So those are the principles of life-cycle investing.
Now let's compare if you will, Zvi, for our audience tuned in here online.
How does your approach, really, the Bodie-Merton-Samuelson life-cycle paradigm compare to kind of the
old school tends be more prevailing paradigm still in the markets today?
So in the early 90s by which time I was already a full professor at Boston university, I came
to Bob Merton, I said, "You know what, let's take your model and build in what I think
needs to be a part of the standard approach to the life-cycle."
And that is labor, leisure choice.
And we worked on this together with Bill Samuelson, who is the son of Paul Samuelson and a faculty
member at BU.
We came up with a model which has kind of become the standard model for the life cycle
adopted by just about any theorist who writes on it.
They may elaborate on it, but at its core, it's the Bodie-Merton-Samuelson model.
How does that differ the theoretical model from the existing, what I call old paradigm?
And also we'll talk after this about how you implement that.
In other words, what does it imply in practice?
So first of all, what is the measure of welfare?
Well, in the old paradigm, which starts with the work of Markowitz and Tobin in the 50s
and 60s, it's wealth.
And what is being maximized is the expected utility from end of period wealth.
That turns out, I mean, for some purposes, that's fine.
Very few purposes.
In the real world where you've got many periods and you've got a retirement decision to make,
it's lifetime consumption.
And in mathematical terms, you're maximizing utility or happiness from consumption in every
period of your life.
And Zvi, remind our audience, it seems like there would be different measures of risk
as well if you're managing towards wealth that may be the volatility of your account
balance, but in your paradigm, what is the metric of risk then?
Yes, absolutely.
One of the things that Bob Merton harps on and he made this point early on in his earliest
papers, is that there can be and often is a big difference between measuring risk in
terms of your consumption or measuring risk in terms of wealth.
In other words, wealth can fluctuate or may have to fluctuate in value in order for consumption
to be smooth.
Well, that gives rise to all sorts of hedging demands.
That's really a key insight of Merton's model long before I started writing anything with
him.
The timeframe in the old paradigm is a single period.
Now, might be a very long period.
Like today and 30 years from now, retirement.
And what you're trying to do in this model is maximize expected utility from end of period
wealth.
Well, a problem with that approach is that it often makes stocks the risky major risky
asset seem less risky as you increase the length of the horizon.
Why?
Because if you're using average rate of return as the thing that's varying, the longer the
time period, the narrower the range of possible values of average rate.
But that's an illusion.
That is to say it's not, the right way to measure the risk is the short fall risk, the
cost of insuring against the shortfall.
That's a problem with this paradigm and practical term's a very big problem.
And in the BMS paradigm, Bodie-Merton-Samuelson, many periods, in fact in the limit, it's continuous
trading so that you're frequently revising the portfolio, whoever is managing the portfolio
is revising it.
And you see immediately the stocks are risky both in the short and in the long term.
And that's where risk management becomes crucial.
It seems like a more dynamic approach, right?
In the BMS paradigm, you really have to be dynamically rebalancing and adjusting towards
the goal.
Yeah.
Suppose this were a flight from here, Austin to Boston.
And one approach is to say, all right, we're going to take off, head in a certain direction
and that's it.
Four and a half hours from now, we'll hit someplace, hopefully it'll be Boston.
Versus from the time you start out, you've got Boston in your sights and you're adjusting
to make sure that you get there.
Okay?
Risk management techniques that are employed.
Well, in the existing or old paradigm, it's save as much as you can, so precautionary
saving and diversification.
That's it.
In the new paradigm that I'm advocating, it's those two things plus hedging and insuring,
very important.
What are the retail financial products that are the objects of choice?
Well, in the existing paradigm, what is it?
Cash, stocks and bonds, the three mutual funds and insurance policies to manage some of the
risks.
That's part of the existing paradigm.
But in the new paradigm, you've got targeted saving accounts.
In other words, specific hedging instruments that are designed to hone in on a particular
goal.
So it might be inflation link, retirement income, or it could be tuition accounts, health
savings accounts, things that have specific goals.
And those are managed in a different way.
Those are hedges.
I have your structured standard of living contracts.
The only thing that today takes that form are structured products like market index
CDs for example.
But very few people use those.
Very few financial planners are using those.
I think they could be used a lot more.
All right.
Quantitative model.
The existing paradigm is really mean variance optimization.
It's Markowitz with Tobin thrown in for the safe asset, Monte Carlo simulations of outcomes.
This is much more high powered mathematics.
It takes a lot of study to master it.
Right now it's financial engineers, but people working in institutional risk management who
are up to speed in the mathematics of it.
You really have to have, say, an undergraduate major in math and your learning dynamic programming
and contingent claims analysis, it's Mertonian mathematics and finance.
We're not getting into it in this discussion.
What are the control variables?
Well, the old paradigm, it's how much you save, how you allocate your assets, stocks,
bonds, and cash, and adjusting your retirement date.
Those are the control variables.
In the new paradigm, you've also got a portfolio of contingent contracts.
In other words, you can actually have a demand for products that have certain payoff structures.
The example that I would give in the framework of retirement saving is income annuities,
lifetime income annuities, which clearly are beneficial to at least people who don't have
a bequest motive.
So, someone who’s single wants to have as much income as he or she can get while they're
alive but doesn't really have any utility from income that's left over after they have
passed.
Well, you want to make sure that that person is making use of that contingent contract.
For the same amount of retirement saving, you can get more income out.
Your paradigm seems much more holistic.
It's also much more sophisticated and complicated.
I don't know a lot of advisors out there that are doing contingent claims modeling.
I certainly am not.
Where does that all lead us?
So you've got a very sophisticated model that targets the right goals.
How can advisors actually harness this or we as a financial services industry, how can
we use this in practice?
Okay.
So first of all, you got to be careful about the terminology you use.
So we don't want to say contingent claims, we want to say insurance contracts.
Because that's basically what they are.
Although, if you're talking about call options, it's not really insurance, it's the upside.
You're buying the upside.
But the key point and even options are something that can be explained to people because options
exist all over the place in everyday life.
So, terminology is very, very important.
Certain terms become like dirty words.
Got to stay away from them because people are going to think, oh oh, this guy doesn't
know what he's talking about.
I get that a lot.
I do know what I'm talking about, or at least I think I do.
So, that's a key issue.
But one has to explain in simple terms.
I don't think there's anything that I presented here that couldn't be understood or explained
in a way that an average person can understand, if they're willing to listen.
Now of course there are a lot of people just don't want to know.
They are allergic.
I understand that perfectly because there are areas of my life where I tune out the
minute the discussion gets technical.
I mean, a good example is controlling my television set in the age of remote controls and Netflix
and streaming this and streaming that and direct TV.
I just don't have an interest in mastering all of that.
All I want is when I press the on button, the television should turn on, and when I
press end, it should turn, you know, I have limited demands.
But we live in a complicated world, and even for something like that, you can't be completely
ignorant.
There's a certain minimum amount that you have to know.
I want to learn it from somebody who's not trying to sell me on a particular product
or a solution.