The Trinity Study In Another Dimension

Did you read my guest post on Rockstar Finance on looking at testing Safe Withdrawal Rates from another angle? 

If not, I suggest you go there first. If you want to read some more technical details, then see below.

If you want an overview of the Trinity Study then Chief Mom Officer published a very nice summary article that goes into a good level of depth without being overwhelming. 

The Trinity Study in Another Dimension

Have you read the important notes? It’s a condition of reading this blog.

Technical Details

 In the post I looked at what Safe Withdrawal Rates (SWR) would look like in a world without mean reversion of equities (and note that it’s quite possible that we already live there now). I implemented a thought experiment from the Nobel prize winning economist Paul Samuelson who considered randomly drawing historical annual equity returns from a hat to create a new sequence of returns. Crucially, he considered replacement in drawing the individual returns.

This is the really key part. Since you then get a sequence of returns with historically ‘accurate’ annual returns and volatilities but you destroy any potential mean reversion.

Mean Reversion

Mean-reversion, or negative serial correlation, is a hotly debated topic, and there is no general consensus to my knowledge. Without doubt equity returns exhibit non-randomness, however there is no simple key to the mysteries of stock price evolution. Any signal is generally swamped by the noise, and no serious equity investor is a ‘chartist’.

The fact is that there are no rules for equities to follow and there is no inbuilt law of the universe that says that equities must outperform bonds, or even cash. There is considerable data to support this assertion, but no cosmic requirement. A stock simply gives the holder part ownership of an enterprise and it might give some voting rights. But it gives no entitlement to returns or any stream of cash or share of profits.

So equities are not like bonds. They are not bonds on steroids, and they do not automatically provide greater returns than bonds. They are more risky and this should be so, since they provide the holder with far fewer guarantees than a bond investor.

Stocks are Risky

If long term equity returns were guaranteed then equity managers would pay the investor to hold their cash (see this post for example). Similarly you could arbitrage the market by borrowing cash and investing in the equity market to achieve a riskless return. Whatever you believe about the market you have to believe in limited opportunities for persistent and substantial arbitrages. Therefore equities are risky; there is a chance that you lose all your money, and a chance that they underperform bonds for a sustained period.

The future could therefore be very different to the past. There is no market force that compels a re-run of past performance. Consequently the Trinity Study has rather limited use. It tells us what would have happened, but tells us little about what could happen. This was the subject of my Rockstar post – what could happen in the future?

Whadya think? A load of baloney? Dangerous tinkering with one of the cornerstones of retirement analysis? Thought-provoking and useful? Comment below.

Want to read some more analysis? Check out Lump Sum or Dollar Cost Average Investing? or Introduction to Sequence of Returns and Buying a Boat in Retirement

And don’t forget to sign up for email updates from me – yay!

13 thoughts on “The Trinity Study In Another Dimension”

  1. I would argue that many of us index-fund investors are “chartists”; we buy and hold with the expectation that our X-axis will continue to rise given a long enough time horizon. 🙂 And that’s really the crux of your argument, isn’t it? Maybe 10-15 years ago, there was a lot of talk in the investment world about diversification. Now, with the advent of low-cost index funds, there’s less. But successful institutional investors like Ray Dalio have always based their models heavily on balancing the inherent risk of equities heavily with bonds. So, to answer your question, yes, I think it’s important to consider what would happen to your particular retirement plan if equities underperformed your plans and/or the Trinity Study, and plan accordingly. That may be by diversifying and accepting the probability of lower returns or planning to withdraw less than 4% per year from your equities portfolio in retirement. OR planning to work a bit in retirement. After all, as Warren Buffet so wisely said, “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”

    1. actuary on FIRE

      Laurie – thanks for the thoughtful reply. I liked your point about Ray Dalio’s portfolio construction and the balancing of risks. This is a very similar point to what Gasem makes below. Ray Dalio has a version of his institutional portfolio that he calls the “All Weather” portfolio that is pretty similar to the Harry Browne portfolio that Gasem is a fan of.
      I’m always advising my institutional clients to rely less on the equity risk premium. Don’t put all your return eggs into that equity basket. But I don’t see the same advice in the personal finance space, so you have prompted me to think about how I can do that.

  2. jeffry klugman

    i think the whole notion of a swr is mistaken.
    1. it is behaviorally unrealistic- if a retiree saw that their funds were quickly depleting they would not continue to spend at their prior rate. otoh, if they saw their portfolios soaring, would they not treat themselves to, say, an extra vacation?
    2 it is mathematically arbitrary and strange in its implications. if workers A and B have the same portfolios and worker A retires that year, A bases his withdrawal on 4% of the portfolio value THAT YEAR. if one year late the portfolios have both lost, say, 20% and B retires he bases his withdrawals on 4% of that lower value, even though at that time A’s portfolio has a lower value than B’s [having had 1 year of withdrawals]. for the next 29 or 30 years A will be “allowed” to withdraw a larger amount than B because of the higher initial value, even though every year his portfolio will be smaller than B’s. does this not seem bizarre and misleading?

    1. actuary on FIRE

      Oh boy, I can only nod my head in agreement here. Modeling can only take you so far, and you have raised objections that are too true.
      I think ERN has done some work on this, and hopefully others.
      I will totally admit that my stuff on this topic has been in a mathematical vacuum, and ignoring the behavioral reality. I think the analysis provides a base from which you can then adapt your strategy. The overwhelming experience from early retirees seems to be that they have at least some income in ‘retirement’ and so a theoretical SWR is pretty irrelevant.
      Thanks for adding some good comments to the debate Jeff.

      1. 100% agree. You guys have hit the nail on the head of why traditional financial “planning” (glorified investment planning) is failing and has for decades. We as humans fear future uncertainty so a the industry likes to pretend they can eliminate it with: linear math, using variable as constants, past performance all occurring in a vacuum. Life doesn’t work that way. We can either embrace the uncertainty of we can pretend it doesn’t exist.

  3. Superb article AoF. I was reading on the Harry Browne Permanent Portfolio, which is a low risk low return portfolio of astonishing stability. It is so stable in fact due to it’s low risk it allows a greater SWR up to and over 5%. I think your original point dominates “Stocks are Risky” and in most modern portfolios therefore risk dominates the portfolio. You wind up paying for a measly little bit of return with a whole lot of risk. In the HBPP, stocks in no way dominate, so their risk in no way dominates but they do make a meaningful contribution to return over time. In the HBPP there are always plenty of other resources beside stocks from which to get your lunch money so you never have to sell low. In fact you are forced to buy low since yearly re-balancing forces that. I’m not hawking the HPBB but I am hawking the idea of truly diversified non-correlated risk adjusted portfolios. VTI is not diversified. VTI is stocks and purely carries the risk of stocks.

    1. jeffry klugman

      you’d enjoy a look at portfoliocharts dot com, which has extensive info on browne’s and other “lazy” portfolios. in particular, take a look at the “golden butterfly”- a slightly adjusted pp. if you don’t want a lazy portfolio, you’d benefit by checking out allocatesmartly dot com, which allows the construction and backtesting of tactical asset allocation portfolios with monthly trading.

      1. Thanks for the tips. The butterfly is actually pretty good.

        My own portfolio incorporates sources of non correlated assets different but not entirely dissimilar to the butterfly . In the 2008 debacle S&P went down 50% from the 2007 high but my portfolio went down only about 35%. S&P recovered to the 2007 high 6 years later. My portfolio recovered 2 year learlier than S&P and was 18% ahead when S&P finally recovered.

        A better mix for the butterfly would be VTI 39% VUSTX 39% GLD 12% VFISX 10% For a return of 7.64 and a risk of 6.84 compared to 7.6 return and 7.49 risk on the butterfly, same return a 9% lower risk. Still a very low cost portfolio.

      2. actuary on FIRE

        Thanks – I need to take a look at those sites. For me, I couldn’t do monthly trading, it would have to be set-it-and-forget-it.

    2. actuary on FIRE

      You raise a great theme of whether I should sacrifice expected return for lower volatility. Your point being that a portfolio that does not drop so much in a drawdown has less ground to gain, and so with compounding will come out ahead. I’m bought into that… I think. I have certainly seen that work in my corporate life.
      But I need to do some modeling on the SWR aspect of that…

      Also see the comment from Laurie. She raises the Ray Dalio All Weather portfolio that is not dissimilar to the Harry Browne portfolio.

      Hey – thanks for dropping by Gasem!

  4. jeffry klugman

    less volatility helps with the behavioral aspect of portfolio management. a lot of people SAY they can handle volatility, but when the time comes… not so much. less volatility=>lower likelihood of panic selling, better sleep at night.

    gasem- your portfolio is interesting, but i worry about it being overfitted. what data are you basing it on? and over what time period? i tried to model it at portfoliocharts and came up with a 5.1% return and 7.7% std dev, but i might not have correctly understood what’s in those funds.

    of course, past results, etc, and we do live in interesting times. i worry a lot about the dollar, so have a full 20% allocation to phys [i don’t use gld because the large short positions means that in a crisis you’ll get settlement mark to fantasy. phys is audited and there are no more owners than gold held.].

    because of my concern about the dollar and rates, i’m not holding any long duration treasuries. my 40% fixed income is partly in an 8year tips ladder, partly in foreign currencies dsum, cny, fxy, fxe. and the rest in cash.

    i divide my 40% equity into 20% held in a private equity real estate partnership, only 20% in stocks. further, i manage the 20% stocks with a model i created at allocatesmartly. from 1990 to present [only data available] the model would have made 10.3% with a volatility of 6.8%, and a maximum drawdown of 6%.

    i ignore the model’s fixed income and gold allocations, and just invest tracking its equity positions. if the model gets bearish it will reduce my stock allocation.

    i dodged the bullets in 1987 [closed my last s&p futures contract the friday before black monday], and the 2000-2002 debacle. right now i’m avoiding sequence of returns risk and being – to my own mind – very conservative.

  5. I was using portfolio visualizer efficient frontier analyzer and those assets as described

  6. Pingback: Random Thoughts On The 4% Rule And Closing My Office - Doctor of Finance MD

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