Thinking About Retirement Portfolios
Finance professors Andrew Lo and Stephen Foerster have
given us a tour or modern finance theory through the lives and ideas of
its leading academics and practitioners with the goal of coming with a
“perfect” retirement portfolio. He starts his intellectual history with the
mean-variance work of Harry Markowitz and then goes on to discuss the “betas”
of Bill Sharpe, the efficient market hypothesis of Eugene Fama and the options
pricing world Black-Scholes/Merton. We also have Jeremy Siegel who’s “Stocks
for the Long Run” became the bible of the 1990’s bull market, yet Siegel did
call the top in the NASDAQ in early 2000.
His practitioners are index fund founder John Bogle,
pension consultant Charles Ellis and bond guru Martin Leibowitz. We also have
the behavioral economist Bob Shiller of irrational exuberance fame. In the
interests of full disclosure Marty Leibowitz was my boss for a time at Salomon
Brothers and I worked with Myron Scholes there as well. I also first met with
Bob Shiller at the infamous Fed meeting on the stock market in 1996 where I was
a participant.
What all of them had in common is that they were math
“nerds” as kids. Further something must have been in the water at the
University of Chicago and M.I.T. in the late 1960s. It was at those two places
along with Sharpe’s UCLA that modern portfolio theory exploded on to the scene.
For my perspective I received an MBA from UCLA in January 1966 in finance where
modern finance was barely discussed and four years later when I returned for a
Ph.D. in finance it was all that was discussed.
So, what is an investor contemplating retirement to
do? The general consensus is that there is no generic retirement portfolio. It
depends on the individual investor’s tolerance for risk and consumption
patterns. Within that framework nearly all of them would recommend low-cost
index funds and TIPs. There is some support for the traditional 60/40 stock
bond portfolio, but Siegel and Ellis are skeptical of bonds when interest rates
are extraordinarily low as they have been for the past several years. However,
this presents a quandary, if bonds can be over-priced why can’t stocks be and
vice versa. This is where Shiller’s cyclically adjusted price earnings ratio
might be a tool to be used qualitatively.
Several of them recommend adding international stocks
through a low-cost index fund, small cap stocks and value stocks to the mix.
Although this was certainly theoretically sound around the turn of the century,
over the past two decades those substitutions within an equity portfolio would
have severely detracted from investing the S&P 500 alone.
My criticism of the book is that it gives to great a
weight to the concept of efficient markets. While the markets are efficient
most of the time, that is always not the case. Witness the recent collapse of high
value-money losing companies as an example. The authors mention the term “black
swan,” in passing, but they do not mention Nicholas Nassim Taleb who
popularized the term a decade ago. This omission is unfortunate because Taleb
is one of the keenest critics of modern finance theory. Simply put the tails of
return distributions are much fatter than in a normal distribution and the
probability distributions are not stable over time. Moreover, we know our lives
are path dependent, why shouldn’t markets be path dependent, at least, in some
cases and especially when the economic regime changes.
Although cited, the 1900 dissertation by Louis
Bachelier in Paris, should have been given more emphasis. As mentioned,
Bachelier anticipated Einstein by five years on the idea of Brownian Motion, he
also had a well-developed idea on the pricing of stock options that pre-dated
Black-Scholes by 70 years. Specifically, he defined the notion of put-call
parity which is essential for modern options theory to work.
Nevertheless, Lo and Foerster have written a very
helpful book for investors seeking sensible guidelines for retirement planning
and who also would benefit from modern finance theory.
For the full amazon URL see: Thinking About Retirement Portfolios (amazon.com)
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