Undercover Economist

February 28, 2014 1:34 pm

Golden rules of thumb

‘The human brain is a marvellous thing but it does not seem to have evolved to cope with high finance’
Illustration for the Undercover Economist's 'Golden rules of thumb'©Raymond Biesinger

The human brain is a marvellous thing but it does not seem to have evolved to cope with high finance. I’ve written before about the economist and financial literacy expert, Annamaria Lusardi. One of her findings is that one-third of Americans over the age of 50 failed to answer this question correctly: “Suppose you had $100 in a savings account and the interest rate was 2 per cent per year. After five years, how much do you think you would have in the account if you left the money to grow: more than $102, exactly $102, less than $102?”

One answer to this woeful situation is financial education. But can such depths of ignorance be paved over with a few evening classes? Another option is to nudge us into sensible decisions – for example, by automatically setting up pensions for us. Again, this is fine as far as it goes.

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Undercover Economist

A third line of attack, embraced by some financial gurus, is the rule of thumb.

Here’s one: your age in years should be the percentage of your portfolio that is not invested in shares. Here’s another: your debt payments should be no more than 36 per cent of your gross income. A third, widespread in the US, is that in retirement one should draw down 4 per cent of current wealth each year.

Such rules of thumb are clearly limited. For example, the suspiciously precise stricture that debt payments should not top 36 per cent of gross income ignores inflation. If your mortgage interest is 12 per cent, your annual pay rise is 10 per cent and inflation is 10 per cent, then all you need do is survive two or three years and inflation will erode your mortgage. But if interest rates are 2 per cent, your pay is flat and inflation is low, then a difficult repayment schedule now isn’t going to get any easier in the future.

Some economists have been investigating how close these rules of thumb are to the optimal strategies they can compute. In a research paper entitled “Spending Retirement on Planet Vulcan”, Moshe Milevsky and Huaxiong Huang compare the “4 per cent” rule to the optimal drawdown of assets in retirement, as it might have been calculated by Star Trek’s Mr Spock. They conclude that the 4 per cent rule is not a very good one.

Another economist, David Love, looks for more sophisticated rules of thumb – for example, “moving to a (piecewise) linear rule based on the share of financial wealth relative to the sum of financial wealth and a simple approximation of the present value of future income”. Such a rule produces outcomes that closely track the Spock-like optimal strategy – which would be great if I could figure out what the rule actually was.

Love’s research suggests that it is possible to approximate the Spock strategy with decision rules that are simple enough for a website or a trained financial adviser to compute – even if it would be stretching it to call them rules of thumb.

 

But is the Spock strategy really the one we want to emulate? The psychologist Gerd Gigerenzer has examined a number of genuinely simple heuristics. One example: if you’re buying shares, buy the names you recognise. Another: if you’re distributing a fund between various asset classes, just distribute it equally between them all. Such clumsy-seeming rules suggest themselves naturally to the unschooled investor. Astonishingly, they work splendidly.

Here’s what seems to be happening: economists with powerful computers get hold of a stream of data on asset returns; they compute a complex optimal strategy given this historical data; then the world changes and the old “optimal” strategy turns out not to be quite so optimal.

Meanwhile the naive heuristics work rather well. Perhaps there is some hope after all.

‘The Undercover Economist Strikes Back’, by Tim Harford, is published by Little, Brown

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