something like the CPI ETF, at least in terms of volatility.  But notice how this fund of funds' fees is causing it to underperform the CPI.  It initially seems like a "smart" version of the PP with a few more asset classes and monthly rebalancing.  I didn't read up on what the strategy was, but perhaps it is worth emulating to avoid the fees.

The market's capacity isn't full.  Institutional traders, such as hedge funds, are forced to trade above a certain level of minimum liquidity that retail traders can easily trade below.  This is a structural edge that can be exploited.

MG

I thought a survey had found that "enough money to be content" was always 1.5x what you currently have and that that relationship extends across several orders of magnitude of wealthiness. Also that risk and reward trade off is baseless isn't it? What would have less risk than the PP? 100% cash has great risk from inflation. Craigr was told by his accountant that not one of the accountant's clients outdid Craigr's PP. Of course the Ranaissance Technologies Medalion fund etc do much better but they probably also are lower risk than the PP too. They just take an army of rocket scientists to operate and have a small capacity within the market and that capacity is already full. Am I in a mudle about this?

[cowboyhat]

Below is the transcript of what he said. You are right that he did not specifically say whether this $60,000 was for the average family or per individual.



Chris Anderson: Thank you. I've got a question for you. Thank you so much. Now, when we were on the phone a few weeks ago, you mentioned to me that there was quite an interesting result came out of that Gallup survey. Is that something you can share since you do have a few moments left now?


Daniel Kahneman: Sure. I think the most interesting result that we found in the Gallup survey is a number, which we absolutely did not expect to find. We found that with respect to the happiness of the experiencing self. When we looked at how feelings vary with income. And it turns out that, below an income of 60,000 dollars a year, for Americans, and that's a very large sample of Americans, like 600,000, but it's a large representative sample, below an income of 600,000 dollars a year...


CA: 60,000.


DK: 60,000. (Laughter) 60,000 dollars a year, people are unhappy, and they get progressively unhappier the poorer they get. Above that, we get an absolutely flat line. I mean I've rarely seen lines so flat. Clearly, what is happening is money does not buy you experiential happiness, but lack of money certainly buys you misery, and we can measure that misery very, very clearly. In terms of the other self, the remembering self, you get a different story. The more money you earn the more satisfied you are. That does not hold for emotions...

[cowboyhat]

Kahneman's research was on household income. He published it in PNAS last year. The article is available for free at the following link:

http://www.pnas.org/content/107/38/16489.full

According to the paper median household income in the United States in 2010 dollars was $70,000. The boundary for maximization of emotional well being is a household income of about $75,000. About 1/3 of US households are above the boundary.

Was a pretty well funded and complete study with 1000 interviews a day for a year. From the methods:

The survey involved a telephone interview using a dual-frame random-digit dial methodology that included cell phone numbers from all 50 US states. Interviews were conducted between 9:00 AM and 10:00 PM (local time), with most done in the evening. Up to five callbacks were made in the case of no answer. Spanish language interviews were conducted when appropriate. Approximately 1,000 interviews were completed daily from January 2 through December 30, 2009.

[smurff]

In addition to specifying family size, it would also help if he specified whether the $60,000 was pre-tax (meaning the family would be left with $45K or so after tax) or after tax (meaning the family would have to have earned 80,000 or so pre-tax, both at a modest 25%).

[Roy]

Larry recently (this year) revealed a modified way of handling rebalancing to control risk.  What he does for himself, and certain clients, is to establish an upper boundary for equity rebalancing with no lower boundary.  That is, in a 30/70 portfolio, if equities get to, say, 35%, he rebalances;  but if equities drop he does not rebalance, ever.  He once mentioned that one can "rebalance themselves into the poor house," so this deals with that.  Some frequent readers of his were very surprised at this strategy, since they had only ever heard him discuss disciplined rebalancing, with all that such entails.

[stone]

Roy, what if a peak such as 1999 never gets reached again? It all seems so arbitary. If someone happened to start off in 1999, then they might never ever see rebalancing gains. Meanwhile someone else who happened to start in 2002 might see 8% gains for perpetuity

[Roy]

Roy, what if a peak such as 1999 never gets reached again? It all seems so arbitary. If someone happened to start off in 1999, then they might never ever see rebalancing gains. Meanwhile someone else who happened to start in 2002 might see 8% gains for perpetuity

Hi, Stone. I suppose the point is to set a ceiling on how much equity one wishes to lose, while still (likely) always having some equity in the game;  it is primarily about preservation of capital, and clearly not meant for most investors.

[stone]

Roy, I think Clive came up with something interesting that showed that over the 1929 to 1949 period, rebalancing into stocks via a pseudo-PP (with silver in place of gold) was suprisingly benign. Although stocks lost money, the buying in was predominately at the market bottom and the market doubled from the bottom before halving again.

[Bongleur]

Seems like one has to specify the goal of rebalancing -- to maximize gains, or to preserve capital.  Only then can you determine your rules for rebalancing.

[cowboyhat]

In a poker tournament, where one player has all the chips at the end and wins (obviously different from life), the optimal strategy between maximizing gains and preserving capital depends on the ratio of a player's capital (stack size) to the cost of playing (ante and blind bets).

For no limit Texas Holdem a stack size that is > 20x the cost to play per round of dealing is considered by some authors to be large enough to allow the player to adopt either a conservative or an aggressive strategy. When a player's stack size drops in to the 10 to 20x expenses/round range the only viable strategy is aggressive play because the costs begin to consume capital more rapidly than a conservative style will replenish it. Below 10x costs/round the player is near elimination without some kind of lucky break and therefore the only rational strategic option is berserk aggression.

Life in a developed country is different because there is a social safety net and therefore dying abruptly from poverty isn't really a consequence in the way card players bust out of poker games. That means there is always some reason to preserve capital since it will increase happiness over the minimal baseline of misery. Which I think means aggressive investing may not be the best choice for people who are behind in the presence of a safety net.

It does seem like Kahneman's boundary is a line around which a rational investor would change strategy, presuming they were smarter than me and could figure out the correct strategy to use below the boundary.

[Bongleur]

Medicaid requires you to spend down to essentially nothing before you get the safety net.  Must be rationale at some wealth level to be very aggressive, because if you blow it you have only lost marginal utility that would not get you out of Medicaid anyway.

[cowboyhat]

So if you are never going to be able to save enough to matter it is rational to "invest" whatever you can spare in lottery tickets. You are sure to lose, but your were sure to lose anyway, and maybe your one in a zillion chance will hit. Plus you get a little thrill from gambling.

And if you already have a zillion dollars then it really doesn't matter what you invest in as long as it isn't lottery tickets. You can afford to be conservative or aggressive, but there really is no point in being aggressive because the marginal utility of 2 zillion dollars over 1 zillion dollars is pretty close to zero unless you want to build a giant limestone pyramid in the desert outside Las Vegas so that for the rest of human history people can come gawk at where you were buried.

Conservative v. Aggressive style choices only matter around Kahneman's boundary.

[Bongleur]

Kahneman investigated "happiness" but there is no correlation between that feeling and being a wise enough investor to adequately plan for retirement money.

His findings say absolutely nothing about how aggressive one must be to assure an adequate retirement.