If you are like me and most members of the middle class, you are used to your living standard and would be loath to have it drop even 10 percent. But many of us invest much or most of our wealth in the stock market because we are lured by its average high yield. Is there a way to guarantee our living standard and still invest in the market? The answer is yes. It's called "upside investing."
Before describing how it works, let me explain why we are generally very adverse to experience a drop in our living standard, but would be delighted to see it rise, assuming the increase is permanent. The answer comes from one aspect of behavioral finance, called habit formation. Habit formation arises when people derive utility (happiness) not only from their current consumption but from its relationship to their past consumption. If it's higher they are happy. But if it's commensurately lower, they are, well, miserable. Hence, they try their best to avoid any living standard decline.
Is habit formation different from risk aversion? I'd describe it as a stronger form of risk aversion. Do we see habit formation in practice? I think we see it routinely when it comes to playing the casino. I recall a convention of economists in Las Vegas. It was the first and last time economists held their convention in Vegas. The casinos were expecting we'd drop a lot of money on the slots. But most of us just stood around observing what we viewed to be irrational behavior - gambling addicts placing less than fair bets. But some of us, myself included, gave gambling a try. But we did so by taking a small amount of cash (my amount was $50) and leaving our wallets at home.
Leaving our wallets at home ensured and insured our living standard would stay intact, i.e., there was no way we were going to experience a decline in our living standard even if we did poorly at the tables or slots. And, yes, we did poorly. My $50 lasted all of 42 minutes and the story was similar for my colleagues. This was the last time the American Economics Association held its annual convention in Vegas. The reason wasn't a lack of interest in that location by the Association. The reason was that Las Vegas wouldn't invite us back because we weren't lured into throwing away our savings.
The stock market is also a gamble - a highly risky one. But it's one that offers far better than even odds. That's why I and every economist I know invests in the stock market. But we're, like you, very averse to seeing our living standard drop. The financial advice industry has tried to accommodate this concern. How? By trying to put a floor under our retirement income. One such method is called bucketing.
If I have it straight, bucketing entails investing differently to spend safely at different dates. Thus the short-term bucket is invested in cash and Treasury bills. The mid-term bucket is invested in somewhat riskier bonds and relatively safer stocks. The long-term bucket is invested mostly in stocks.
The notion underlying bucketing is that assets, like stocks, that are risky in the short term are safe in the long term. As my Boston University colleague Professor Zvi Bodie has convincingly shown, this notion is empirically far off base. If it were true, put options on the stock market would be a lot cheaper if they came due farther in the future. But the opposite is true. Insuring the long-term performance of the stock market is much more expensive than insuring its short-term performance.
Even were the assumptions underlying bucketing correct, there is nothing in this investment strategy that constrains spending. If households spending in the short term assuming their buckets will perform as expected and, it turns out, they underperform, spending will likely have to drop. This, of course, is a no-no from the perspective of those of us who have habit-formation preferences.
A second income-flooring method is to adopt a plan that withdraws and spends some share, say 4 percent, of assets calculated at the point of retirement. This "steady" stream - systematic withdrawals is the industry term - represents the income floor. Yet there is nothing that guarantees the household will always be able to withdraw each year an amount equal to a fixed share of the assets they had back when they retired. Take, for example, someone with a $1 million retirement kitty.
A 4 percent steady withdrawal sounds feasible. After all, it's only $40,000 per year. But what if the kitty's investments go bad and drop 50 percent. Then the steady stream rule says spend 8 percent of your current assets. If your assets don't head back up, you'll be broke within 13 years.
The whole notion of income flooring is off base. What people are after is flooring their spending. This is easily done following what I call upside investing. This strategy is incorporated in my company's esplanner.com software and will soon be included in my company's maxifiplanner.com software. I figured it out in the course of talking with Professor Bodie about his terrific book Worry-Free Investing.
The idea is simple and connects directly to how I and most people play the casino. We leave our wallets back at the hotel, we take in our pockets only the amount of money we're prepared to lose, and we don't spend any winnings before we leave the casino.
Now think of the stock market as the casino. When you run my company's software in upside investing mode, you tell it how much money you have in the stock market and how much you will be adding to the stock market. You also tell the tool when you will begin and end the conversion into safe assets of the stocks you end up with at the start and during the conversion.
Given this information, the program does two things. First, it calculates what you can spend on a sustainable (smooth) basis assuming every penny you have in the stock market and every penny you intend to add to the stock market is lost for good. Second, it runs Monte Carlo simulations to show you what happens in the vast majority of cases in which your stocks won't go entirely down the tubes.
In these scenarios, the program will have you permanently raise your spending based on every dollar of stock that's been converted into safe assets. The bottom line is a spending plan that entails a living standard (spending) floor with the potential for upside, i.e., higher spending. The trick is simple - treat what's in the stock market as entirely lost until it's been found (made safe).
Running upside investing provides a major education about investing. The more one allocates to the stock market, the lower the floor and the higher the upside. The less one allocates, the higher the floor and the lower the upside. The education comes in realizing that the floor is much more important to most of us than the upside, i.e., we're not inclined to invest as much in the stock market when we see what it means for our living standard floor.
At least that's the realization that most people seem to derive in running our ESPlanner tool in that mode. And their takeaway is that not spending today based on money that still can be lost is not just the safe way to play the casino. It's also the safe way to play the market.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.