I stirred up some controversy when I said in a May 13, 2002, post to a Motley Fool retirement planning board that it is not possible to calculate the safe withdrawal rate accurately without taking into consideration the valuation level that applies on the day the retirement begins. One of the first questions that I was asked by skeptical community members was: “If you don’t think that the safe withdrawal rate for retirements beginning today is 4 percent, what do you think it is?”
I didn’t know. As a result of those conversations I hooked up with a systems engineer (John Walter Russell) who possessed greater statistical skills than I possess and together we developed a calculator revealing the true safe withdrawal rate at all of the various retirement starting-point valuation levels. But I didn’t have that information available to me at the time and so I tried to beg off responding to the question. But those asking it were persistent and eventually I buckled to the pressure. I said that I guessed that the safe withdrawal rate at the top of the bubble was probably something close to 3 percent.
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The calculations that I did in development of the calculator showed that the correct answer was 1.6 percent. I was nowhere even close to the mark with my guess of 3 percent. If anyone believed me, I could have hurt that person in a very serious way. A safe withdrawal rate of 3 percent would permit someone with a $1 million portfolio to live the rest of his life on $30,000 spending per year. A safe withdrawal rate of 1.6 percent would only permit spending of $16,000 per year. I obviously view it as important to get retirement planning numbers correct or I never would have advanced my post challenging the numbers in the Buy-and-Hold studies in the first place. So why was I so careless as to venture forth with a number that was nowhere close to the mark?
I fell victim to “anchoring.” Wikipedia explains that: “anchoring is a cognitive bias for an individual to rely too heavily on an initial piece of information offered when making decisions…. During decision making, anchoring occurs when individuals use this initial piece of information to make subsequent judgments. Those objects near the anchor tend to be assimilated toward it and those further away tend to be displaced in the other direction. Once the value of this anchor is set, all future negotiations, arguments, estimates, etc. are discussed in relation to the anchor. This bias occurs when interpreting future information using this anchor. For example, the initial price offered for a used car, set either before or at the start of negotiations, sets an arbitrary focal point for all following discussions. Prices discussed in negotiations that are lower than the anchor may seem reasonable, perhaps even cheap to the buyer, even if said prices are still relatively higher than the actual market value of the car.”
I believed that the Buy-and-Hold numbers were wrong. The logical thing to have done would have been to ignore the process by which those numbers were generated on grounds that it was flawed. But we humans are often placed in circumstances in which we are required to make decisions without having access to all of the information that we need to make them effectively. So we cheat. We tell ourselves that numbers that are not entirely reliable might have some value all the same and act as if those numbers offer reasonable estimates of the realities. We fool ourselves without knowing that that is what we are doing and create trouble for ourselves by coming to believe things that are simply not so.
I no longer believe that the safe withdrawal rate is 3 percent or anything close to 3 percent at times of extreme overvaluation. But I wonder how many investors do believe something along those lines. Most investors never have to respond to questions about their beliefs put to them on internet discussion boards So most investors never formulate the thought that the safe withdrawal rate never drops much below 3 percent. But the vast majority of investors accept that Shiller showed that valuations affect long-term returns. So they know on some level of consciousness that the safe withdrawal rate cannot always be 4 percent. I believe that they employ anchoring to persuade themselves that, while the number cannot always be 4 percent, it is probably never too far off from that mark. They tell themselves something that isn’t true and that could hurt them in a very big way because they do not have immediate access to the information they would need to identify the accurate number and because they would feel uncomfortable not filling that gap in their knowledge even if they can only do so by making use of a discredited anchor.
Mark Twain is often credited with the saying that informs us that: “It’s not what you don’t know that hurts you the most, it’s the things that you know for certain that just ain’t so.” It is my sense that a lot of that goes on in the investing realm. We feel that we need to know the answer to every possible question, but we don’t. So we fill in gaps in our knowledge base with the help of cognitive biases like anchoring.
The 4 percent number has persuasive power for me and for millions of others only because it has been repeated so many times that our minds have come to accept it as an anchor that may not be questioned. It is a discredited anchor. It is an anchor that was calculated without making reference to valuation levels. It is an anchor that must be discarded if we are to advance in our understanding of the safe-withdrawal-rate topic.
To think clearly about how stock investing works in the real world, we need to abandon beliefs that we came to accept in the years before Shiller “revolutionized” (his word) the field with his finding that valuations affect long-term returns. If that is so, then we need to question everything we came to believe in the days before the new knowledge became available to us. Anchors are often not helps. They are often crutches that cause us to believe things that simply aren’t so. We need to give up beliefs formed in the past to become free to understand anew the realities of stock investing.
Rob’s bio is here.