Professionals still haven’t questioned our epistemology

I found this post on Suze Orman through, I believe, the Baseline Scenario blog.  BS referenced a reader’s comment, and I have posted it in full since it pretty closely reflects my views.  Basically, no one has questioned our the epistemological framework structuring the discourse on finance and equities, and this ahistoricism is a major shortfall.  Here is the post.

“Orman’s advice is perfect for a stable world in which:

- the price of stocks and homes tends to rise faster than their true value, and

- the purchasing power of paper currency is changing slowly and at approximately the same (inverse) rate as incomes, and

- interest rates are significantly positive, both to borrow and to lend.

Notice that this describes typical conditions in the developed world between 1950 and 2000. In other words, nearly everyone now living has adjusted their basic financial assumptions to these conditions. So it’s not surprising that Orman and others who provide financial advice to mainstream individuals bases that advice on this set of fundamental assumptions.

Unfortunately for people who take that advice, the past 50 years are anything but ordinary, especially for Americans. Being a citizen of the world’s single dominant military and economic power at a time when the above assumptions mostly held true is an historically exceptional experience. A far more typical lifetime includes periods of war (in which losing in a way that forever alters one’s lifestyle is a real possibility), hyperinflation, depression, and so on, intermixed with occasional booms and peaceful interludes. The sheer size and liquidity of today’s developed-world financial markets is itself an exceptional result of an exceptional period of political, military, and economic stability.

Some of Orman’s advice is timeless: spending less than you earn is probably correct at least 95% of the time, no matter where you live or what you do. Most of the disagreement seems to stem from what one ought to do with the surplus, but most of the disagreement fails to question the fundamental underlying assumptions I mentioned above. DCA haters, for example, would prefer to cut their losses and avoid holding all the way to zero. That may make sense for particular individual stocks, but it also assumes that the holder will invest that money elsewhere and that the alternative investment will perform better. Is that a good assumption? If the investor has a long-term winning track record, the best we can say is “maybe”. Orman’s audience can’t say that; if anything, they’re likely to make the same mistakes repeatedly, racking up both losses and fees. They’re probably better off just indexing. Given that, is selling at a loss sensible? Well, again, that depends on your assumptions. I don’t see a lot of DCA haters saying that $SPX is going to zero, nor do I see them telling anyone where money ought to be instead of SPY.

The problem here is that in order to provide good advice, you need to have a reasonable understanding of what the economic universe is going to look like for the next 30-75 years. No one does, of course, but we can make reasonable assumptions and act on them. The most reasonable assumption to make is always “reversion to the mean.” But when an advisor born in 1950 thinks about “the mean”, he or she is making a lot of assumptions based on a truly exceptional period in history. The cold reality is that “the mean” is very mean indeed. When one looks beyond the borders of the United States, or farther into history, it becomes clear that our three assumptions are very rosy indeed. A second observation takes on some importance as well: our assumptions haven’t been very correct for the last 10 years, either. A decade is a long time to be violated for assumptions based on only 50 years of observation. How confident can we really be right now in our thinking about what constitutes “the mean”? Put another way, how confident are we that avoiding debt, saving US dollars, investing some of them in equities, and DCAing into those investments is a sound strategy? That strategy worked spectacularly well from 1950 to 2000. It would not have worked very well at all from 1900 to 1950: several devaluations (some stealthy), a depression, and two world wars made for a rocky experience and a modest outcome in real purchasing power terms.

I could not in good conscience advise a friend or client to pursue that strategy today, or more precisely, to pursue it exclusively. Owing dollar-denominated debt is probably very wise right now. Load up; borrowing is cheap and the dollar doesn’t pay any interest so saving is a waste of time. If you end up in bankruptcy, so what? The government will bail you out. Incomes have been falling in real terms for quite a while now; working is less rewarding than ever, and widespread unemployment isn’t going to help. That midlife crisis induced year off living the Bohemian dream in Europe isn’t really a bad idea. And US stocks are plenty risky – in addition to ordinary global economic risk, you’ve got political risk (confiscatory policies), interest rate risk (how are these 3% yields going to look when 10-year interest rates rise, even only to the “mean” of 8%?), and especially currency risk. There are an awful lot of dollars being printed right now, and there’s no real incentive to hold them. It’s entirely possible that these risks won’t be borne out in reality, but they look real today and stocks aren’t particularly cheap. I don’t advocate zero exposure, but if your financial plan relies on a 10% return, year after year, it’s not your investment mix that needs reexamining, it’s your plan. You’re going to have to learn to make do with less. Given your probable skill set and real value to the world economy, that’s probably just reversion to the mean. In most cases, individuals who have been working and saving in US dollars for a long time would do best to cut most of their losses and stick what’s left in gold. It won’t make them any money, but it will protect them from most of the risks – risks that they lack the expertise and experience to evaluate. It will also protect them from the ill-advised actions of their government. That’s something anyone from Myanmar or 12th-century Europe would understand intuitively in ways most Americans alive today simply cannot grasp. The good times are probably ending, as good times always do. Pretending otherwise is suicidal.”
As a side note, I do not know enough about Suze to have a strong opinion, but anyone who seeks to improve our financial literacy is ok in my book.