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Four Debates

Adam M. Grossman

HARRY MARKOWITZ was a graduate student in economics at the University of Chicago. It was 1954, and he had just finished defending his thesis. Most of the committee accepted his work. But Milton Friedman, an economist with a national reputation and easily the most influential member of the economics faculty, had a problem. While he found no errors in Markowitz’s work, the problem was that it contained no economics. Markowitz’s thesis was about investments and, in Friedman’s view, that wasn’t economics.

In the end, the department granted Markowitz his PhD. But Friedman had raised an interesting question: What exactly is finance? Is it a science like biology or chemistry? Or is it more like sociology or psychology? Or is it something else?

In 2013, the committee that awards the Nobel Prize in economics offered one clue. In that year, one prize went to Eugene Fama, an academic who had pioneered what’s now known as the Efficient Markets Hypothesis. Fama’s theory argues that investors are rational, and that they act with mathematical rigor and discipline when they buy and sell investments.

But at the same time, the Nobel committee also awarded a prize in economics to another academic, Robert Shiller, who holds the opposite view. In Shiller’s work, he’s found that investors are only sometimes rational and that psychology is a significant—if not the most significant—factor motivating investor behavior.

That, of course, doesn’t offer a very satisfying conclusion. The Nobel committee seemed to be saying that investing might be a rigorous science—or it might not be. But the members really weren’t sure and they didn’t say. Perhaps what they were trying to communicate is that both views are partly correct. Fama is right that sometimes investors approach things scientifically. But Shiller is also right in observing that investors lose their heads sometimes. In general, that’s the way I see it. Investors can be rational, but they can also be quite irrational.

In the decades since Markowitz’s initial work, researchers have helped to more clearly delineate the aspects of finance that are scientific from those that are more subjective. The trouble, though, is that it can be tough to know which is which. Oftentimes, that gives rise to disagreements among partisans within personal finance. One camp will view a particular question as purely scientific—with a right and a wrong answer—while the other will view it as entirely subjective and open to debate.

When disagreements like this arise, the two camps rarely see eye to eye. Those who view a question as having a right and a wrong answer can’t comprehend why anyone would persist in debating it—like continuing to debate whether the Earth is round. On the other hand, those who see a question as subject to debate are endlessly frustrated by the stubbornness of those who believe there’s only one answer.

This dynamic poses a problem for investors. As Mark Twain purportedly once said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” Over the years, I’ve come across many such debates. Below are the four that, in my experience, seem to cause the most consternation. On each of these questions, people tend to become overly dogmatic. In my view, though, each is an open question and should be subject to discussion:

Should you bet on cryptocurrencies? In the past, I’ve described my concerns about bitcoin. In short, I don’t like it because it lacks measurable intrinsic value. For that reason, I don’t recommend it. Others, however, point out that the dollar itself has no intrinsic value. It only has value because we all agree it has value.

Crypto enthusiasts believe that one or more digital currencies may one day attain that same status. While the U.S. government has the ability to create new dollars, which can generate inflation—as we’re now witnessing—bitcoin, by design, is capped. No more can be created. This debate has gone round and round for years. So far, I’m not convinced on cryptocurrencies. But this is a case in which I don’t think anyone should say there’s a right and a wrong answer. Like a lot of new things, it bears watching.

When should you claim Social Security? If you’re eligible for Social Security, you can claim it as early as age 62 or as late as 70. With only a few exceptions, the benefit increases by about 8% for each year that you wait. For that reason, many believe that the best strategy is to wait as long as possible to maximize the benefit. That’s my view.

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But I’ve also seen people develop detailed analyses to argue that claiming earlier makes more sense and that it can be a waste to forgo multiple years of benefits. This camp believes that benefits should be claimed early so those dollars can be invested in the stock market, where they would likely earn a higher return. This is another argument which seems to have no end. There are, of course, too many unknowns—including your own longevity and market returns—to be too wedded to any one strategy. There’s no right or wrong on this.

Should you pay down your mortgage? If you have extra funds, should you make extra mortgage payments and perhaps even pay off your balance entirely? This debate is similar in spirit to the Social Security question. The strictly mathematical view is that it doesn’t make sense to pay off a mortgage with an historically low rate of 2% or 3% when those funds could be invested in the stock market and potentially earn 8% or 10%.

There’s a good amount of logic to this argument because the stock market does go up—on average. The U.S. market has historically delivered a positive return, on an annual basis, almost 75% of the time. But as we’ve seen so far this year, it doesn’t always go up. It’s hardly guaranteed that an investor will earn more by investing than by making extra mortgage payments. On top of that, this strictly mathematical approach ignores certain realities, including the satisfaction of being debt-free. The upshot: There’s no right or wrong on this question, either.

Is 4% still a safe portfolio withdrawal rate? In 1994, financial planner Bill Bengen concluded that 4% is the safest portfolio withdrawal rate for retirees. In short order, this became known as the “4% rule.” But as Bengen himself noted, this 4% conclusion was based on a number of assumptions and, therefore, not universally applicable. In his own practice, in fact, Bengen said he preferred 4.5%.

The bottom line: There’s no reason 4% should be treated as a rule. Still, there are many who regard it as such. On the other side, though, there are now those who believe that 4% is an outdated figure and that it would be borderline reckless to build a plan around that number. Over the years, the research on withdrawal rates has been extended and refined, and it’s certainly worth following. But since every retiree is different and will live through different market conditions, I wouldn’t be too swayed by the dogma on either side of this debate.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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Chris Myers
Chris Myers
9 months ago

Regarding the question of whether or not to pay off your mortgage, I’ve entertained hundreds of conversations on the matter. In the early days I would consider the mortgage rate, tax bracket, appreciation rate of the property, investment alternatives, etc., all in an effort to provide the “right” answer…simply to find out in the end that the they “just didn’t want to owe anybody”. I soon learned that it was much better to talk about how they “felt” about paying off the mortgage before running the numbers. Further, I found it made less sense to pay if off early if you were still working and had the cash flow to satisfy the debt service. But once you retire, it’s all about cash flow. If you lack a pension or any other “guaranteed” income stream, and you rely primarily on your tax deferred savings for your income it doesn’t make much sense to withdrawal money and pay tax at 20% to service a 3% mortgage payment. Bottom line, I encouraged everyone to pay the mortgage off by the time the retired. And not once has anyone ever come back to me and said they regretted doing so.

Arek Sendecki
Arek Sendecki
9 months ago

The strictly mathematical view is that it doesn’t make sense to pay off a mortgage with an historically low rate of 2% or 3% when those funds could be invested in the stock market and potentially earn 8% or 10%.

This is a strict mathematical view based on simplistic math because it does not take risk into account.

  • The same line of reasning will make you believe there is no place for bonds in your portfolio – after all they have lower expected returns than stocks.
  • You also need to belive the banks are a banch of idiots, they give you money and charge 2% so that you can go to the stock market and earn 8% with the money.
  • You also need to belive other investors are a banch of idiots. How come almost nobody is persistently able to beat the market if everything you need to do to generate above market returns is to leverage up.
Ormode
Ormode
9 months ago

I have been an investor for 30 years, and have concluded that investing is an art, not a science. An economist expecting the stock market to behave rationally would lose a lot of money, but after all this time I have a pretty good feel for what might happen. Unfortunately, I am too cowardly to invest based on my instincts, and have left a lot of money on the table.

macropundit
macropundit
9 months ago
Reply to  Ormode

I think expecting markets to be efficient or rational in the short-term is a poor idea, but in the long run it probably is or nearly so.

steveark
steveark
9 months ago

That’s a wonderful post! I think you’ve covered four of the most argued concepts in finance and showed how there are no absolute right or wrong answers. Many people hate that, of course, so you may not get as much positive feedback as this deserves.

Ginger Williams
Ginger Williams
9 months ago

Thought provoking, as usual, Adam.

For the social security, mortgage, and withdrawal rates, there’s an optimal answer mathematically, based on the average person’s lifespan and average returns and completely rational behavior. But people are unique, so those average assumptions produce guidelines, not rules.

Cryptocurrency strikes me as similar to investing in an IPO, taking substantial risk on a single asset with a limited track record. To me, those risks belong in the small play money portion of portfolio, that might one day fund luxuries if it’s not worthless. I’d rather play with word puzzles instead of money.

Economics may inform finance, but personal finance decisions are ultimately personal.

R Quinn
R Quinn
9 months ago

I understand the issues surrounding the 4% “rule” but in its absence what guidelines can the average Joe or Jane use to give them some stability in withdrawing? I’ve heard some say use the RMD tables but that doesn’t help at 65. Others say just take what you need each year which seems a bit risky.

Cole Sloan
Cole Sloan
9 months ago
Reply to  R Quinn

Big ERN’s Safe Withdrawal Rate series is a beefy undertaking, and I honestly forget his recommendation for a SWR but if I recall correctly it was around 3.25%.
https://earlyretirementnow.com/safe-withdrawal-rate-series/

Granted this was for a 50-60 year time horizon more geared towards the FIRE crowd and may not be the most applicable answer for the 65 year old in your question.

wtfwjtd
wtfwjtd
9 months ago
Reply to  R Quinn

At 65, couldn’t you just use life expectancy tables in lieu of RMD tables? That’s what a lot of 401k payout guidelines suggest and will implement for you, and it seems to be a pretty good approximation.

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