The Great Life Cycle of Risk Aversion Fallacy

If there is a single bit of established personal finance wisdom that is most popularly accepted and most wrong, it is what I call the Life Cycle of Risk Aversion. I have to name it myself because it is so widely assumed to be so obviously true that hardly anybody even notices it.

The Life Cycle of Risk Aversion is the idea that as you get older you should take fewer risks in your investment portfolio. When young, you should invest aggressively in stocks and similar exciting things. As you age, you temper your investments gradually into bonds and the like, until in retirement you have an all-boring portfolio.

This unspoken assumption of retirement planning is so pervasive that right about now you are probably wondering if I am really crazy enough to challenge it. Before clicking away, imagine the following “thought experiment.”

Suppose you are 25 years old and your great-uncle leaves you a very strange bequest. You get a million dollars, but only to be used for your retirement in 40 years. The terms of the will say that you must hire a money manager and, although you can talk to him all you want now, once he gets the money no communications are allowed until you are 65, when you get full control over the money.

What instructions would you give the manager before he sets off on his 40 year mission? Would you, for example, tell him to invest aggressively at the start but taper down to conservative investments in the final decade? If that makes sense to you, consider that investment results are multiplicative. The returns from each of the forty years are equally important to the final value of the portfolio. (Annual returns of +10%, -5%, +22% and -3% will always result in a four year return of +23.7% no matter what order they came in.) So as far as you know, starting out risky and ending safe has exactly the same expected result as starting safe and ending risky.

If risky-start-safe-end doesn’t make sense as a plan for this blind investment plan, then why would it make sense as generic advice to those saving for retirement? Well, of course, it doesn’t.

To be clear, there are many reasonable circumstances in which a person might want to reduce risk as they got older. A 55 year-old who has done well in his investments and is on an easy glide path to retirement might not want to jeopardize that to possibly make more money than he really needs. Alternatively, the same guy who has done poorly might want to reduce his risk so as to hold on to what he has left and fund at least a modest lifestyle.

If those two examples of rational risk reduction in late middle age have you convinced that maybe I am wrong, consider that a desire to increase risk in both those situations could be equally rational. The richer 55 year-old could decide to swing for the fences, reasoning that either he can live large in his golden years or, at worst, even if he loses half his kitty he can still be pretty comfortable. The poor 55 year-old might reason that he has some serious catching up to do and he is willing to accept the risk of possibly having to live off Social Security.

The point is that how much risk you should take on has a little to do with how much money you have got, a lot to do with your level of risk aversion, and just about nothing to do with your age. And risk aversion, even though it can be described with fancy math, is ultimately simply a personal matter of psychology. There is no logical argument to make that the 55 year-old who wants to increase risk is wrong, and therefore no reason to advise 55 year-olds in general to reduce risk in their investments.

So why is this universally accepted wisdom? My theory is that it is because in the late 20th Century, when this idea took over, risk aversion was well correlated with age. Folks born in 1915, who came of age in the depression, were much less willing to invest in risky things than those born in 1945, who in turn were considerably more cautious than my cohorts born in 1965, who learned about investing in the ‘80s and ‘90s.

If present trends continue, I expect that my kids’ generation will be much more risk averse than mine. So in a decade or two personal finance blogs (and books, if they still exist) will drop the idea that you should reduce risk as you get older. Or, possibly, they will come up with a reason why you should take on risk in mid-life but not before or after, to accommodate the inclinations of the various generations in their readership.

Never Sell a Used Car

Yet another blog post from the personal finance mainstream that I must grudgingly acknowledge is good and useful. This one is on the advantages of driving a car until it is an inert pile of rust, rather than trading it in for something new. Get Rich Slowly guest blogger Joel Berry describes the financial benefits of driving a 1995 Geo Prizm, which has got to be just about the least impressive set of wheels imaginable.

That you should always buy cars used rather than new is a common and cliched bit of advice. Like many cliches, it is generally true. But I have always been amazed that the relatively obvious corollary, that you should never sell a used car, is rarely mentioned.

The crux of the matter is a bit of insanity that we all take for granted without reflection. New cars lose something like 25% of their value the moment they get an owner and continue to depreciate rapidly over the next year or two. Step back and think about this. The physical attributes of the car do not change when it is driven off the lot and generally do not deteriorate very much at all in the first years. So why does the market price for the car plummet?

There are basically two explanations. The first is that people are crazy. They will pay good money for the new car smell. Or they think that a newer car will attract members of the opposite sex. Much as I am biased in favor of any explanation based on the mental deficiencies of my follow man, I do not think this is all that is going on.

There is an inherent information asymmetry in the used car market. The owner of a car knows its true condition while the buyer does not. So the market price for a particular used car is based on the average value of similar cars for sale, not the specific value of the car in question. An owner considering selling a car will compare what he knows the car really to be worth to what he could get if he sold it. If it is worth more than the going rate, he holds on to it, if it is worth less, he sells. Which means that the used cars for sale tend to be the bad ones, which in turn reduces the average selling price, which means even fewer good cars are for sale, and so on. This is from a truly seminal paper published in 1970 called The Market for Lemons: Quality Uncertainty and the Market Mechanism.

On any rationally objective measure, used cars are cheap as compared to new ones. Moreover, and this is the point that most personal financial advisers miss, the average value of used cars that are for sale is far less than the average value of similar cars that are not for sale. So unless you have a real clunker, that car in your driveway is almost certainly worth more to you than you could get if you sold it.

It would be hard/impossible to get real numbers, but I am of the opinion that you take a bigger hit selling a used car than you do buying a new one, at least on a percentage basis. The optimal car strategy is to buy two- or three-year-old used cars and drive them until they are scrap metal. Which is what the experts recommend. But the real benefit is on the back end, not the bargain you get up front. Given the choice, and here is where I part company with the established wisdom, buying new and driving the thing until it stops running makes more sense than buying youngish used cars and selling them again when they are not so young.

WSJ Article on New Advice Books

Today’s Wall Street Journal has a great item on the wave of new personal finance books now hitting the shelves and how the tone has changed from how to get rich to how to avoid going broke. In fact, it is more than tone, the content has shifted. There’s a great skewering of David Bach in the last few paragraphs for nearly pulling a 180 on his advice about home financing.

Further evidence of my thesis that these books just serve up what the readership demands, rather than any sort of objective reality.

Not Profiting on Home Improvement

WalletPop’s Zac Bissonnette has a great post on what a poor investment home remodeling is. Every year the folks at Remodeling Magazine (yes, really) publish a survey of the impact on a house’s value of various types of home improvements. Helpfully, they do this as a percent of what was spent, so if you blew $20,000 on a new bathroom that only increased the value of your house by $15,000, then that’s a score of 75%.

The survey breaks out 19 types of projects, across nine regions. Most of the recoup values are in the 60%-80% range. The best from this year seems to be the 97% of your money you get to keep if you are adding a wooden deck onto a midrage house on the Pacific Coast. As far as I know, the survey has never found a value over 100%.

To be fair, this does not quite mean that all home improvements are money losers. These are averages, so almost half of those West Coast decks actually did add value. And the survey only covers relatively large projects, the kind for which you would hire a contractor. If you ask a good real estate agent how to make your house more valuable he will suggest cosmetic improvements, e.g. a new paint job. I am guessing that those sorts of fixes really do turn a profit.

But the basic observation, that home remodeling is a terrible investment, still holds. In a more perfect world, this would be so obvious that nobody would bother to mention it. Buying something at retail and hoping to sell it used at a profit, essentially what we are talking about here, is rarely a winning strategy.

But as Bissonnette points out, there is an entire category of cable TV shows based on the premise that you can make money remodeling. How can it be that home experts on responsible networks can advocate something so contrary to reality?

Because these are only TV shows. The people who make and broadcast TV shows are successful if people watch the shows, not if the shows are factually correct. And people want to see video of gleaming new kitchens and hear what a great investment they are. Ending a show saying “And Bob and Sue’s new sun room only vaporized $10,000 of their net worth.” would not help ratings.

Which brings up an important point about personal finance advice. We all make an unspoken assumption that successful givers of advice must give good advice, otherwise people would stop listening. This is not (quite) true. Popular givers of advice tend to get that way because they say what their audience wants to hear and wants to believe is true. People want to believe that they can become millionaires relatively easily by skipping the lattes or that they can work only four hours a week. That doesn’t mean it’s true.

Big Ben Franklin

The blog Get Rich Slowly had a post two days ago celebrating Benjamin Franklin’s 303rd birthday. I’m sorry I missed it. (The date; not so much the post.) Little Ben came into the world right here in Boston, about where the Claire’s store is now.

I’m a big fan of Ben’s, although not for the reasons that attract the Get Rich Slowly crowd. (And wouldn’t calling the blog Get Rich Slow be more parallel with get rich quick? It’s a great name anyway.)

Franklin was a very successful entrepreneur on what was then a wild frontier. In his spare time he was the leading American statesman and diplomat of his generation. And that stuff they told you in school about his discovering electricity is more true than not. Three centuries later, one end of your AA battery is labelled “+” and the other “-” because that’s what Ben decided to call them.

But for the adherents of the frugal faith, Franklin is known for the aphorisms he published in his Poor Richard’s Almanack and rehashed in Father Abraham’s Sermon, a.k.a. The Way to Wealth. These were wildly popular works in 18th Century America. You might say they are the beginning of our personal finance advice genre.

The Way to Wealth is all the more convincing because it is from a notably wealthy man. But just like the personal finance gurus of today, Franklin did not get rich from following his own advice so much as from selling it to others. It is not clear how frugal he was in his own life; he certainly understood that making a good show of being thrifty was good for business.

It is clear that getting rich slowly and quietly was not his thing. At 17, he skipped out of his apprenticeship to his brother in Boston (after learning the printing trade) and settled in Philadelphia. He fathered an illegitimate son that same year. By age 24 he was publishing a newspaper of his own and agitating for political reform in Pennsylvania. He managed to found most of the civic institutions the city needed, including a university, a public library, a volunteer fire department, and the militia. And then on to a bigger stage. In 1757 he got himself appointed the colony’s representative in London. He stayed there more or less continuously until the revolution broke out in 1775. If things hadn’t gotten nasty he probably would have lived in the big city for the rest of his life. His wife was back in Philadelphia the whole time.

Like I said, I love the guy. But those aphorisms of his, many, if not most, borrowed from others, may not relate all that well to his life. He did not, it bears pointing out, ever sign his own name to them. Get Rich Slowly quotes one of them as “Who is rich? He that rejoices in his portion.” That’s not in The Way to Wealth. As far as I know, it is in one of the 25 issues of the Almanack, but it’s originally from the Jewish Mishna, quoting Shimon ben Zoma two thousand years ago. (Pirkei Avot 4:1) Authorship aside, I am pretty sure that in real life my man Ben was not the kind to be satisfied by what he had already.