Scott Cederburg is an Associate Professor of Finance and the Thomas C. Moses Endowed Professor in Finance at the Eller College of Management. He earned his PhD in Finance from the University of Iowa. His research focuses on issues related to long-horizon investment outcomes and retirement security, return predictability, and mutual fund performance. His studies have been published in top academic journals, including the Journal of Finance, the Journal of Financial Economics, the Review of Financial Studies, the Journal of Financial and Quantitative Analysis, and the Review of Finance. He won the 2018 TIAA Paul A. Samuelson Award for Outstanding Scholarly Writing on Lifelong Financial Security for his study, "Tax Uncertainty and Retirement Savings Diversification," and his work has been covered by The Wall Street Journal, Bloomberg, Forbes, and Consumer Reports, among other outlets.

In this episode, we welcome back the esteemed Professor Scott Cederburg, Associate Professor of Finance at the University of Arizona. In this highly anticipated episode, Professor Cederburg revisits the show to delve into his groundbreaking paper on life cycle asset allocation. Professor Cederburg's latest research presents findings that disrupt traditional thinking in the field, prompting a deep dive into the implications of these new insights. In our conversation, we unpack the findings from the paper and how they challenge established norms in retirement planning and asset allocation. We discuss what the new paper adds to the discourse, his approach and methodology, the different assessment criteria used, and the main findings from the paper. We also delve into the different asset allocation strategies assessed, which strategy performed best, aspects that would influence the various strategies, and how to invest for the long term safely. We explore the nuances of stock versus bond returns and the hidden benefits of international diversification. Gain profound insights into the significance of social security, inflation-protected bonds, target date funds, and the repercussions of an all-equity strategy. Comparing his latest paper with prior research on withdrawal rates, Professor Cederburg highlights surprising aspects of the results and provides invaluable takeaways for financial advisors from these cutting-edge findings. Discover how this pioneering work challenges conventional wisdom, reshaping the landscape of retirement planning and investment strategies in this illuminating conversation with Professor Scott Cederburg.

Key Points From This Episode:

(0:00:00) Background about Professor Cederburg and episode overview.

(0:03:38) How his new paper challenges the central tenets in life cycle investing.

(0:06:56) What sets his method apart regarding its ability to challenge the status quo.

(0:09:40) How he characterizes the life cycle of the household modelled in his study.

(0:12:09) The data set used and his approach for sampling and analyzing the data.

(0:13:56) Retirement outcomes used to evaluate life cycle asset allocation strategies.

(0:15:49) Asset allocation strategies investigated in the paper and which one performs best.

(0:22:52) Left tail outcomes of all-stocks strategy, stock returns vs bond returns, and the benefits of international diversification.

(0:28:29) Learn about the importance of social security in the model and the nuances of inflation-protected bonds.

(0:32:05) Investing in target date funds and the downsides of an all-equity strategy.

(0:35:33) Hear about the impact of large intermediate losses on retirement savings.

(0:40:01) Unpacking the lag time on returns between stocks and bonds.

(0:42:15) Exploring investing behaviour and reasons for underperformance.

(0:45:03) The importance of return dependencies and what happens to the results if monthly returns are used.

(0:49:29) Navigating and modelling flaws and common aspects overlooked in financial analyses.

(0:50:36) Dissecting retiree adherence to traditional approaches to long-term investing.

(0:52:12) Home country bias and its influence on portfolio allocation.

(0:55:32) Currency effect and domestic stock hedging as a strategy.

(1:00:24) Comparing the findings from his latest paper with those from his paper on withdrawal rates.

(1:02:07) Aspects of the results that surprised him and takeaways for financial advisors from the latest research findings.

Read The Transcript:

Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.

Cameron Passmore: Welcome to another week, and episode 284 this week and we welcome back a fan favourite, Professor Scott Cederburg for an incredible conversation. I loved it. I loved every minute of it. He's just such a great guest, nice guy, clear thinker and boy, did we learn a lot today. But I'll let you do the setup. Let me just do a quick background on Scott.

He was our guest 60 episodes ago on episode 224. He's the Associate Professor of Finance at Eller College of Management at the University of Arizona and he earned his Ph.D. in finance from the University of Iowa. With that, Ben, you've got to give us the backstory.

Ben Felix: Well, I mean the backstory is that I've kept in touch with Scott since he was on Rational Reminder last time, back in episode 224. We went back and forth a whole bunch on a paper that he had done on safe withdrawal rates, did a video on that and people on the internet went crazy over it. Scott was kind enough to provide me with some additional data that wasn't in that paper that really added to that whole discussion.

But then, he had mentioned to me just in the course of chatting about stuff that he was working on his other paper on life cycle asset allocation using his data set that listeners are probably familiar with. If not, they'll hear about it in a minute. He said, “We're working on this thing.” Then a bunch of time passed. Scott talks about his pace of doing research near the end of the episode. But it's hard. He's thinking about really hard stuff. The model is huge and the data set is huge. He finally sends me this paper. I read it and posted it in the community. It's incredible. It challenges, which is basically what we talked about in this episode, it challenges some of the fundamental traditional wisdom of retirement planning and asset allocation. That's basically it.

The paper came out and I was like, “Well, you have to come back on the podcast.” I asked. I didn't tell him. “Would you like to come back on the podcast?” He was more than happy to do so. Between when the paper came out and him doing this episode with us, he's presented the paper at conferences. He's also discussed it in the Rational Reminder community. He's gotten all these different questions from people. Did you look at this? Did you think about this? I think we get a lot of that during this conversation because he has looked at so many things and thought about so many different things. Every time you think like, “Well, no. That can't be right, because of this,” he has an answer.

Cameron Passmore: He does.

Ben Felix: That was amazing. The findings are just incredible. As the title of the paper suggests, it really does challenge the thinking on life cycle asset allocation, which is something. I'm still thinking about it, what we do with it. How do we go forward from here knowing what we know now?

Cameron Passmore: Great guest to finish off 2023. With that, let's go to our conversation with Professor Scott Cederburg.

***

Ben Felix: Scott Cederburg, welcome back to the Rational Reminder Podcast.

Scott Cederburg: Yeah, thanks for having me back.

Ben Felix: We are very excited to be talking to you again. I know that I shared your paper in the Rational Reminder community a while ago. It has been discussed extensively. Since then, you've participated in some of those discussions, but I know people are very much looking forward to this episode. To kick it off, what are the central tenets of life cycle investing that you challenge in your recent paper ‘Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice?’

Scott Cederburg: There's really two main things that we're focused on that are common pieces of investment advice. One is to diversify across stocks and bonds. Then the other one would be that the young should invest more heavily in stocks compared with the old. If you think about some of the popular rules of thumb, like a 60/40 portfolio, super common, 60% stocks, 40% bonds is pretty widely talked about. A common classroom example for mean variance efficiency, the benefits of diversification across different asset classes.

Then another rule of thumb thrown around is a 100 minus age rule. If you would put 100 minus age into stocks and then the remainder in bonds, so that becomes an age-based stock bond strategy. When you're 25, you're 75% in stocks, 25% in bonds. Then you're 75, the opposite, you're 25% stocks, 75% in bonds. Those are the main things that we're looking at.

Ben Felix: Can you talk about the general logic behind that traditional age-based thinking on life cycle investing?

Scott Cederburg: Those super high returns that we've seen historically on stocks make them just a really good tool for wealth accumulation. If you're young, you invest in stocks, you have the potential to build up quite a bit of wealth by the time you're retiring. The problem is always that stocks crash. The conventional wisdom is if you're young, then you have enough time that you can sit around and wait for things to bounce back and recover from the crash. Whereas, if you're older and in retirement and stocks crash, that's a problem. Bonds have been historically viewed as being much safer for that set of investors. As people transition into retirement, the allocation of bonds has typically increased.

Cameron Passmore: How common is it for people to receive the traditional life cycle investing advice?

Scott Cederburg: I mean, it seems to be an all over the place. Textbook treatments and CFA study materials, all these sorts of things. I think a lot of the financial advice that you're going to get from advisors follows these types of everybody has their own little approach, but it tends to have these features to it. There's also popular books and academic literature. I always joke, if John Campbell and Dave Ramsey are telling you to do the same thing, they must be onto something.

Then it's even like, in the US, especially it's become coded into regulation effectively where there are in employer retirement funds, there are these qualified defaults effectively, where the employer no longer has any liability, as long as they put the right default into their fund. These have become these target date funds overwhelmingly and the target date funds, they'll have some dates associated with them. Maybe it's a 20/60 fund for people who think they're going to retire in 2060. Then the fund has a glide path where invests in domestic equity, international equity, bonds, bills, but just with an age-based approach, that's going to shift more towards bonds as that cohort ages.

Ben Felix: Can you talk about what sets your method apart in its ability to challenge the status quo on this thinking?

Scott Cederburg: It might sound almost a little simplistic. I think, if you're thinking about long-term investing and investing outcomes, it's the returns. You have to model returns in the best way possible if you're trying to figure out what's going to happen to long-horizon investors. There's three aspects here. First is pretty simple, but I think it's important to lay out at the beginning, we're going to be focusing on real returns, so adjusted for inflation throughout everything. That makes a difference when we're thinking about something like, how safe are bonds, for example.

Some 10-year treasury bond is going to be pretty safe until you think about the possibility that inflation could spike up and you're going to actually lose a lot of your real value. In the US, it's been talked about a lot recently, 2021-2022 in the US, if you held 10-year treasuries, you lost 30% in real terms over that two-year period. Your super safe asset almost lost 30%, and it's going to be pretty tough to get a lot of that capital back.

The second aspect of our data, as we're thinking about long-horizon investors, a household, there's a reasonable possibility that a household lasts until age 100. If you're starting to save at 25 or 30 years old and you're thinking about all the way until a 100, we're now thinking about 70-year periods of what are my investments going to do over 70 years. If we just think about the US, which is a commonly used data set for this type of an approach, there's just not much information on 70-year outcomes from a relatively short history that you're going to get from one country.

We're going to take an approach where we look at developed country returns that allows us to greatly expand the sample, basically, by adding a whole bunch of additional countries, and so, we get additional data from a bunch of different countries and we just bring a lot more information to the problem.

The third thing that I think is super important is if you're thinking about long-term returns and long-term investment outcomes, you have to actually look at long-term returns. It's pretty common to look at monthly means, standard deviations, correlations, but we've found throughout our work that these don't really tell you everything that you want to know about what happens over longer horizons. There's important properties of returns that happen over months and years and even decades that if you want to realistically capture what happens over long periods of time, you have to carefully keep those features in the data.

Cameron Passmore: So well put. Can you describe the life cycle of the household that you have modelled?

Scott Cederburg: We're considering couples, opposite-sex couples. At age 25, they can start working and saving. They're going to work until age 65, at which point they're going to retire. We have uncertain mortality or longevity. We're using the actuarial tables from the Social Security Administration in the US to model the life spans. That's an important aspect of it because you have an uncertain horizon as a household. Then during the working years, we have a model from a recent Econometrica paper that has been fit to actual worker data from the Social Security Administration.

We have uncertain income throughout the life cycle. Different people have different income profiles. There's the possibility of non-employment during times during the working years. Then we're going to have, our investors are going to save 10% of their money as they're working. Once they hit retirement, then they start drawing monthly income. They're going to have social security based on the US social security system. Then they're also going to be pulling out of their retirement savings. For our base case, we're just using this really simple 4% rule approach, where initially upon retirement, you see how much money you have, multiply that by 4%. If you have a million dollars, that's $40,000. They're just going to withdraw each month based on an annualized $40,000.

Then each year, just adjust that for inflation. If you have 10% inflation, then they're going to take out $44,000 the next year. The idea is just to get this real stream of income through this 4% rule, but that does open up the possibility that at some point, they actually just run out of money from their savings. At which point, they would just have social security. Then finally, if a couple passes away and they still have money, we have the bequest to any of their heirs. It's the basic setup of our life cycle.

Ben Felix: Yeah, it's cool. You've got an opposite-sex couple and you're really just following them through this hypothetical lifespan of saving and investing and then retiring and drawing down their assets and then potentially having an inheritance to the next generation. Is it 10% of their gross income being saved?

Scott Cederburg: Yeah.

Ben Felix: Cool. Now, listeners probably remember your returns set up and you alluded to it a little bit when we were talking about what sets your method apart. Can you talk about how your data are set up and how you're sampling from the data?

Scott Cederburg: We have this data set that we put together. It's been, I think, four years, maybe going on five years since we started putting this data set together. Our overall data set, we're looking at returns on domestic stocks, international stocks, which would be this value-weighted average of all of the other countries, anything that you don't live in, with currency conversions and all that stuff built in there. Then we have government bonds with a 10-year horizon and government bills.

We have these data. We've been able to go back, fill in all the holes and all this stuff. We have these data, overall sample study period, 1890 to 2019. We have a total of 38 countries that are in the sample. Overall, it's about 2,500 years’ worth of developed country-year observations that we have. We did a couple of things, or we did several things, I think, that help with one of the big worries when you're looking at historical information and then trying to project forward is the possibility that you have look-ahead biases.

One important one is survivor bias, where if you were conditioning on everybody being happy in a country right now, Then that doesn't necessarily pick up the bad events. This is one quick example. We have Czechoslovakia in our data set, which was a failed market shortly after World War II. This 2,500 years of data versus with the US sample, we have about 130 years’ worth of data would be all for the US sample to learn about the long horizon stuff.

Cameron Passmore: Incredible. What retirement outcomes did you use to evaluate life cycle asset allocation strategies?

Scott Cederburg: We're looking at four primary things. One is what's wealth at retirement. For each of these cases, we're going to simulate a million couples. We simulate the lifetimes of a million couples, and we're getting distribution the possibilities effectively. We look at the distribution of wealth of retirement, then there's retirement income that comes from both social security and withdrawals from the savings account, at least while it lasts. There's what we call a ruin probability that we completely exhaust the savings. If we use this mechanical 4% rule, if the market crashes, or we live for a really long time, we might just run out of money, and we're done with our savings at that point. We look at the probability of that happening, and then the size of any bequest at the end of the couple's life.

Ben Felix: That was retirement wealth, total consumption, ruin probability, and bequest?

Scott Cederburg: Yeah.

Ben Felix: Yeah, okay. That's cool. Ruin probability, would that be independent of retirement wealth? Because you're using the same withdrawal strategy for all of the – regardless of what wealth is, yeah?

Scott Cederburg: Yeah, exactly.

Ben Felix: Because you're using the 4% rule for everybody at retirement, someone who's accumulated more wealth is not in a better position from the perspective of ruin probability than someone with less.

Scott Cederburg: That changes, obviously, if you switch to different withdrawal strategies. We've looked at something like, you just withdraw 4% of whatever wealth you have built up every year. Then that takes your ruin probability down to zero. The effects all come in at that point with how much retirement consumption are you going to get?

Ben Felix: Super unstable retirement consumption, I think, in that case.

Scott Cederburg: Yeah.

Ben Felix: What asset allocation strategies did you look at in the evaluation using those metrics?

Scott Cederburg: We have five different variations on these things called QDIAs. In the US, it's qualified default investment alternatives for retirement savings. These are all going to be age-based stock bond strategies. The headline that I'll probably concentrate on the most is the glide path from a target date fund that's advertised from one of the largest – you would know the investment company if I said it. One of our main focuses is the target date fund approach. We do as a baseline comparison to that. If you go before the regulations that put in these rules in the US, things like money market funds and stable value funds were pretty common defaults in employer plans. We do have a case that's just like, what if you invest all your money in government bills? That's going to proxy for that.

Then we look at two all equity strategies. One would be, you just do 100% domestic stocks. Then the other one is you're going to do all equity, but 50% domestic and 50% international. We're at least diversifying geographically at that point.

Cameron Passmore: Which asset allocation strategies perform best on your evaluation metrics?

Scott Cederburg: If you're looking at the TDF for these other QDIAs relative to the bills strategy, hey, they're doing great in terms of actually generating some wealth before retirement and giving you a little bit more safety relative to that previous approach. If we look at the two all equity approaches, either a 100% domestic, or diversified internationally, they both by retirement create about 30% more wealth compared with the TDF. On average, they create about 30% more wealth at retirement.

If we then started looking during retirement, because the stock-based strategies have more wealth at retirement. You tend to get higher consumption, but there's some chance that you're going to run out of money and the TDFs are shifting away from equities to try and do capital preservation. During retirement, what's interesting is the internationally diversified equity portfolio, so 50% domestic and 50% international, ends up being safer during the retirement period compared with this TDF that's getting you into the bonds. You're actually less likely to run out of money during retirement if you're remaining a 100% equity.

At least, part of the reason for this, if we then take our million couples that we simulated and we say, “Okay, let's concentrate on the 200,000 couples that lasted the longest,” that's when the difference becomes really, really stark, where if you remain invested in equity, these are all households that are going to be living, one of the members of the household is living until say, 90, 95, a 100, or even beyond. Even at retirement, there's still a 30-year horizon, or maybe even longer than a 30-year horizon. You need to keep on generating wealth in retirement in order to hedge yourself against that possibility that you just live for that long.

One of the really interesting things is even though it's a higher volatility strategy in the short run and over the long run, it has a better chance of being safe from the perspective of maintaining retirement consumption. Then at the bequest, similar to a wealth build-up by the retirement date, the equity strategies, there's a long right tail on stocks if you're able to sit there for 75 years invested in stocks. There's some possibility at death that you still have substantial assets as an all-equity investor and it's just a little bit less so if you've been sitting in bonds for the last 30 years.

Ben Felix: Retirement accumulation, no one will be surprised that equities win there. Ultimate bequest, people might not be surprised about that. You're also saying that the all-equity strategies have a lower probability of ruin throughout retirement than the target date fund.

Scott Cederburg: If we're looking across our different strategies and we're looking at the ruin probability under the 4% thing, this would extend to different types of withdrawal strategies and stuff, the general idea. With bills, some money market approach that seems super safe, it's actually not safe at all. There's a 34% chance we estimate that you would run out of money before death. With the TDF, it comes down a lot, but it's still 17% chance, a 17% ruin probability with the TDF.

If you're 100% domestic stocks, then there's a little bit of an offsetting thing going on where it does help you against that longevity risk, because it's going to, on average, keep on generating quite a bit of wealth during retirement. A 100% domestic stocks is pretty risky, it's pretty volatile. That's still about a 17% chance. It's a slightly higher probability of ruin than a TDF is. TDF is a little bit safer than being a 100% domestic equity. If we're looking at the internationally diversified equity strategy, 50-50, that has an 8% ruin probability. It's like, half of the ruin probability of the TDF.

I think one other thing that's important to note here is, I think, sometimes our statements are being maybe construed as we're saying, that it's super safe to be in equity and all equity. I think 8% ruin probability with the 4% rule is still probably higher than a lot of people would want it to be. We're not saying that stocks are super safe, it's just on a relative basis if we're looking like, “Well, I got to do something,” this is the strategy that gives you the lowest overall risk during retirement.

Ben Felix: The safest thing would be an inflation-adjusted annuity, but you also wouldn't get anything close to a 4% equivalent distribution.

Scott Cederburg: Yeah, exactly. With the inflation-adjusted annuity from a theoretical perspective, this should be the dominant asset for basically, everybody in retirement. People don't really do it that much. If we were going to do that, then the entire game comes down to how much wealth do I have at retirement in order to buy one of these things. The all-equity strategies are so dominant during working years that we would continue to say, “This is the strategy, even if you are planning on fully investing.”

Ben Felix: The 50/50 domestic international all-stock portfolio dominates everywhere, including probability of ruin, and increasingly so at the longer end of the longevity distribution. Is that right?

Scott Cederburg: Exactly.

Ben Felix: Super interesting. Okay, now, what about in the left tail of outcomes? All stocks is good on average. I can hear listeners thinking, but it's probably got a much worse left tail. What do you see there?

Scott Cederburg: If we're looking at these outcomes that we're talking about, like the wealth at retirement, retirement consumption, ruin probability is tied to that left tail. Then wealth at death, the left tail is better for this all-equity, diversified strategy, compared with any of these age-based stock bond strategies that are supposed to be protecting you on the low side. A lot of this is just bonds seem super safe if you're looking at them over a short period of time. But from the perspective of a long-term investor where you don't know what inflation is going to be throughout your life, you're going to live for a long time, probably. Any period of inflation is just going to hit those bonds so hard, and it's just tough to recover in bonds.

The real return on stocks, the average real return on stocks is four times as high as the average real return on bonds. Even if you get hit sometimes on stocks, there's just a much better chance that you can bounce back from that. The international diversification also just helps so much. The left tail, the domestic stock distribution is not that favourable. But once we diversify internationally, we talked previously, like a year ago or so, there are these interesting effects with international portfolios, and we're doing all non-currency hedge international investments. But what we find over longer periods of time is that these currency adjustments tend to offset some of your local inflation shocks. If you have a lot of local inflation, your currency tends to depreciate, which actually benefits your international investments, and it can act as a little bit of a natural hedge against your own inflation. Just getting some money outside of your own domestic system, get it into this big basket of international markets seems to be a super helpful thing for reducing risk.

Cameron Passmore: So interesting. Is there any benefit to having even a small allocation of bonds, even for just diversification sake?

Scott Cederburg: If we're looking throughout the entire lifecycle, we've run it like, what if we just throw 5% in bonds, or 10% in bonds? The investors don't like it. They prefer 0% to 5%. Even, my guess is if we were allowing them to short bonds and lever up in stocks, they would probably want to go minus 20% or 30% in bonds and go even heavier in equity.

Ben Felix: That's intuitive. Does that speak to mean-variance optimization not being super useful for long-term investors?

Scott Cederburg: People are either going to listen to us on this paper where they aren't, but I think one of the most important things that we're hoping with this line of research is just, let's all carefully think about how to model long-horizon returns. If we're interested in long-horizon returns, let's think carefully about how to model these things. If you look over short periods of time, so say we look at monthly data in our data set, the correlation between domestic stocks and bonds is 0.15 at a monthly level. Not very correlated. You're probably getting a lot of diversification benefit there.

At the monthly level, domestic stocks and international stocks have much higher correlation than that. But if we look over the long horizon, like a 30-year horizon, the correlation between stocks and bonds is almost 0.5. There's actually much higher correlation at long horizons for bonds and stocks, and then domestic stocks and international stocks have a lower correlation at a long horizon compared with the stock and bond, so the geographical diversification is actually more beneficial than the diversification across the two asset classes.

Domestic stocks and international stocks both have high expected returns, bonds don't. There's even a thing where stocks – there's mean reversion in stocks, so higher returns tend to be followed by relatively lower returns, lower returns tend to be followed by relatively higher returns, and it reduces the risk a little bit for long-term investors. It's the opposite thing going on in bonds. If you're currently in a high inflation environment with increasing interest rates, both of these things are bad for real returns on bonds. I mean, if that's happened each of the last 12 months, the odds that it happens this month, next month, the month after that and the month after that is all pretty high.

The way that bond returns act, they actually get more volatile from the perspective of a long-term investor. Bonds are becoming more and more volatile. But you don't get that bump on the return, you still just get that small, little return. You're getting this thing that over longer horizons, it’s getting riskier, it's becoming more correlated with stocks, and it's just not compensating you much on the average return set.

Ben Felix: Wow. Inflation's persistent and is not predictive of higher future bond returns. Whereas, with inequities, you have that mean reversion.

Scott Cederburg: Yeah, exactly.

Ben Felix: There's a paper that you may think of – I think it's from Cliff from AQR called ‘International Diversification Works (Eventually).’ They basically look at that like the short-term versus long-term correlation on domestic and international stocks.

Scott Cederburg: Yeah, exactly. It's my belief anyway that we should really be concentrating on return properties at the horizons that people actually care about. We know so much about monthly returns, but how many of us have a one-month holding period?

Cameron Passmore: So true.

Ben Felix: How important is social security? You’re modelling social security. If you take that out, is 100% equity is still optimal?

Scott Cederburg: A 100% equity is still optimal, regardless of what we would do with the social security piece. The reason for that, the distributions are all better throughout the distribution. Wealth of retirement, it's just giving you a better distribution of wealth of retirement compared with the other strategies. Retirement consumption. The differences across the strategies are all coming from the withdrawals from the strategies and not social security. The way we set up the simulation is we have eight parallel couples that all in each month have the exact same income as each other in the exact same contributions to social security and everything like that and the exact same longevity. The only thing that differs across the couples is the strategy that they pick.

Social security is mainly in our paper to give us maybe a little bit more realistic sense of utility-based calculations in retirement. It's not realistic to say that you go to zero consumption if you run out of money. There's still something there. It's just not going to be the lifestyle you were open for if you run out of savings.

Cameron Passmore: How would adding inflation-protected bonds affect what you found?

Scott Cederburg: It's tough for us to explicitly look at this in the historical data because these things just haven't existed for the entire history and they don't exist in all countries even now. I think, Ben, you were saying that Canada has phased out their program. These things, if you do have access to them, the way that we've tried to look at it is to imagine that there is some hypothetical TIPS where you're just going to get – I'm probably going to say TIPS a lot, so treasury inflation-protected securities in the US for TIPS.

Imagine that you have these inflation-like bonds that are just going to pay you 1% real rate. We try to do maybe 0%, or 2%, one of the kind of risks with TIPS, if you're waiting until retirement to put part of your money in this, I think real rates right now are pretty high, so you would be getting a pretty good investment, but it wasn't that long ago, the real rates even on long-term TIPS were negative. There's a little bit of that reinvestment risk that you have with the TIPS.

As we looked at the trade-offs, if we put 20%, or 40% of money in TIPS after retirement, they're still not good for the wealth accumulation phase. But after retirement, putting 20% to 40% in TIPS, it was this trade-off where the ruin probability comes down. You're more likely to maintain consumption throughout your life if you're using a 4% rule, but your bequest is going to go way down too, because you're not generating nearly as much wealth.

Then if you use one of these alternative withdrawal strategies where you're withdrawing more if you make a lot of money in your portfolio, if you link withdrawals to the savings, then it's a trade-off of, “Do I want to avoid super low consumption at some point, or do I want the possibility of getting more?” There is just a safety trade-off that would be different across different investors, I think.

Ben Felix: You're not modelling taxes, right, which could be a problem for inflation-protective bonds?

Scott Cederburg: That's another practical issue with inflation-protective bonds is you pretty much – I mean, I think you want to have those things in a retirement account, or perhaps the TIPS funds. I mean, those have a lot of volatility on a year-by-year basis, potentially. But there are implementation issues with the TIPS.

Ben Felix: Same issue in Canada. Although, like you said, those are being phased out anyway, so we don't have to worry about them. How much more would this household have to save in target date funds to fund their retirement consumption to match that of someone investing in stocks through the full lifecycle?

Scott Cederburg: Our investors in the base gates are saving 10% of their income as they go. We run this in a utility comparison during retirement. The couples are getting utility from each month of consumption, and then they're getting some utility from bequest to their heirs. If we try and do this comparison, what would it take for me to save in a TDF to get the same happiness in retirement as this all-equity strategy? You would have to save 14.1% with the TDF throughout your entire life. That's relative to the baseline of 10%. You have to save, in some sense, it's 4.1% more, but that's 4.1 of your total income, and it's a 41% increase in the amount that you're actually saving in order to achieve the same outcomes.

Cameron Passmore: Wow. Those are real numbers. Can you talk about the downsides of investing in an all-equity strategy?

Scott Cederburg: The really big one is, been sweeping this one under the rug up to this point, but it's drawdowns. Intermediate drawdowns. If I'm defining a drawdown, this is like a peak-to-trough change in your account balance, ignoring any withdrawals that you've done, just like, what happened to your assets, or your asset returns over a period. Again, we're thinking in real terms. But as an example, in retirement, the largest drawdown that a couple will face in retirement, on average, across simulations for a TDF, there'll be some time on average where you're going to lose 38%. You have a peak-to-trough dip of 38% of your asset value. For the internationally diversified stock portfolio, that's 50% on average.

At some point, you're going to have a bigger drop, like stocks are more volatile over relatively short periods of time. You do have to be prepared for, it's going to be a little bit bumpy, but then all of those eventual outcomes that we were talking about, wealth of retirement, wealth of death, retirement consumption, probability of running out of money, all of those paths include those big drops in stocks. At least, if you have a big drop in stocks, we see quite often in the data anyway, that the stock’s come back. Whereas, if bonds crash, especially if it's just losing real value due to inflation, it's never coming back.

The issue with bonds is if you do get hit at 30% loss over a two-year period in bonds in the US, I mean, the only way that you can get some of that back is if interest rates go back to zero. But you're never going to get back that inflation eroded portion of that wealth.

Ben Felix: It's a much bigger average drawdown, but you're still better off on all evaluation metrics.

Scott Cederburg: It's very much like an eventual outcome, versus sitting there and looking at your account balance every day. Those are going to be two very different experiences for you if you're one of these all-equity investors.

Ben Felix: Man. Barring behavioural issues, you just alluded to and we can come back to that later, just objectively, how much of a risk do you think large intermediate losses actually are for people who are saving for and living through and funding their retirements?

Scott Cederburg: We force our investors in the simulation. They have no emotions. We tell them what strategy to do and they are very loyal to the strategy that we tell them to do. That becomes the key. It does come down to the behavioural stuff. I know US regulators are worried about drawdown risk. I think that's just something that we need to confront head on effectively and say like, this is something that exists. If we do a strategy that is likely to give us better outcomes, but has these intermediate drawdowns. Okay, now we just need to figure out what are we going to do, because the obvious issue is people panic and withdraw their money from risky assets when they crash and probably have the highest expected returns. At least with stocks, we think that after a crash, that's at least partially because expected returns are probably really high at that point. You have to stick it out.

Cameron Passmore: Keep going, Scott. What about in retirement when retirees often talk about the sequence of returns risk, which is really these intermediate losses? What does all that say about that?

Scott Cederburg: Our investors don't respond to sequence of return risk at all. Some of it definitely is going to be coming in in this ruined probability that we have. The 4% rule is subject to the sequence of return risk. If you have an immediate crash in stocks, in retirement, you're more likely to run out of money. That risk is baked into the results that we're getting. Different withdrawal strategies are going to handle that in different ways.

One thing that we did at one point is just say, okay, so this is the scariest thing. You're a retiree, you're a 100% stocks, and then stocks crash immediately upon retirement. We actually looked and we're like, what if we just looked at the worst outcomes in stocks for that first year of retirement? What's the best strategy to be in? It's still the internationally diversified stock strategy.

Ben Felix: Whoa, that's wild.

Scott Cederburg: We can go even throughout the entire retirement period and say, okay, so the worst-case scenario is that stocks do poorly while you're retired. What if we take the 20% worst outcomes for stocks during your entire retirement period? In that case, the baseline ruin probabilities were 17% for TDF, 8% for this stock strategy. If we're in this 20% set of worst outcomes, then it's 34% for the TDF and 24% for the stock strategy. It's worse to be in a period where stocks do really badly, but the TDF actually still does worse when the all-equity strategy when stocks do poorly. I think this goes back to if we look at the long-term relations across assets from our previous paper using these data that we talked about last year. Over a 30-year period, stocks are going to not beat inflation with about a 12% probability and bonds, that's 27% probability. But if we look at a loss period for stocks, if stocks lose over a 30-year period, bonds lose 61% of the time over that same 30-year period.

The TDF has tried to get you away from the risk that stocks are going to go down by getting you into bonds. But if stocks go down, bonds probably go down. That's not a safe place to go. Stocks still 4% higher average return than bonds. We're not saying that this is all safe and a rosy outlook on everything if you're in all stocks. We're just saying the data tell us that there are no good alternatives to that, with the potential exceptions of these annuities, like inflation, linked annuities, or inflation-protected bonds are potentially going to be a helpful part of retirement. Other than that, you have to take some risks and hope that you have a good outcome.

Ben Felix: Stocks and bonds will go down together in the long run, because people will hear that and think, “Well, no. Bonds go up when stocks crash.” But that's like, that month, or maybe that year. In the long run, if domestic stocks do badly, bonds will also tend to do badly in the data.

Scott Cederburg: There are interesting lags, because I don't even know if I mentioned how we're modelling our long-term returns, but we're using something called the block bootstrap approach, where we're taking this historical data and we're going to be randomly drawing periods from the historical data and coming up with a return sequence that lasts your entire life. We're taking on average 10 years of consecutive data from the same country, so we'll get all four asset classes from the same country and taking 10 years, on average, we're able to maintain some of these longer-term asset return dependencies.

I think a nice thing about the bootstrap is we don't even have to take a stance on what it is that we're trying to find in there. You're just asking the data, how does stuff behave over long periods? There are these interesting lags, I think, between stocks and bonds, even stocks and insulation, where going back to the 70s, Fama and Schwert are showing, there's a negative relation between nominal stock returns and inflation at short horizons.

Then if you look over longer horizons, it has to be the case that if we have a ton of inflation over the next 50 years, stock prices are going to be really high. There's a major investment firm that reports in one of their white paper things, a 70-year correlation between nominal stock returns and inflation reports a correlation of 0.1.

In the state of the world, where a loaf of bread costs a 100 million in 50 years, I think the bread company is going to be worth more than 600 million. At some point, these two things have to be really tied together over the long run, but I think it's just very important. If you're trying to look at long-term returns, look at long-term returns.

Ben Felix: We mentioned investor behaviour recently. There's a bunch of research that we looked at recently showing that investors underperformed the asset classes they invest in, and increasingly so with increasingly volatile assets. For equities, depending on the paper you look at, it's like, 1.5% or 2% per year. How do you think investors should factor that into their asset allocation thinking?

Scott Cederburg: I mean, it comes entirely from, are you pulling money out of the market at certain times? This is, I mean, relative to a buy-and-hold strategy. It all comes down to, are you committed to the strategy or not? I acknowledge it's a large problem to think about is that people are going to have to actually just sit there, while their retirement account is crashing and not respond to it, but that's what has to be done in order to realize these gains.

Ben Felix: From their perspective, it feels like, they're watching the world end, because that's what it always feels like. In your sample, there are cases where the world hasn't ended, obviously, but where countries have economically ended, at least as represented by the stock market, and things have still worked out okay.

Scott Cederburg: It's still coming out in the data that these are the best outcomes. In some of these periods, too, where just stocks have gotten hammered in some of these countries, but nominal bonds have not exactly been the greatest thing in the world either.

Ben Felix: You've said that a few times, that it's like, you're not saying stocks are safe, you're just saying, given the opportunity set of stocks and bonds, bonds look terrible in the long run.

Cameron Passmore: We have to behave like the data in your sample. That's the message. Turn off the human brain and behave like data.

Scott Cederburg: It's interesting. I don't know how to think about the entire range of policies that are feasible and possible. The potential for just reporting. When I go on my Fidelity account, I swear it depends what the graphs look like in terms of – if they look like this, because things have been going down, Fidelity will try and find some range of time where it didn't go down the whole time and show me that graph. Then if things have been going well, it shows me a graph that's going up. I don't disagree with this sort of an approach. It's finding some way of giving somebody a longer-term view of their account performance, versus just what's my dollar amount right now, versus the highest number that I remember. That's the problem that we face with this type of thing.

Cameron Passmore: Some sort of adaptive feedback loop.

Scott Cederburg: There are systems in some other countries, too, where you're just invested in a pension fund and that pension fund invests your assets and you're just invested in that pension fund. That, where the investors have a little bit less personal control over the asset allocation, I mean, it feels like you're losing control. But maybe that's not such a bad thing if you're locked into a strategy.

Cameron Passmore: How important are return dependencies, like mean reversion in stocks and your results?

Scott Cederburg: Super, super important. Mean reversion is really important. Both domestic stocks and international stocks, we see this mean reversion effect, so they get safer over longer horizons. I think, even, potentially more important, are these unmodeled and I don't even know exactly why they happen. The things like stocks and bonds becoming more correlated over time. We didn't have to explicitly model what was going to happen with inflation and currencies. In the data, it shows up that over longer periods of time, exchange rate fluctuations tend to offset some of your local inflation and make international stocks safer over time. We think it's really important.

We're thinking about long-term investors. We want to know about long-term returns and you have to just go grab the data and make sure that whatever we're saying about long-term returns is consistent with what's going on in the data.

Ben Felix: Can you talk about how your results change when you switch to using monthly returns?

Scott Cederburg: We ran one analysis. Our base case, we're using this full-developed country sample and we're using this block bootstrap where we're trying to preserve the time series, dependencies and the data. We're taking 10 years on average of data. There's an alternative for, I guess, a couple of alternatives. One, we could use the US data and then two, we could use what we would call an IID bootstrap. That's just going to assume that months are independent of each other. In that bootstrap, you just go and we have 30,000 months of data and you just go pick one of the 30,000 and you go pick a different one of the 30,000 and you string these altogether. What that does is it breaks up any of those time series dependencies in returns. If we look across these, you can then think of four different approaches.

We have our base, which is developed country sample block bootstrap. Then you could think about doing, well, US sample, block bootstrap. Or we can do our developed country sample with the IID bootstrap, or the US sample with the IID bootstrap. We can go across those two dimensions, get fill in those four boxes.

What's interesting is if we do either switch from developed country sample to US sample or switch from block bootstrap to IID. The gaps close between, say, the TDF and the all-equity strategy, they close a little bit. All of the ruined probabilities come down relative to our base case, but the stock strategy actually still dominates. If you're changing either of those two assumptions, the stock strategy still dominates. It's only when you go to the US IID approach. You're saying, whatever, we have 130 years’ worth of US data and you say, “Okay, that's sufficient and that's what I want to learn from.” Then you're taking the stance that returns don't have any time series properties.

In that scenario, stocks still tend to be better at wealth accumulation, but there are lower ruin probabilities on some of these stock-bond, age-based strategies. There are investors who would prefer in that case, to get into bonds. That does rely on a couple of pretty strong assumptions. I mean, we can argue about the US versus developed country sample. We always have this argument about whether the US is special and whether other developed countries are exactly the same or not. There's a debate to be had about that.

I think the really tough debate is returns are not IID. We know that volatility is time-varying and we can all see these patterns, even just looking at the market for a few days. You know that volatility varies over time. There's a lot of evidence that there's variation in expected returns and mean reversion. We see a continuation in bond returns and all this stuff. We think maintaining those aspects of the data is really important. If you're going to do that, then it actually doesn't matter anymore whether you're using the developed country sample or the US sample, you're getting the same answer, where the all-equity strategy is safer than the TDS.

Ben Felix: Wild. That part's crazy. I think a lot of people use either monthly returns, or just simple Monte Carlo that is assuming IID and that you would get the result that you're describing, which is the result that everybody gets.

Scott Cederburg: A lot of the academic literature, we assume that returns are normally distributed IID, or something like this. It does extend around. There's another approach that seems to be pretty commonly used in industry that's vector autoregressions, where there's an attempt there to model out long-term outcomes, but the structure of these things tends to be that you're going to use pretty short-term data to estimate stuff. Then you try and estimate the dynamics. I think a very tough thing for a vector autoregression to pick up though is there's so much reliance on these short-term correlations to figure out how things are related over long horizons that I just don't see how they're going to get stock-bond correlation to go from 0.15 in a short horizon to 0.5 at a longer horizon. It is just such a dependence on these really short-term correlations. I think that that's probably where a lot of things are getting missed.

Ben Felix: Given all this, and I mean, obviously, this is a new paper so people didn't have the information. Maybe that's part of the answer, but why do you think retirees are doing stuff that's more similar to traditional advice?

Scott Cederburg: Everybody’s doing what they're told. Your listeners are thinking a lot about their asset allocation and doing their own analyses and all these sorts of things. If we look across investors, like retirement savers in the US, some numbers by Vanguard recently, I mentioned these QDIAs where employers can put this thing as the default and then they're free of liability. 98% of employers have a target date fund as their default. Then if you look at the investors, 83% of investors hold at least some of their money in a target date fund and 59% have all of their money in one target date fund.

It's three fifths of Americans are just doing the thing that they're being defaulted into, or they are taking that as financial advice. Most people don't really think about it that much. If that's the status quo, then that's the status quo and that's going to tend to be what people do.

Ben Felix: Yeah, it makes sense. I want to ask about home country bias. This paper is mind blowing for all of the reasons that we just talked about. This part, I'm very interested to get some answers here. The optimal portfolio is 50% domestic, 50% international. You show in the appendix that going down to 35% domestic is marginally better, but that 35% domestic, that's still a massive home country bias for investors outside the US. What is driving that? Why is there such a large optimal allocation to domestic stocks? Sorry to keep going on the question, but we talked earlier about how much better international stocks look in the data. I just don't get it.

Scott Cederburg: A few aspects, starting out with maybe the potential of at least having some domestic relative to international. There's still long correlations, like not huge. There is certainly a positive correlation and relatively large, but it's not 0.9 correlations, or anything. We're out at 30-year horizons. There's some just plain old diversification benefit. I think part of it, it's a little tough to pin all the million couples down on why they preferred what, but I think a good part of it is probably currency stuff. If you think about over a long horizon, a 30-year period, if your currency appreciates over that whole period, then that tends to hurt your international investments.

Because in the US, I would be selling dollars to buy foreign currencies, to buy some stuff, and then eventually, I would have to buy dollars back again. If the dollar has strengthened, I'm able to buy fewer dollars. If we look at those cases where the currency has appreciated, it also tends to be the case that currency is appreciating in a country, because the economy is doing fairly well and the stock market’s doing fairly well, typically in those same periods. We do see that domestic stock returns are better than international stock returns if your currency appreciates over a long period.

Then if the currency depreciates, the opposite on both of these, I get to buy back cheap dollars, so my international investments do really well, and then the domestic market has probably suffered a little bit if the currency is weakening. I think that's probably part of what's going on. One thing that we looked at a little bit in our previous paper is all the stuff that we're talking about now is completely unhedged on the currency side for the international stuff. It's a little bit tough to perfectly look at this in the historical data because we have to make assumptions. We don't have currency derivative data for this entire history, so we would have to make some assumptions about currency hedging and stuff.

It might be possible that if you were able to partially hedge your international portfolio or something, I don't think you want to fully hedge the currency risk in your portfolio, because it has this nice property of offsetting local inflation, but that currency exchange rate volatility, if you're really loaded up on international stuff, might become a little bit of an issue. It may be the case that partially hedging that cushions down the domestic piece.

Ben Felix: Interesting. Okay, so partially hedging some of your foreign currency exposure might push down the optimal allocation to domestic stocks.

Scott Cederburg: Speculation, but I think if that's where some of the risk is coming from, then it seems to make sense. I don't think you want to get a 100% of that volatility out of your portfolio, but I don't think we ever looked at partial hedging. We looked at either currency hedged, or unhedged.

Ben Felix: John Campbell has a paper, I think, looking at that. We asked him about when he was on about optimal hedging, and I think it was partial hedges were better than unhedged, or fully hedged. That is interesting speculation. Man. On the currency effect, are domestic stocks hedging local consumption because of the currency exposure? Is that a way to say that?

Scott Cederburg: It's going to tend to be the case, I guess, that the domestic stock market is going to be doing better in these times with relatively better local economic growth. It would probably also be relatively lower local inflation if the currency is appreciating. That's the times that the domestic stocks would be doing better is relatively good times. But perhaps, another way that might affect this, we haven't yet built in any correlation between our labour income and stock market outcomes. It's also possible we're planning on doing that and basically building in some correlation structure between human capital and stock market stuff just to see whether that pushes anybody off of stocks. If that's all at the local level, if that tends to be at the domestic stock level, that could push people a little bit away from domestic stocks there, too.

Ben Felix: When you take into account any correlation between domestic stocks and labour income, that might push down the home country bias?

Scott Cederburg: I think, also, if we're looking at the economic magnitudes of some of these things, one of the things that we've looked at is basically, the whole range of, what if I go 5% domestic, 10% domestic, all the way up to a 100% domestic? If you take this 50-50 domestic international investor and you force them to be 100% domestic, they're angry. This couple saving 10% now feels like they have to save 16%. They do not want to be a 100% domestic stocks.

But this 50-50 couple is indifferent between being 50-50 and 20-80. So, 20% domestic, 80% international, and even all the way down to 5% domestic, 95% international, the savings rate is still only 10.6%. Once you get on that side of the midpoint, it's a lot flatter over the outcomes. The difference between 35% and 10% in domestic stocks is not going to be super, super huge from an economic perspective, and so, then it probably comes down to what makes you feel most comfortable?

In the paper, we've been talking about the 50-50 because one, it's a simple rule of thumb. We are specializing to the US in the sense that we have US longevity, US social security, and then the US is roughly 50% of the global market, and so, something around market weights seems to make sense. For the Eurozone, I think, because so much of this is currency driven, I think if you're in the Eurozone, you probably want to think of the Eurozone as you are domestic market at this point in history. That 35% in the Eurozone probably doesn't seem to outlandish. That's, again, probably roughly in line with market weights.

The smaller markets, like Canada, so own currency, but smaller market, maybe these results, maybe bump it up a little bit, bump something up to do a little bit more home bias, or something like that, or maybe it's a little bit of a justification if you are doing home bias. But if you really feel like doing market weights, I also wouldn't argue too much with that. As long as you're not doing a 100% domestic, then you're probably doing okay. 

Cameron Passmore: Would adding an additional cost by owning international stocks push the optimal home bias further?

Scott Cederburg: I think, certainly, that would push it in that direction. The US at this point, everything's pretty good. My friends around town, I tell them like, put half each in two ETFs, so VTI and VXUS. Domestic stocks and international stocks, and I think the weighted average fee on those is about five basis points per year. We don't really look at fees in our setup, but it is certainly going to have an impact.

I still think if I'm eyeballing the distributions, I think that the international diversification is still going to be better on the left tail than even if we're taking some fees out, still going to be better on the left tail than a lot of the other strategies. But just depending on the size of the fee gap, it's going to lose average performance relative to domestic.

Ben Felix: Can you talk about how the findings in this paper relate to the findings in your paper on safe withdrawal rates? Because in that paper, you show the 100% stocks, although it's domestic, and I just gave the answer away, is dominated by 60/40, but can you just talk about that?

Scott Cederburg: That paper, we had all domestic strategies. It was domestic stock-bond approaches, and 60/40 is better than domestic stocks, largely because of that left tail type of risk that you get in the domestic stock distribution. That was what we were looking at in that paper.

Ben Felix: Basically, safe withdrawal rate is better at 60/40 than it is at 100% domestic. But once you add in international stocks, an equity portfolio dominates on safe withdrawal rate.

Scott Cederburg: Yeah, the geographical diversification is better than the stock bond diversification.

Ben Felix: Do you have by chance the safe withdrawal rate at the 5% room probability for the 50/50 portfolio?

Scott Cederburg: We ran 3% and 5% rule cases. I can interpolate between 3% and 4%, and it's about roughly 3.4% is the withdrawal rate. It's much, much higher than for the target date fund, or any of these other things are still going to be much lower withdrawal rates. The TDF is still whatever it is, 2.3% or something like that. If you are willing to do this and you are willing to not touch your portfolio, then we would argue that a little bit higher withdrawal rate, this 3.4% is potentially feasible.

Ben Felix: That's based on the average mortality?

Scott Cederburg: It's for the couples in our simulation. It's uncertain longevity. With the 50/50 equity strategy, roughly 3.4% withdrawal rate.

Ben Felix: It's a big jump.

Cameron Passmore: Willing and able, of course. I'm curious, Scott, what aspects of all this work surprised you?

Scott Cederburg: The relative safety of 100% equity even during the retirement period, I think is initially counterintuitive. We've been working with this for so long. We've seen a lot of the tail risk for bonds, especially in real terms and stuff like that. We had a sense of what we were going to be getting in this, just that investors are pretty much completely not interested in holding bonds at any point was a bit of a surprise.

I think the other thing that was surprising to us as we were doing it if I'm telling the story of us writing the paper, a thing that was more difficult than I thought was reconciling with the conventional wisdom. Where do I find results that tell me that this TDF is better than the all-equity strategy? From our base case, we're doing these one-off change this assumption, change this assumption, change this assumption, and we're not finding any single assumption that gets us back to a TDF being an optimal strategy.

It took this combination of US data and an IID bootstrap of ignoring the time series properties of return to get us there. I'm probably revealing how slow I am to research, but I think that was three or four weeks to be like, maybe I should run this combination of USA and IID. But then that was finally the thing where you're like, “Oh, that is the thing that makes the TDF look safe in retirement is just this very special modelling approach.”

Ben Felix: Man, so the life cycle investing advice that everybody gets is basically based on the survivorship bias and easy data bias sample that everyone looks at.

Scott Cederburg: It seems to be the case that that's heavily influential, like the US data are just heavily influential on this. Then the modelling, how we're modelling long-term returns, I think, is super important for this problem.

Ben Felix: You tested withdrawal rates from 3% to 5%. At 5%, stocks have a lower probability of ruin than the other alternatives.

Scott Cederburg: Yeah.

Cameron Passmore: Wow.

Scott Cederburg: This is off the top of my head. I want to say, the TDF was up to 35% ruin probability, or something, and the diversified stock strategy was at 16%, 17% something.

Ben Felix: Is that in the paper?

Scott Cederburg: We have it in the appendix, or at least a picture in the appendix.

Ben Felix: I'll have to dig that up. There are a lot of appendices in the paper.

Scott Cederburg: Yeah.

Ben Felix: I didn't read all of them yet. Crazy. All that points to, like the fact that it continues to be a much lower probability of ruin at higher withdrawal rates, again, just as me thinking about whether the sequence of return risk is really something that people should be as concerned about as they are.

Scott Cederburg: Those withdrawal rates are the things that are most subject to the sequence of return risk. Those rules are what open you up to that, and our investors are doing nothing to mitigate that risk. They're just literal ones and zeros in a machine.

Cameron Passmore: Therefore, behaviour is what really matters?

Scott Cederburg: Moderating behaviour is going to be central in all of this stuff. If anybody is ever actually going to do this type of an approach, I mean, I'm doing this approach, but I probably am a little better than most at remembering the long-term aspects of these things.

Ben Felix: This research, as with your other research, but this one, even more so, really touches a lot of the advice that we give to clients. From where you sit, in your opinion, how do you think these findings should affect how financial advisors talk to their clients?

Scott Cederburg: I think our goal with this paper is just to open up the conversation even a little bit more. I mean, there's always talk about what life cycle investing should look like, but let's just even have more of a conversation. I think on the very technical geeky side, I think there should be more conversation on how do we model long-term returns and how do we make sure that our models that we're putting into these things, like in industry and academia, how do we make sure that the models that we're putting in are generating long-term returns that match the properties of actual long-term returns? That's a really important part, just from a technical perspective, because that's where a lot of the advice ends up coming from.

Then at a client level, I think there's a couple of psychological aspects, perhaps, I think are going to be really important in figuring all this out. One is still, every time I present anything on this, people are like, “But I just want to have some safe bonds over here.” It's like, well, that would be great, except they don't really exist with the exception of potentially TIPS in the US. But bonds seem so safe to everybody, and that's just ingrained in everybody's mind. I think that's going to be an issue that needs to be overcome if we're pushing people off of bonds a little bit, is just changing the perception around that.

The second thing, just being like, if we implement this stuff, those drawdowns are going to happen, and then everybody has to get talked off the ledge, and very much long-term focus, outcome-based focus stuff. I think these are all challenges. There's whatever it is, 600 billion per year, new retirement savings every year in the US, 600 billion dollars. We're finding large differences in outcomes, like economically large differences. This is just a huge problem, and I think we should dedicate some resources to making sure that we're getting as close as possible to doing the right thing.

Ben Felix: The volatility piece is so interesting. I was talking to someone earlier about liquid private equity investments. One of the things they said that I found just fascinating related to this discussion is that the best thing about a product like that is going to be that it's going to be less volatile than public equities, because the underlying assets are valued less frequently. It's like, it’s not less risky, but it's going to look less risky, and behaviourally, that's going to be good for investors. That's such a weird roundabout way of getting to a better place for investors, and it probably costs a bunch more.

Scott Cederburg: Some of the reporting stuff, if you can report smoother things or more long-term things, that's advantageous. It would be interesting with liquid private equity stuff to see the extent to which the investors are guessing at what the current value of the private assets that are only being valued ever once in a while, but the price of that fund probably doesn't have to be exactly equal to the stated net asset value. That would be a really interesting view on how investors are working with very limited information to come up with current prices for things.

Ben Felix: They would be interesting. It's just so funny how the psychology plays into decisions, where it's like, even if we know something is objectively optimal, people still won't do it just because it moves up and down a lot from day-to-day. Well, Scott, I think that's all the questions we have. This has been an incredible conversation. This paper is awesome. It's changed the way that I'm thinking about stuff. I think it'll change the way a lot of people think about their portfolios, so it's a big contribution. Very well done.

Scott Cederburg: Awesome. Yeah, thank you, guys, so much. It was great talking to you.

Cameron Passmore: Yeah, great to see you, Scott.  Thanks again.

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Benjamin Felix — https://www.pwlcapital.com/author/benjamin-felix/ 

Benjamin on X — https://twitter.com/benjaminwfelix

Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/

Cameron Passmore — https://www.pwlcapital.com/profile/cameron-passmore/

Cameron on X — https://twitter.com/CameronPassmore

Cameron on LinkedIn — https://www.linkedin.com/in/cameronpassmore/

Professor Scott Cederburg — https://eller.arizona.edu/people/scott-cederburg

Professor Scott Cederburg on LinkedIn — https://www.linkedin.com/in/scott-cederburg/

Professor Scott Cederburg on Google Scholar — https://scholar.google.com/citations/

Eller College of Management — https://eller.arizona.edu/

Episode 224 — https://rationalreminder.ca/podcast/224

Episode 250 — https://rationalreminder.ca/podcast/250

‘Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice’ — https://dx.doi.org/10.2139/ssrn.4590406

‘The Safe Withdrawal Rate: Evidence from a Broad Sample of Developed Markets’ — https://dx.doi.org/10.2139/ssrn.4227132

International Diversification Works (Eventually) — https://doi.org/10.2469/faj.v67.n3.1

‘Stocks for the long run? Evidence from a broad sample of developed markets’ — https://www.sciencedirect.com/science/article/