Gambling: Happens in Vegas — and Should stay in Vegas

Artifacts dating to 2500 B.C. indicate that gambling and games of chance represent one of the oldest forms of entertainment. Modern times have seen a proliferation of gambling forms and venues—the most famous of which is Las Vegas, a city which is literally synonymous with organized, legal gambling.

Interestingly, organized gambling generates reams of data on the actions and behavior of participants. Study of this data by researchers reveals fascinating and in some cases surprising results. One consistent finding, involving horse track betting, exposes the pronounced tendency of gamblers to bet on long shots—especially long shots during the final races of the day1. Most researchers attribute the desire for long shots at the end of the day to the fact that bettors have on average lost money during the day, yet they desire to go home a winner (or at least not lose any money).

While this tendency to favor long shots at the end of the day may not surprise frequent visitors to betting establishments, it contravenes established financial theory. A reduction in wealth generally leads to a reduced willingness to bear risk, not a desire for increased risk taking. The counterproductive desire to increase risk to avoid a reduction in wealth manifests not only in gambling but also in the choices investors make. In fact, a newer strain of investment research known as behavioral finance has documented this very effect. Investors tend to seek more risk when they are “behind” or losing, and are more risk averse when they are winning or “ahead,” contrary to traditional financial theory.

Some suggest that a solution to inadequate retirement savings lies in increasing exposure to risky investments such as equities. Substituting higher risk with the hope of earning returns that will compensate for insufficient savings applies the fallacy of betting the long shot at the end of the day to retirement planning and investment.

In fact, higher equity allocations at the start of retirement may only serve to increase the likelihood of running out of money. As shown in Figure 1, if an investor has saved adequately for retirement—permitting withdrawals at a reasonable 4% annual rate—higher (lower) equity allocations lead to significantly increased (decreased) probabilities of running out of money (so-called “longevity risk”).

Figures 2 and 3 extend this analysis to situations assuming even higher annual withdrawal rates (6% and 8%, respectively) where these higher withdrawal rates correspond to an investor who has not saved adequately for retirement. In these two figures, higher withdrawal rates significantly increase the likelihood of running out of money in retirement for all equity allocations at longer time periods, making the relative differentials almost trivial.

In other words, with an 8% withdrawal rate and a 20% equity allocation, the probability of running out of money during retirement is virtually 100%, whereas the probability of going bankrupt is “only” 86% if one held 80% in equities. The likelihood of bankruptcy is so high in both cases as to make the comparison virtually irrelevant.

As one can see, the risk of outliving one’s retirement savings is a complex function of several variables, including annual withdrawal rate, equity allocation, and time horizon. Overall, as one would expect, the lower the annual withdrawal rate, the lower the chance of running out of money during retirement, regardless of time horizon or equity allocation.
The penalty for inadequate savings (thereby necessitating a higher annual withdrawal percentage) is significantly higher “longevity” risk—that is, the risk of outliving one’s retirement savings. In Figures 2 and 3, this is shown as a higher probability of going bankrupt in retirement versus Figure 1.

The relationship of equity allocation to longevity risk is somewhat more complex and nonlinear, but the general conclusion is that higher equity allocations are inferior to lower allocations in the most reasonable scenarios. In those cases where higher equity allocations do show more favorably, the risks of bankruptcy are very high for all equity allocations, and the differentials arguably become trivial.

For the higher withdrawal rate scenarios of 6% and 8%, lower equity allocations are superior (i.e., they exhibit lower bankruptcy probabilities) for time horizons up through 15 to 20 years of retirement. However, longevity risk differentials tend to converge and even reverse over longer time periods (20 to 30 years or longer), indicating that higher equity allocations may, at the margin, be superior, but only in these more extreme cases. This is due to the growth component and compounding effect of higher equity allocations over longer periods of time.

In summary, simulation results supporting the case for lower equity allocation at/through retirement are robust for varying levels of withdrawal rates through the first 15 to 20 years of retirement. After that time, for the higher withdrawal rate assumptions, higher equity allocations dominate lower allocations, but only at very high absolute levels of failure.

Higher equity allocations will not adequately compensate for insufficient retirement savings and will not protect against longevity risk in any meaningful way.

The solution to inadequate retirement savings lies in increasing the amount being saved for retirement. This increase in savings can result from saving more or working to a later age, which also decreases the expected amount of retirement funds needed. Alternatively, inadequate savers must accept less retirement income, an unpleasant and undesirable option. Adopting a long-shot investment approach as an antidote to the inability or unwillingness to save applies a technique to retirement investing that is best left in the Nevada desert. “Doubling down” at a casino with money you can presumably afford to lose is one thing—gambling with your retirement nest egg is quite another.

1 The Winner’s Curse: Paradoxes and Anomalies of Economic Life, Richard H. Thaler Princeton University Press 1992
 
The opinions expressed are those of Scott Wittman, CFA, CAIA; Rich Weiss; and Irina Torelli, CFA; and are no guarantee of the future performance of any American Century portfolio. Statements regarding specific holdings represent personal views and compensation has not been received in connection with such views. This information is not intended as investment advice.