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Saturday, July 12, 2008

Thoughts on Financial Planning

I recently had occasion to discuss financial planning with several folks with a variety of backgrounds and interests. And it's really interesting to me how challenging financial planning is:
  1. Several folks had all the recommended books on their book shelves (Four Pillars of Investing[kindle edition], Random Walk Down Wall Street[kindle edition]), but had either not read them, or not understood them.
  2. Several folks understood what the right thing to do was, but just simply didn't do them. The discipline to execute is in fact one of the reasons why some people need a financial advisor, even if they're intellectually capable of understanding the fundamentals
  3. Being smart can just as easily work against you --- smart people have a tendency to want to second-guess the market. That usually works against you because there are just as many other smart people trying to do this as well, so they all cancel out and you end up not getting a good result either.
  4. Costs really matter. In many countries (in particular European countries), the financial markets are so under-developed that brokerage commissions are high, and costs are high. What I'm finding is that in Europe most people don't trust the stock markets, and turn to real estate to finance their retirements, along with all the hassle that entails.
  5. Finally, financial planning is hard because returns are measured by decades, not months or even years. This makes all the usual methods of learning (do something, see if it works, and do more if it does) fail --- the kind of discipline and devotion to learning from history that this requires ensures that there are very few Warren Buffets out there, and that you're unlikely to be one of them. It also leads to the kind of retirement planning disasters described in Nudge.
All in all, I am coming more and more in agreement with Bill Bernstein's statement:
Will, for example, small U.S. investors become ever more involved in the capital markets? This is largely a political question, dependent on whether the electorate ever wakes up to the mess of IRA/defined contribution pottage sold to them by the libertarian right. Over the past few decades, it has become apparent to even the most enthusiastic proponents of private accounts that most plan participants are about as qualified to manage their retirement portfolios as they are to do brain surgery or play left wing for the Rangers. Some autonomy needs to be stripped from them by mandating default opt-ins, lifecycle funds, annuitization, and so forth. Would it not be better simply to throw in the towel, throw out Wall Street, and establish a national pension system? Most Europeans, when they gaze upon our retirement system (and our health care system as well), laugh themselves silly.

In short, the typical person is as qualified to be his own financial planner as he is to be his own plumber (myself included). Unfortunately, unlike plumbers, where it is quite possible to find an honest and competent plumber in nearly every town, the existence of competent and honest financial planners is all but myth. That's why I ultimately end up doing all of it myself. In my travels, I find myself meeting lots of retired Americans --- almost all of them (a surprising number of them former teachers) are beneficiaries of the defined benefit system which has been phased out in recent years. I wonder if my generation will be able to travel as extensively as those whom I have met at the same age.

5 comments:

DWallach said...

A cousin of mine in New York has a union job with a major corporation. Prior to my talking to him, his idea of investing was buying stocks of random companies that sounded interesting to him. I had to do things like talk him out of buying into China Mobile (which might have made sense five years ago, but not five months ago when he wanted to do it) He's now got a 401(k) that I helped him set up. I pushed him to put his spare money in a Vanguard account (to minimize his fees, to get him to stop trying to pick stocks, and so I can effectively recruit Vanguard's advisors to help me convince him to do the right thing).

I'm not sure whether he buys the efficient market hypothesis or not, but he seems to respect my advice. He's a case study in why most people are unable to properly manage their money.

md said...

Ah, you agree with Bernstein's view that Some autonomy needs to be stripped from them by mandating default opt-ins, lifecycle funds, annuitization, and so forth.

Are you saying that you're in favor of the nanny state? Yeah, on my worst days I think most people are drones who need to be spoon fed to survive. Certainly that seems to be true for some people. But we (society) need to put some effort into awakening individuals in this state - or preventing them from falling into it to begin with, because our society seems intent on turning people into such drones ala The Matrix.

I think there's a danger in the nanny state, as well. The fact that most 401Ks have limited fund choices with higher than necessary expenses is an example. Here I have a great tax savings device, but to take advantage of it I have to pay a premium over and above what I'd get from a reasonable family of funds like Vanguard. The 401K system produces some savings, but is not optimal for me because it is corrupt. (I have a choice of eight funds in my current plan.)

I really wish benefits like retirement funds and health insurance would become decoupled from the workplace. I'd much rather make my own choices than have my choices filtered by my employer.

I do think that many if not most people are unqualified to handle their financial planning. However, could this be a result of poor education? My parents taught me nothing about investment or finances, aside from a broad fear of the stock market (which, in their view, was where you go to gamble your money away) and also a numbing fear of debt. In contrast, my parents spent substantial money on lottery tickets every week. These are people who should have known better. It still amazes me looking back at it, and I wonder how I ever managed to avoid following in their footsteps. By the way, they were not dumb people, even though they sometimes acted like it.

I wonder if my generation will be able to travel as extensively as those whom I have met at the same age.

I doubt it, but you shouldn't be concerned. It would appear that most Americans prefer to travel no more than 100 miles from home.

Piaw Na said...

Are you saying that you're in favor of the nanny state?

I'm in favor of libertarian paternalism, to as much of an extent as anyone can stand. But I would also be willing to settle for a defined-benefits pension system (fat chance of that happening).

think there's a danger in the nanny state, as well. The fact that most 401Ks have limited fund choices with higher than necessary expenses is an example. Here I have a great tax savings device, but to take advantage of it I have to pay a premium over and above what I'd get from a reasonable family of funds like Vanguard. The 401K system produces some savings, but is not optimal for me because it is corrupt.

And you want to blame the nanny state for that? I'd blame the corrupt private enterprise, where kick-backs determine which health-care plan and which 401(k) plans are available. By contrast, the federal employee defined-contribution plan has extremely low costs (0.10% --- almost as low as Vanguard's admiral shares)

I do think that many if not most people are unqualified to handle their financial planning. However, could this be a result of poor education?

No. 10 years ago you might be able to convince me of that. Not now. I've seen too many well-educated people who are sophisticated financially (i.e., they all know what the right thing to do and the intellectual smarts to understand the rationale behind it) still be unable to do the right thing. As D&D players would say, intelligence and wisdom are not the same thing, and unfortunately, financial planning appears to require a lot more wisdom than intelligence. That's why libertarian paternalism is so effective (obviously, defined benefit pension plans are also effective --- but no private enterprise seems to be willing to offer those any more).

md said...

And you want to blame the nanny state for that?

Yes, because in the US the nanny state is inherently corrupt by virtue of the fact that businesses manipulate the state. I find it hard to imagine a version of the nanny state in the US which is not corrupted by private enterprise. It seems to me that most of the new programs have been developed primarily to aid businesses not people - from welfare-to-work, to "faith-based initiatives" to Medicare Part D.

It appears to me that European states do things much better in this respect, although I suppose appearances can be deceiving.

The 401K program is an example in which the nanny state's good intentions have been corrupted. In the retirement plan example I gave, I wish both my government and my employer would keep their hands off my retirement plan. Give me the $15K deduction and let me put it in the fund that I choose (a Vanguard fund, of course).

However, since we can't trust people to do reasonable things with their money, and then we end up tripping over aging homeless people, we have to take another approach. Why not force all businesses to offer a wide range of low-fee funds in their 401K plans? Only employers with well-rounded fund choices get to take the tax deduction. Wouldn't this be simple enough? Not with our current nanny state.

I've seen too many well-educated people who are sophisticated financially... still be unable to do the right thing... financial planning appears to require a lot more wisdom than intelligence

You seem to be asserting that "wisdom" cannot be taught. I think it can be, which is what I meant when I said it's a matter of poor education. Maybe in that I'm an optimist.

obviously, defined benefit pension plans are also effective --- but no private enterprise seems to be willing to offer those any more

And why do you suppose that is?

Piaw Na said...

Why not force all businesses to offer a wide range of low-fee funds in their 401K plans?

So the only solution to the nanny state problem is more nanny state? :-) I find that ironic. Why not just have the state invest for you then?

obviously, defined benefit pension plans are also effective --- but no private enterprise seems to be willing to offer those any more

And why do you suppose that is?


Because businesses don't seem to have any more wisdom to keep from recording surpluses from successful investments in their pension plans as profit either. That's why I'm skeptical that wisdom can be taught.