For example, a recent article discussed a very topical issue: how to determine if your slumping fund or advisor has permanently lost their touch.  Clients grapple with this issue all the time and, most frequently, get it wrong.  Studies show that both retail and institutional investors tend to terminate advisors after a period of poor performance and to hire advisors after a period of good performance.  Most often, this period tends to be temporary and the studies have demonstrated that investors cost themselves an enormous amount of money by doing so.

On the other hand, no client wants to be permanently stuck with a lousy manager.  So how can you differentiate?

There are a couple of different conditions in which Morningstar suggests you not act too impetuously.

1. Funds that don’t follow the crowd often have very different performance profiles than the broad market.  Their ranking can zig when the market zags.  (Our Systematic portfolios tend to visit both the top and bottom deciles with regularity.) 

2. Sometimes an anomalous time period can make a fund look worse than it is.  Relying on the ranking of a value fund at the end of a growth cycle, or vice versa, would probably be a significant mistake.

In both cases, the fund’s peer ranking can suffer, but as Morningstar points out, the ranking often comes roaring back.  The rankings are exceptionally fluid because the returns are often tightly clustered.  For example:

…most category rankings are based on a tightly constrained range. In the large-value category, a 10-year annualized gain of 1.6% lands a fund in the group’s worst third, but a 3.1% gain puts it in the top third. Neither is good on an absolute basis. It is easy to see how a good month or two is all it would take to vault a fund from the group’s basement to its penthouse, and vice versa.

I’ve added the emphasis because I don’t think the fluidity in ranking is generally understood by the investing public.  If a good month or two can swing your 10-year ranking significantly, it seems to me that it is much more important to understand the manager’s process than it is to worry about the temporary ranking.  Rankings can be unstable; process is permanent.

Ms. Benz starts with the “risk tolerance” section of the typical consulting group questionnaire.  They generally ask at what level of loss an investor would become concerned and pull the plug.  (In my experience, many clients are not very insightful; every advisor has seen at least one questionnaire of a self-reported aggressive investor with a 5% loss tolerance!)  In truth, these questionnaires are next to worthless, and she points out why:

Unfortunately, many risk questionnaires aren’t all that productive. For starters, most investors are poor judges of their own risk tolerance, feeling more risk-resilient when the market is sailing along and becoming more risk-averse after periods of sustained market losses.

Moreover, such questionnaires send the incorrect message that it’s OK to inject your own emotion into the investment process, thereby upending what might have been a carefully laid investment plan.

But perhaps most important, focusing on an investor’s response to short-term losses inappropriately confuses risk and volatility. Understanding the difference between the two–and focusing on the former and not the latter–is a key way to make sure your reach your financial goals.

There are three different issues she addresses here, so let’s look at each of them in turn.

1) You’re a crummy judge of your own risk tolerance.  We all are.  That’s because our money is personal to us.  One of my psychologist clients once exclaimed, “Money is my most neurotic asset!”  It’s much easier to take an outside view and look at it with some psychological distance.  An experienced advisor is more likely to be able to gauge your risk tolerance correctly than you are.  There are also good resources like Finametrica for learning more about psychologically appropriate levels of portfolio risk.  But Ms. Benz really gets to the heart of things: your risk tolerance will change depending on your emotions!  That’s something no advisor can calibrate exactly, nor are you likely to guess how powerfully the swell of fear will hit you after a particularly heinous quarterly statement.

2) It’s not okay to panic.  As Ms. Benz points out, discussing loss tolerance in this fashion implies that it is ok to bail out emotionally at some point.  If you have losses that are uncomfortable, perhaps you need to revisit your overall plan, but it’s unlikely that major modifications are needed if you were thoughtful when you put it together in the first place.  Markets, and strategies, go through tough periods and it’s important to be able to persevere.

3) At the height of emotion, volatility and risk get confused.  Volatility is just a measurement of how much your investments are whipping around at the moment.  Risk isn’t the same thing.  Ms. Benz clarifies the difference:

…volatility usually refers to price fluctuations in a security, portfolio, or market segment during a fairly short time period–a day, a month, a year. Such fluctuations are inevitable once you venture beyond certificates of deposit, money market funds, or your passbook savings account. If you’re not selling anytime soon, volatility isn’t a problem and can even be your friend, enabling you to buy more of a security when it’s at a low ebb.

The most intuitive definition of risk, by contrast, is the chance that you won’t be able to meet your financial goals and obligations or that you’ll have to recalibrate your goals because your investment kitty come up short.

Through that lens, risk should be the real worry for investors; volatility, not so much. A real risk? Having to move in with your kids because you don’t have enough money to live on your own. Volatility? Noise on the evening news, and maybe a frosty cocktail on the night the market drops 300 points.

This is one of the best descriptions of risk I’ve ever read, one that puts opportunity cost front and center.  Risk isn’t your portfolio moving around; that’s just volatility—noise, really.  Risk is eating Alpo in retirement, or as she mentions, being forced to move in with your kids.

Source: Purina

Risk is the very real possibility of having a severe investment shortfall if you avoid volatility like the plague.  Low volatility investments earn low returns (or worse if they are Ponzi achemes).

The challenge of every individual investor, hopefully with help from a qualified financial advisor, is how to balance volatility and return–while keeping risk from sneaking up and biting you you-know-where.  Ms. Benz has some thoughts on this as well:

So how can investors focus on risk while putting volatility in its place? The first step is to know that volatility is inevitable, and if you have a long enough time horizon, you’ll be able to harness it for your own benefit. Using a dollar-cost averaging program–buying shares at regular intervals, as in a 401(k) plan–can help ensure that you’re buying securities in a variety of market environments, whether it feels good or not.

Diversifying your portfolio among different asset classes and investment styles can also go a long way toward muting the volatility of an investment that’s volatile on a stand-alone basis. That can make your portfolio less volatile and easier to live with.

Again, she makes several very cogent points, so let’s deal with them one by one.

1) Volatility is inevitable.  Deal with it.  Preferably by constructing your portfolio thoughtfully in the first place.

2)  Better yet, volatility can be your ally.  Buy on dips.  (Easy to say, harder to do.)  In truth, high-return, high-volatility strategies can be tremendous wealth builders because the long-term returns are good and you get plenty of opportunities to add money during the dips.  Toward that end, we publish a High RS Diffusion Index each week to help identify those dips in our particular strategy.

3) Diversify appropriately.  We believe it’s often more fruitful to mix strategies as opposed to asset classes.  For example, relative strength strategies tend to work very well when blended with deep value strategies.

Ms. Benz lays out the real definition of risk: failing to accomplish your goals.

It also helps to articulate your real risks: your financial goals and the possibility of falling short of them. For most of us, a comfortable retirement is a key goal; the corresponding risk is that we’ll come up short and not have enough money to live the lifestyle we’d like to live.

Clearly, the biggest risk for most investors is their own behavior.  They avoid volatility rather than embracing it.  Instead of buying on dips and being patient with proven strategies, they sell during pullbacks and buy only after an extended period of good performance.  When you start to conceptualize risk as shortfall risk, you can also see that another of your big risks is not saving enough in the first place.  At the risk of sounding like my mom, if you don’t have any money, no investment advisor is going to be able to help you retire.  Savings, too, is behavior that can be modified.

What can be done to help clients embrace volatility, or at least deal constructively with it?  Are there any ”nudges” that can be applied in order to increase their patience and their overall good investment behavior?  Ms. Benz makes a suggestion in this regard:

Many financial advisors have begun to embrace the concept of creating separate “buckets” of a portfolio–and in particular, a bucket for any cash the investor expects to need within the next couple of years.  By carving out a piece of your portfolio that’s sacrosanct and not subject to volatility or risk, you can more readily tolerate fluctuations in the long-term component of your portfolio.

Sure, it’s a cheap psychological trick that plays to the mind’s natural tendency to segment things–but if it helps, why not?  We’ve discussed in the past that a portfolio carved into buckets is functionally equivalent to a balanced or diversified portfolio with the same asset allocation, but if it helps clients behave better then it’s worth trying.

Whether you are an advisor or an individual investor, educating yourself about key concepts like the difference between volatility and risk will pay large dividends down the road.

The concept is simple, but sometimes investors make the execution more complicated.  For us, relative strength and trend following provide the tools and methodology to find the northbound trains.  The same tools and methodology can be used to tell you when the switch engine has come along and started to move the train south.

The problems happen when investors deviate from the simple goal-directed hobo mentality and get too clever for their own good.  Can you imagine how irrational some investor behavior must look to a hobo?  Here are the top six dysfunctional hobo sayings:

1. I wanted to go north, so I hopped on an out-of-favor southbound train, hoping it would go north eventually.  (value hobo)

2. I got on a northbound train, but it only went north a few miles.  A switch engine came along and started to take my boxcar south.  How embarrassing!  This train owes me.  I’m not getting off.  (ego-attached hobo)

3. There are so many trains going north.  I want to hop on one eventually, but I’m afraid it will go south right after I get on it.  (failure to launch hobo)

4.  This northbound train is picking up speed.  I’d better get off.  (premature ejection hobo)

5. I want to go north, but my train pulled on to a siding and stopped.  Maybe I’ll just sit here and see what happens.  (buy-and-hold hobo)

6. There are so many trains going north without me.  Eventually they will all have to go south, and then I’ll have my revenge!  (bitter hobo with economics background)

If you want to go north, get on a northbound train.  KISS really applies here.  On our good days, we all know this, but it’s so easy to forget.

Relative strength has deep historical roots in financial market analysis.  Prominent technical analysts like Richard Wyckoff and H.M. Gartley wrote books in the 1930s that discussed relative strength (among other things) and made it clear that the practice of examining relative performance was not new even then.  Richard Wyckoff used it to make a fortune in the stock market, retiring to an estate in the Hamptons next to Alfred E. Sloan, the legendary chairman of General Motors.  George Chestnutt, the iconic manager of the American Investors Trust, compiled the best mutual fund track record of the 1960s using relative strength–and did not flame out in the 1970s like many other managers from the go-go years.  Technical analysis failed to profit much from its association with relative strength, however.  Over the years, warm-hearted technical analysts welcomed market strays promoting all sorts of esoteric waves, angles, retracements, ambiguous patterns, and even astrology into their tent.  Even though there were still plenty of excellent practitioners, the further technical analysis strayed from actual market-generated data and testable hypotheses, the more its credibility as a profession slipped.  To understand how relative strength had its identity stolen, it makes sense to revisit the scene of the crime.

A uniquely American school of thought from the 1930s was fundamental security analysis, best exemplified by Benjamin Graham at Columbia University.  His idea was that an intrinsic value could be placed on a company, so that it could be readily determined if a security was undervalued or overpriced.  This was much more scientific than speculative buying on margin based on rumor or inside information.  Security analysis quickly gained adherents in the investment community, even as valuation metrics proliferated, some having little to do with value in a way Benjamin Graham would recognize.

Another milestone in finance came in 1952 when Harry Markowitz pioneered Modern Portfolio Theory.  In a paper published in the Journal of Finance, he discussed the mathematics behind the effects of asset risk, return, and correlation in the construction of an optimal portfolio.  Academia swooned and the rout for relative strength was on.

Fundamental analysts quickly allied themselves with the academic community, although the marriage was always a little problematic.  After all, how do you reconcile the notion that the market is efficient with the idea that you can identify undervalued securities? 

In time, anomalies popped up in efficient-market land.  For example, Eugene Fama and Ken French discovered that there were performance differences between large-cap and small-cap stocks.  Even Fama and French, however, didn’t know what to do with relative strength.  According to James Picerno in his wonderful article “Bodies in Motion:”

Professors Eugene Fama and Ken French cited the momentum factor as an “embarrassment” for their own popular three-factor asset pricing model, which identifies small and value stocks, along with the overall market, as the primary risk factors driving equity returns. Fama and French couldn’t explain the success of momentum investing, even if they did acknowledge its existence.

Unfortunately for relative strength, some of the research was sloppy.   For example, numerous studies were published purporting to show performance differences between growth stocks and value stocks.   Value stocks always won, evidence that, taken on its face, seemed to validate the value-oriented security analysis crowd.   Since relative strength had always been viewed more as a growth factor, this outcome was particularly damaging to the reputation of relative strength.   

Closer examination of the studies revealed a serious flaw in their construction.  The stock universe used was typically segmented by some valuation ratio, with the good value stocks classified as “value” and the bad value stocks getting thrown into the “growth” category.  It took John Brush to point out that growth was not the same thing as bad value.  His re-examination of the data showed that growth factors actually outperformed value factors over time.

In 1967, an American University graduate student named Robert Levy did the first computerized testing of relative strength as a return factor.  His article, “Relative Strength as a Criterion for Investment Selection,” in the Journal of Finance, soon followed by a book, was earthshaking.  Academia, still in the thrall of efficient markets, shouted him down.  How dare he show that a simple momentum factor could consistently outperform the market?  Levy left the investment field–but his relative strength return factor continued to work, as was shown in subsequent papers, like our own 2005 article published in Technical Analysis of Stocks & Commodities magazine.

Unfortunately for Modern Portfolio Theory, anomalies continued to proliferate to the point that they were perhaps more frequent than the things that worked according to theory.  Academics were emboldened to explore new avenues, one of which was really an old friend, relative strength.  Given the reception that Levy had received, modern academics thought it perhaps wiser to rechristen the return factor as “momentum.”

The first academic papers on momentum began appearing in the early 1990s, alongside more popular treatments of relative strength like James O’Shaughnessy’s What Works on Wall Street.  Even so, discussions of relative strength still took a backseat to value-oriented anomalies.  When I went to the first conference on behavioral finance held at Harvard University in 1997, the crowd was captivated by Josef Lakonishok and his presentation of investor over-reaction and under-reaction, I suspect because it fit in very nicely with the contrarian/value bias of most of the conference attendees.  In contrast, when Lakonishok later presented his paper on momentum at the same conference, the crowd was sparse and uninterested.

Very recently, relative strength has garnered new attention.  In an outstanding article in Financial Advisor, James Picerno traces some of the history of momentum as a return factor:

Since it was formally revived in the academic literature for the first time in the early 1990s, there’s been a wide-ranging debate about why momentum investing exists and what it means for modern portfolio theory. Yet now there’s a growing acceptance of it as a separate and distinct driver of return premiums.

As a gauge of institutional acceptance, Morningstar recently announced plans to include momentum as a return factor and will begin to rate funds by the average level of momentum in the holdings as well.  (It should be noted that quantitative analysts did not ignore Levy’s groundbreaking work.  Quants long ago confirmed relative strength as a return factor, which is why it is now ensconced in nearly every multifactor model.)

This re-acceptance of relative strength, as Picerno points out, is well-grounded: 

The concept of momentum investing is compelling not just because investors are hungry for diversification and new strategies but also for it’s durability in the real world. Relatively few other strategies survive the transition from paper to real-world portfolios the way momentum investing does.

In the textbooks, minting profits looks easy because the standard asset pricing theory suffers from so-called return anomalies—sources of excess returns above and beyond what’s implied by the academic models. But exploiting these anomalies in actual portfolios is hard. Trading costs, taxes and other frictions take a toll. And many profitable return patterns that look solid in the financial laboratory have an annoying habit of disappearing when the crowd comes rushing in.

Is momentum investing different? It appears to be. Academics and money managers tend to agree that it is a resilient source of return that stands up to the usual lines of attack, such as criticism that it’s simply a byproduct of data mining or that it’s vulnerable to arbitrage. It doesn’t hurt that the basic idea is as old as investing itself and so it’s stood the test of time.

Relative strength also turned out to be a universal factor.  It worked not just for U.S. stocks, but for asset classes, and for all manner of foreign markets.  Picerno writes:

“Momentum is ubiquitous across all major asset classes,” says professor Craig Pirrong at the University of Houston, summarizing the conclusion in one of his own research efforts.

A similar finding echoes throughout the analysis of Mebane Faber, a portfolio manager at Cambria Investment Management. His work demonstrates that momentum investing’s close cousin—trend following—has proved its worth as a risk management tool in connection with tactical asset allocation.

What’s the point in our forensic analysis of the scene of the crime?  What can we take away from this tale of intellectual kidnapping, of eclipse and re-emergence?  There are several useful lessons, I think. 

First, respect history.  Don’t be too quick to dismiss the “primitive” ideas of  your predecessors.  They may not have had the same technological tools as we do now, but that doesn’t mean their IQ was lower.  Relative strength was based on close observation of markets and actual human behavior, and ironically, it has turned out to be much more sturdy than the equations and the rational man of Modern Portfolio Theory.  The only thing new under the sun is the history you haven’t read yet.  

Second, evidence trumps assertion.  Don’t believe everything you read.  Test it yourself.  Levy’s formulation still works more than 40 years later, even though his critics claimed it did not.  Everyone has an ax to grind and you need to figure out what it is.  Many times it is the search for truth, but sometimes it is just the preservation of the status quo.

Finally, seek the universal.  The biggest breakthrough in biology occurred when Watson and Crick were able to show that DNA replication was at the heart of all living things.  Now that we can sequence the genome, scientists realize that humans share most of their DNA not just with other primates, but with insects and virtually every other species.  That is amazing!  DNA is universal and so malleable that it can adapt to create a human eye or the compound eye of a fly. 

Relative strength is part of the DNA of markets.  Markets and asset classes everywhere exhibit momentum.  Relative strength is universal and so malleable that it can be used to power stock selection or global tactical asset allocation.  Relative strength makes no assumptions about the future–it simply adapts to what is.    Darwin wrote, “It is not the strongest of the species that survives, nor the most intelligent, but rather the one most adaptable to change.”   Relative strength is adaptive and adaptation is what ensures survival.

Relative strength has come full circle.  After years of academic neglect and derision by fundamental analysts–and a blatant case of identity theft in renaming it “momentum”– relative strength as a return factor may be regaining its place at the table.

Now, when I use the word “smart,” in the context of capital markets, I’m not talking about IQ at all.  You don’t have to be a university professor or have an extensive financial background to be smart.  In fact, it’s even possible those things could work against you.  Rather, being smart about the capital markets requires a very specific skill set consisting of three things.

1) Knowledge.  Smart means understanding which return factors are likely to outperform over time.  If you plow through all of the investment literature as we have, you will see that it largely boils down to two return factors: relative strength and value.  Both are robust and work in numerous formulations.  Although we use a proprietary relative strength factor, there’s no one formulation that is magic.  Success is mainly a matter of consistently exposing the portfolio to the return factor.  Pick one–or both–because they complement one another extremely well.  If you have just this small nugget of knowledge, you are miles ahead of the game.

2) Discipline.  Smart means understanding that execution is more important than knowledge.  It’s not enough to have the knowledge of which return factors will likely work over time.  You need to have a systematic method of exposing the portfolio to your chosen return factor in a disciplined fashion.  You cannot waver or let your emotions get in the way–and believe me, your fear will try to run you into the ditch during every correction.  Maintain your emotional balance.  You must remain resolute up to and including the end-of-the-world scenario.  Maybe the world will end and I will be wrong about all of this.  Probably not.  If you consistently expose your investment capital to a good return factor in a disciplined way, you are light years ahead of your competition.

3) Patience.  Smart means understanding that great patience is required.  Most investors, I suppose, would like to get rich quick.  That’s unlikely to happen.  In a karmic kind of way, the universe actually makes you earn your money by going through trials and tribulations.  The E-ticket ride you get in capital markets is never easy, and often not pleasant.  Both relative strength and value go in and out of favor as return factors, sometimes slipping into eclipse for years at a time.  Great investors are enveloped with a kind of Zen-like calmness.  They are neither their profits nor their losses.  You can’t take giddy mental ownership of your equity high-water mark or despair at your drawdown during a correction.  Stay centered and let compounding work its magic.  The journey of a thousand miles really does begin with a single step, but don’t forget that it also takes a long, long time to walk a thousand miles!

Investors with a small kernel of knowledge and oodles of discipline and patience are likely to see money flow their way over time–that’s how capital markets are designed to work.  As you can see, “smart” relates much more to temperament than IQ.  I would go so far as to say the temperament piece is probably the most important.  While most investors engage in dumb behaviors like  jumping from questionable method to method, adding money when they feel good about their results, pulling money out when they are temporarily panicked, measuring results over a short period of time, hiring and firing managers like a revolving door, and generally running about like a chicken with its head cut off, smart investors pursue reliable return factors with discipline and immense patience.  If you take the perspective that the market is designed to take your money when you do something dumb, investors would be well-advised to think about their behavior carefully before every portfolio change.

In a watershed event for relative strength investing, Morningstar will begin to consider “momentum” as a return factor.  This nugget was disclosed in a Portfolio Strategy article that appeared in today’s Wall Street Journal.

For many years, academic researchers believed a stock’s performance could be explained by three primary factors: the market where the stock traded, the size of the company, and the stock’s style, along a continuum from shares of fast-expanding “growth” companies to seemingly cheap value stocks.

But now, the academic community has “coalesced” around recognition of momentum as the “fourth factor,” says Mr. Rekenthaler, a sentiment echoed in recent research.

Momentum, as you may recall, is the name academics use for relative strength.  Academic research began appearing on momentum in the 1990s, although market technicians have been writing about–and using–relative strength at least since the 1930s.  (My theory is that academics and value investors can’t stand to admit that technical analysis has tremendous value.)

Morningstar didn’t stop with just the recognition of relative strength as a return factor.  They’re going to measure it:

In a sign of just how popular this idea is becoming, Morningstar Inc. this summer will roll out a new gauge: The research firm will assign U.S. and international stocks a score between 1 and 100 for momentum and take the mean momentum score of a mutual fund’s holdings to give the fund an overall momentum ranking. If funds that consistently score highly on momentum perform similarly, Morningstar might eventually create a new category of momentum-oriented funds, says John Rekenthaler, vice president of research at the firm.

The other salient point that the Wall Street Journal article makes is something that we have emphasized often on this blog.  Relative strength strategies and deep value strategies are often complementary.  The article references the work of Clifford Asness at AQR:

Mr. Asness co-authored a 2009 study entitled “Value and Momentum Everywhere,” which suggested that investors can hedge themselves and boost returns with a simple combination of momentum and value strategies—in stocks and all other asset classes.

In the past, many investors looked to hold a mix of value-oriented and growth-oriented stocks or funds, since the two were thought to take turns in favor. Now AQR suggests that momentum, rather than growth, is the right foil for value strategies.

There’s one area where I take issue with the article.  It suggests that relative strength has no fundamental underpinning; that it is purely a psychological phenomenon, or somehow related to group-think:

These momentum trends in markets have more to do with the faddishness of human behavior than the fundamentals of economics and balance sheets. In essence, investors often flock to the stocks that have been going up, which tends to propel them further.

That is a very incomplete description of how relative strength works.  A number of academic studies have shown that part of the push behind relative strength is that new information sifts into the market gradually and that the time-release effect is one of the drivers of relative performance.  Fundamental analysts often comment that a positive earnings revision is frequently followed by another–the so-called “cockroach effect.”  Analysts tend to adjust their earnings estimates more slowly than they should and relative strength is often just recognition of improved prospects in the market running ahead of the analysts’ conservative thinking.

Indeed, relative strength is typically driven by fundamentals. For example, the largest weight in the PowerShares DWA Technical Leaders Index (PDP) is Apple Computer (AAPL).  If you look at a chart, you can see that it has vastly outperformed the S&P 500 index over the past few years.

click to enlarge

Is that because investors are blindly flocking to it because it has been going up, or is it in recognition of the earnings per share going from $2.27 (9/2006) to $6.29 (9/2009), with a consensus estimate of $13.08 for this fiscal year?  In our view, it’s simple math.  Earnings going from $2 to $13 merits an increase in the stock price.  Value investors can debate if Apple is cheap or expensive, but the market has already voted.  In other words, if a stock is outperforming the market and its peer group, it’s typically because the fundamentals are superior.

That caveat aside, I would like to tip my cap to Morningstar and the Wall Street Journal.  It’s about time that relative strength gets the respect it deserves.

Podcast #2: Investment Lessons from the Gray Haired Money Manager

Harold Parker and Andy Hyer

The 4% retirement spending rule is clearly a rule of thumb, and I am sure that most practitioners modify it depending on the client’s circumstances.  (We prefer a 3% spending rule, and I’ve seen other rules based on the yields available.  For example, one paper I read advocated a spending rule of 125% of the yield on the S&P 500, arguing that you can spend more when yields are high than when they are low.)  Mr. Sharpe says the 4% spending rule is too simplistic.  He’s right–rules of thumb are supposed to be simplistic.  But no one using it is really going to mistake it for the be-all-and-end-all.

An extraordinarily complex retirement spending rule that takes many complicated factors into account is just as likely–or maybe even more likely–to fail.  The real world is a much messier place than an ivory tower.  Things that seem like good ideas in theory, even to Nobel Prize winners (I’m thinking Long-Term Capital Management here), often fail miserably in practice. 

The reason that complicated things never work in real life is that there are too many unknowns in the equation.  In modern portfolio theory, market returns and correlations between assets are not stable, so the whole thing is essentially unworkable.  A perfect retirement spending rule could be made for each client if the practitioner only knew exactly what their investments would earn each year and how long the client would live.  That’s not going to happen, so we are left with rules of thumb.

The most important thing about any modeling approach is how robust it is.  If you jiggle around the inputs, does it fail miserably or does it continue to work?  Is it based on historical inputs which are guaranteed to change, or does it just adapt without making assumptions?  We have strong feelings about this.  The fewer factors a modeling approach uses, the less likely it is to be knocked down by some unanticipated factor interaction.  We use a single-factor model and test rigorously for robustness (you can read our white paper on Bringing Real-World Testing to Relative Strength here).  Academic finance would be much more useful to real investors if they kept in mind another saying:  it is better to be approximately right than precisely wrong.