The Evidence-Based Investor

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1. Stories almost always trump statistics

   February 16, 2023 6:30 am Comments Off on Stories almost always trump statistics

    

    

   By JOACHIM KLEMENT

    

   We would like to think that investors use all the information available to them to make investment decisions. This is why the pages of the financial press are often full of statistics and data about funds, stocks or bonds. Yet, the reality is that most of the time there is a narrative driving the market or a particular stock and that narrative (or story if you like) overwhelms all statistics.

   Thomas Graeber from Harvard and his colleagues used product reviews as a way to identify the influence of stories and statistics on our decisions, but I will give you an investment-related translation of the same mechanism.

   Assume you are interested in buying a stock. As part of your due diligence, you look at purchases and sales of company insiders to get an idea if share prices will go up or down. After all, there is a statistically significant link between director buys and sells and the share price performance in the future.

   Assume that in that company, six executives and directors bought or sold shares last month. Two of them have bought shares while four have sold shares. What do you think is the outlook for the share price?

   Now assume you hear that the CEO of the company, a person who is well-known in the industry and has a high media profile thanks to his ability to make snarky, sometimes outrageous comments about the industry or his competitors decided to buy shares in his company and talked about it in an interview on investment TV. What do you think is the outlook for the share price?

   You think about these two pieces of information but you decide to wait with your investment. The next day you try to remember what the outlook for the stock is. What do you think will happen?

   What happens is that on the day when you are collecting the data and hearing the story, both the statistic and the story about the CEO are similarly influential on your investment decision. Both are fresh in your mind and you will be able to make decisions based on this information. But only a day later, your memory of both the statistic and the story has faded. But with the fading memory comes also a decline in influence on your investment decision. People in the lab experiments on product reviews were much more influenced by the story than the statistics in making their decision.

    

   

    

   In our example, that might have significant consequences. The statistic shows a tendency for corporate insiders to sell their stocks and you may have decided that this is a bad time to invest in the stock. The story about the CEO, however, is a positive story that may nudge you to buy the stocks. But the CEO may not have bought stocks in the open market. Maybe the CEO was just converting stock options that vested or the CEO may buy stocks on a regular schedule. Yet, the story you remember is one of a confident CEO buying shares in his company.

   And this is the problem with stories. As humans, we are naturally inclined to think in stories and we are able to remember stories much better than data. But which stories are the ones that get told? It’s the stories that are story-worthy. Stories that make you laugh or angry, i.e. stories with a lot of emotional triggers, are more likely to be told and re-told and thus have an outsized influence on investors. And these stories can for a while become the dominant story in the marketplace. Some stories last a long time before they lose their power. Just think of stories like “house prices never go down, nationwide” or “cryptocurrencies are going to replace fiat currencies”. Other stories last just a few days or weeks.

   And stories are by no means always wrong. Some stories are true, some are false and some have a kernel of truth with some exaggerations sprinkled on top.

   The point I am making is that as investors, we need to be aware and beware of stories. We need to be aware of them because stories can drive markets and these powerful narratives allow us to identify trends that can be exploited. But stories need to be checked with statistics in order to not fall prey to simple anecdotes that don’t tell the truth. Financial markets are full of great storytellers that can lead you astray and get you to invest your money into losing assets.

    

   JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.

    

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   © The Evidence-Based Investor MMXXIII

    

    

2. Flexible retirement ages exacerbate inequality

   April 4, 2022 9:30 am Comments Off on Flexible retirement ages exacerbate inequality

    

    

   By JOACHIM KLEMENT

    

   Many countries in Europe and North America have changed the retirement age in an effort to turn government pensions economically sustainable. The basic idea is sound, people can postpone retirement by a couple of years and in return get higher payments from social security or other forms of government pension. People who need or want to retire early can do so but have to either wait for government pension payments to kick in at a later date or accept lower pension income.

   Given that we all live much longer today than when the pension systems we benefit from were designed, it is on average a good idea to pay a lower pension to people who retire early and presumably draw on their pension for longer before they die.

   But the problem with this policy, as with so many policies designed by macroeconomists is that while it works on average it does not reflect the differences between individuals. A study in Sweden looked at who these people are who retire earlier or later than the statutory retirement age. In Sweden, at least, about 24% of the workforce retire between ages 61 and 63 and about 18% retire between ages 57 and 61. Compared to that, only about 15% retire after the age of 66.

    

   

   Effective age of retirement in Sweden. Source: Landais et al. (2021)

    

   So almost half the population retires early or prematurely even though that means they lose pension income. And yes, you guessed it, many of these early retirees don’t do it because they want to, but because they have to. One big driver is ageism in the labour market. People who lose their jobs once they are over 55 have a really hard time finding a new job. But more importantly, people who are in physically demanding jobs may need to retire early because their bodies won’t let them work any longer.

   And that is where the problem comes in because people who work in physically demanding jobs also tend to earn less than people who are white collar workers in an office where the biggest physical demand on their bodies is to sit straight in a chair.

   So, if you are in a physically hard job, you are probably not able to save a lot for retirement above and beyond your government pension. And then you have to accept a lower pension because your body is acting up and forces you to retire early. Meanwhile, we office workers have well-paid jobs and can work longer in old age (maybe even get a few consulting gigs in retirement to make some extra money) and our bodies allow us to work until we are 65 or older. In the end, the labourer who retires early has a much larger drop in income and consequently in consumption than the office worker. The income inequality that existed before retirement is increased after retirement. The chart below shows the reduction in consumption from two years before retirement until two years after retirement depending on the age of retirement.

    

   

   Decline in consumption after retirement vs. before retirement. Source: Landais et al. (2021)

    

   What’s the solution to this problem? My friend Michael Falk, who unfortunately passed away last year has provided a lasting legacy with his books on reforming and improving the retirement system. He suggested in his highly recommendable Let’s All Learn How to Fish that retirement age should depend on the type of job you do. People with a physically demanding job should have a lower retirement than people with an office job. In essence, this would shift retirement age more in the direction of a percentage of life expectancy without making it too complex. It would really be good if politicians everywhere would start to think about retirement reform in this way rather than thinking about how to cut pensions without actually having to call it a cut.

    

    

   JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.

    

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   Content such as this would not be possible without the support of our strategic partners, to whom we are very grateful.

   TEBI’s principal partner is Sparrows Capital, which manages assets for family offices and institutions and also provides model portfolios to advice firms. We also have a strategic partner in Ireland — PFP Financial Services, a financial planning firm in Dublin.

   We are currently seeking partnerships in North America and Australasia with firms that share our evidence-based and client-focused philosophy. If you’re interested in finding out more, do get in touch.

    

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3. What a financial planner does

   July 7, 2021 11:02 am Comments Off on What a financial planner does

    

    

   What does a financial planner do? While there is probably no consensus on the exact job specification for a financial planner in general, one part of the job, I think most people could agree on, is to help investors achieve their retirement goals.

   Saving for retirement is one of the most important financial planning exercises we all have to do, and it gains in importance as government and corporate pension funds become increasingly thinly stretched. Even more so, we live in a world where employees of a company no longer have access to defined benefit plans but have to make do with defined contribution plans, which means that the employee bears the investment risk of the pension plan. Making the right decisions with your pension fund investments is crucial, as is the effort to make the right decision in how much to save etc.

   Unfortunately, I know too many financial advisers who define their job as helping people achieve their retirement goals and then translate this as helping them to pick outperforming funds or stocks. And that is not going well, as a new study by researchers from the University of Missouri demonstrates. Rui Yao, Weipeng Wu and Cody Mendenhall looked at 2,000 pension plans in the United States and the performance of the funds and the plans overall between 2013 and 2015. Crucially, they split the plans between the c80% plans that provided advisory services to the investors and the 20% of plans that provided no such advisory assistance.

   Their results show that when it comes to picking outperforming funds within a retirement plan, the advisers are no better than chance. While the average return of employees in plans with advisers was about the same as the return for employees in plans without advisers, the volatility and downside risks of the portfolios of employees in adviser-supported plans was somewhat higher. Thus, advisers moved investors into funds with higher risk but no compensation for that extra risk.

   We could all chime into the usual song and dance how advisers are useless and unable to pick stocks or funds, but that’s not the point. The point is that achieving your retirement goals has nothing to do with picking stocks or funds. The true value add of an adviser lies in the actual planning process, not the selection of investments.

   A decade ago, Annamaria Lusardi and Olivia Mitchell published what I consider to be one of the most important papers on financial planning of all time. They looked at the type of planning individuals engaged in and how that influenced their net worth at retirement. They distinguished between non-planners, simple planners (people who roughly knew how much of their income to save each month or each year), serious planners (people who have a proper financial plan) and successful planners (people who have a financial plan in place and managed to stick to it throughout their career, aka fairies, unicorns and otherwise unimaginably disciplined investors).

   The chart below shows that just moving from non-planners to a simple planning exercise increases net wealth at retirement by a factor of two to three. Engaging in serious planning then adds another 25% to 35% in extra wealth at retirement.

   This is where the true value of financial advice lies and where advisers really add value. It’s in making investors aware that they need to save, how much they need to save and how best to manage their income and expenses to achieve their savings goals. Everything else is just noise and not worth your time.

    

   

    

   JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.

    

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   © The Evidence-Based Investor MMXXI

    

    

4. The pension time bomb: how worried should we be?

   June 28, 2021 5:39 pm Comments Off on The pension time bomb: how worried should we be?

    

    

   Much has been written about the pension time bomb. Demographic changes, we’ve been warned, will mean more and more people needing to draw a pension in the coming decades, with the danger that both private and state pensions will buckle under the strain. Today’s young workers, some suggest, may end up having to foot the bill in the form of higher taxes.

   But how worried should we be? JOACHIM KLEMENT says we shouldn’t be overly pessimistic because society and the financial markets will likely adapt to the changes taking place. 

    

   As my readers know, one of my pet peeves is people who argue that demographic changes will lead to catastrophes, be it higher inflation or the implosion of our social safety net. I could write every day about why these projections are typically not worth heeding for investors, but that would bore my readers, so I tend to space these articles out and limit them to max one a month to give everybody a rest. But now the rest is over, and I can pick up where I left it on 12 May.

   Back then, I showed a chart that got a bit lost in my general argument about Japanese savings rates. The chart shows the old age dependency ratio in Japan in grey. The solid grey line is the usual dependency ratio that divides the number of people over the age of 65 by the number of people aged 16 to 64. This is what we see all the time in demographic projections and articles about demographics. It looks bad for Japan and even worse for China. But it also looks bad for every European country and the United States, though not quite as bad as for Japan.

    

   

   Source: Latsos and Schnabl (2021)

    

   But note the assumption implied in the solid grey line of the dependency ratio. It assumes that people above the age of 65 do not work and have to depend on their savings and transfers from working-age people. What the authors did in the dashed grey line is use data from the Japanese Ministry of Information and Communication to reduce the number of people aged 65 and over that are part of the workforce and have gainful employment. As I said back in May, this usually not some fancy fun employment, but minimum wage jobs that people have to take on in order to make ends meet. No romantic pictures of happy pensioners seeking fulfilment by staying active, please.

   What that adjustment does is increase the “productive population” and reduce the dependent population. The adjusted old age dependency ratio has been flat in Japan since 2010 and is now on its way down.

   And that is my point about demographics not being our destiny. Societies adapt to changing demographics. And because demographics change so slowly there is plenty of time for societies to adapt. In the case of Japan, it has led to a change that essentially defused the so-called pension time bomb by working more and longer in life. But the result nevertheless is that the stress on the Japanese pension system and Japanese social safety nets is not increasing anymore. Instead, it is easing.

   Warnings about the demographic time bomb and how it is going to destroy our pension system are almost as old as I am. I distinctly remember German Economics Minister Norbert Blüm proclaiming that our pensions are safe – just to go back and cut them a little later. More than thirty years later the German pension system still hasn’t collapsed. Germany and other countries have adapted to the changing demographic realities by increasing mandatory retirement ages, cutting pensions, introducing tax-advantaged savings schemes, etc.

   Again, none of that made retirement easier and one reader mentioned to me in May that we go from “work to live” to “live to work”. My response was that “work to live” is anyway a modern concept that is a historical aberration and one that was only made possible with the introduction of social safety nets in the early 20th century. Throughout history, the idea of old age “retirement” didn’t exist except for nobility, priests, and nuns.

   But my point is that as an investor, such long-term economic scenarios are highly flawed, and investing based on these trends is extremely dangerous. Society — and markets — adapt. We may not like how they adapt, but they do and as investors, we need to take the world as it is not as we want it to be.

    

   JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.

    

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   Content such as this would not be possible without the support of our strategic partners, to whom we are very grateful. 

   TEBI’s principal partner is Sparrows Capital, which manages assets for family offices and institutions and also provides model portfolios to advice firms. We also have a strategic partner in Ireland — PFP Financial Services, a financial planning firm in Dublin.

   We are currently seeking partnerships in North America and Australasia with firms that share our evidence-based and client-focused philosophy. If you’re interested in finding out more, do get in touch.

    

   Picture: Sammy Williams via Unsplash

    

   © The Evidence-Based Investor MMXXI