vineviz wrote: ↑Thu Jun 10, 2021 8:57 am
NiceUnparticularMan wrote: ↑Wed Jun 09, 2021 5:41 am
As I have noted before, this is an example of how people should think in terms of probability distributions, and not substitute point estimates, as doing that assumes away important risks.
Thinking "in terms of probability distributions" is not incompatible with using point estimates in your modeling. At typical individual investor shouldn't need (and doesn't need) a sophisticated decision tree or Monte Carlo simulation in order to figure out whether they should use Vanguard Short-Term Treasury ETF (VGSH) or Vanguard Long-Term Treasury ETF (VGLT) for their bond allocation.
Saying that you estimate your investment horizon to be about 40 years (for instance) doesn't necessarily mean you're "assuming away" any risks or uncertainty, since the 40 year estimate might very well reflect a 50% chance of the actual horizon being 60 years and a 50% chance of the actual horizon being 20 years. The uncertainty is an input into the point estimate.
So one of the immediate implications of think in terms of probability distributions over spending is you can no longer assume things like that you will hold a given bond to maturity, at which point you will have spent all the proceeds.
This is important because obviously liquidating a bond position well before you originally expected can in fact have some pretty significant consequences. And more subtly, but just as important, there can be significant opportunity costs to not actually needing the money back as soon as you expected.
So, these are not equivalent assumptions:
(1) I will need this money back in X years;
(2) There is a 1/3rd chance I will need this money back in X years, but also a 1/3rd chance I will need it back much sooner than X years, and a 1/3rd chance I will need it back much later than X years.
Now of course if you were, say, an insurance company and covering a large number of such personal investors, then it might make sense to think that enough people in the second position start to resemble just the first position (although that depends on assumptions that are not always valid).
But if you are just one individual planning for one family, you have to account for what happens in those alternative scenarios. And in many cases, it will make sense to give up some expected return in the middle scenario in order to provide against the other scenarios.
And because investors are typically highly loss averse AND because longevity is one of the most powerful sources of uncertainty in retirement planning, the planned investment horizon is effectively already incorporating the distribution of probabilities. For instance, planning a retirement that lasts until age 95 is not planning for the median outcome in terms of longevity but for something closer to a 20th percentile outcome for most people. And people with highly volatiles earned income will have larger emergency funds which, typically being invested in cash or short-term instruments, effectively lowers the duration of their overall household portfolio. Etc.
Right, in practice people here are already providing for these various alternate scenarios--as they should!
But that doesn't mean that it is easy to know exactly how to do it.
And unfortunately, I think there is a bit of a distortion going on here in that due to the recent pleasant history of typical "Boglehead" plans, a lot of people here are now in a position where they are wealthy enough that it is relatively easy for them to self-insure. Meaning they have accumulated so much wealth they can put a lot in SPIAs (or already have pensions or can defer Social Security and so on), AND put a bunch more in TIPS ladders that will cover a lot of expected spending even though current TIPS rates are low, AND still have a bunch left over for liquid short-term funds, AND still have a bunch left over for long-term at-risk investments.
But it might not always be so easy. If there is an extend period where things are less pleasant for typical Boglehead plans, then people might be facing harder choices about what to do, how much insurance of what kind to buy, and so on.
So, I don't think it is a good idea to assume these are actually always going to be easy issues for everyone. They are relatively easy if you are really wealthy, but not everyone is there yet, and it might be a lot harder to get there in the next long period.