The Truth About Risk, Retirement, and the National Debt with Allison Schrager (EP.196)

0:28We all need to make smart decisions with our money. author Alison Schrager, live from the New York Stock Exchange, for a conversation that ranges from the misconceptions surrounding financial risk to the challenges of the United States managing their national debt, retirement security, and we even get to touch on some of these global economic shifts that we're living through right now. Now, Alison has been on my list of someone I've wanted to have on the show for a very long time. I think you'll find that her insights provide a compelling look at how individuals and institutions should think about risk.

1:00And the timing of the conversation is just absolutely perfect with all the things that are going on in the markets and in the headlines. As always, you can find detailed show notes by visiting thelongterminvestor.com. And if you need a second opinion on your investments, or you have some big financial decisions ahead, whether it's retirement or career change, or just navigating some complex tax, or investment issues, you can click on the Work With Me page while at thelongterminvestor.com. Look for a time to book with me 30 minutes, and we'll just talk about whether or not there might be a good fit in a way for us to help you.

1:35And now, without further ado, here is my conversation with Alison Schrager.

1:44Alison Schrager, welcome to The Long-Term Investor. Thanks for having me. I am so excited. I told you this before, but my audience should know that you were on a list of people that when I started the show, I was so excited to someday reach out. And I built up the courage recently. But at the time, I had read your book, An Economist Walks Into a Brothel, which takes such a unique perspective on risk management. And I was hoping we could just start there and have you share a little bit of like what inspired you to take such a unique angle. Well, I was working at Dimensional Fund Advisors at the time, and we kept hearing from the advisors.

2:20They were having problems really communicating risks to their clients, mainly that, again, if you're investing for the long term, what risk means? How not to look at some other guy who has a guy who's putting you in a riskier portfolio. So he's done better this month versus you sort of having this longer term strategy. So I was always kind of had this side writing career and was really inspired by Freakonomics. I felt like it did so much for the economics profession, helping people understand what economists do. We don't pick stocks, but we think about incentives. So I was thinking the market could use a Freakonomics treatment of finance or financial economics.

2:56I mean, working at Dimensional Fund Advisors was amazing because I had so much access to Bob Merton and Gene Fama and Ken French and David Booth at the time. And I'd learned so much finance from them, Like really not just like the technologists really had to think about finance. And I felt like I could be the one to offer that with my writing skills, my financial training. So I had this idea. I was like for economics, but for finance rather than applied micro. And then it became clear Steve Levitt had this library of research papers. And I did not because I hadn't worked in academia since grad school.

3:26But I didn't know how to write. So I decided I was going to do reporting instead and found all these stories that illustrate the basic principles of financial economics. And one of these concepts, though, in the book is that people just so often misunderstand risk to begin with. So what do you feel like are some of the ways that people misunderstand and interpret financial risk? You know, it's so obvious. It shouldn't be said, but it kind of does. I think people are in complete denial that there's this tradeoff for risk and reward. Or it's like the more risk you take, the more potential reward.

3:59People seem to always think everything seems to go wrong in finance. when people think they can get a bigger than market return and they're in a low risk investment. And I think this is sort of it happens again and again. And it happens to even people who should know a lot better. So it sounds like sort of a cop out to say it. And I should say something more technical or hidden. But it's really just that. I mean, think of Bernie Madoff. Think of the mortgage backed securities. Think of Bitcoin. I mean, people thinking, oh, I can beat the market and have a low risk investment. And as it, I know people have PhDs in finance and they get this wrong, too.

4:30So you've studied risk and you've shared stories through various industries like Hollywood, like poker playing, like brothels. What is an example from your research that you think best illustrates how people should think about financial risk? Well, I mean, any of them, I think, do illustrate people. I mean, I think the Hollywood story was really about data and how we need to measure risk to put a price on it. There's nothing wrong with that, but you're always making an estimate. it. And the problem with it is as data gets out of date, data gets stale very fast. So the only thing you can do is use as much data as possible.

5:06I mean, this is probably what I learned from Gene Fama, is you're not really making an estimate unless you have 80 years plus of data. I mean, I think we just saw with interest rates, people became very convinced that low interest rates were the new normal because we'd had low interest rates for 20 years. And now we see interest rates are going back to something more historically in line. So I think that's another mistake people make is they get too focused on the short term when really the long term data is even more stale. But the thing is, the more data you have, the more trends you get. And I think that helps people think more thoughtfully about how to measure risk.

5:40I think from the brothel, I learned that I think, again, risk and reward, I guess no arbitrage, as we say in finance, you know, you pay for safety. It's just that simple. If you look at price setting and sex work, safety comes at a premium. And that's also true in markets or in anything. I found in any market, we always think about in finance what people pay for safety, and we break that out of financial price. But it's really true in all pricing. Even you think about if you buy a cheaper washing machine. I mean, there's a higher risk it's going to break down. Sure. So you get a higher quality washing machine, you pay more for it, but there's also less risk, probably a better warranty, all of these things.

6:17Self-serving statement, when you hire a trustworthy financial advisor, you remove some of the risk of yourself. But for those of you who are kind of raising an eyebrow and thinking about some of these examples that Allison is sharing, and I will link in the show notes at thelongterminvestor.com to her book, An Economist Walks Into a Brothel. And you mentioned low interest rates, for example. And one of the things I'm really excited to talk to you about is something that a lot of people have opinions on, but they don't really understand, which is our country's debt. And there's this idea that as long as our interest rates are low enough, low enough being no one knows what that level is, but then it's not a problem.

6:50So let's go big picture. Maybe we'll drill down from there. But how do you think about the U.S. national debt today? Well, I think it's a problem. So you're right. And this became very popular when everyone was decided higher for longer meant higher forever. Although it sounds silly because no financial condition lasts forever. Sure. Was an economist trotted out this formula quite proudly showing that, you know, if the industry on the debt is growing slower than our rate of growth, then you don't need to worry. It's just like financing any investment. If you have a lower interest rate than your rate of return, it's great.

7:24But just like in any financial transaction, these are two random variables that are unpredictable and change a lot over time. So the problem is once interest rates go up and your growth rate doesn't go up, you're in trouble. And I think that's what we're starting to see now is that concern is that our growth rate and interest rate are not looking to align the way we want to. So that's why it becomes a problem. I mean, that said, I just wrote a column for Bloomberg. I'm very worried about the debt. I don't want to minimize that. But I think we could have worse problems. I was just in Switzerland at Davos, and people there were very concerned in Europe about low growth.

7:58Especially in Germany. Is that the column you're referencing? Yes. Yes. And we have a debt problem. Europe has a growth problem and a little bit of a debt problem. Not Germany, but other countries. And it is better to have a debt problem than a growth problem. But a debt problem is also still not a good thing to have either. So when you talk about, it's about the growth of the interest rate change, the change in the rate of change, or just the change of the rate growth? So I guess regardless, it's a big number. The rate itself. But the big number itself, if you're going to address it, probably requires some form of entitlement reform.

8:32It's not like we're going to grow our way out of the step problem. Is that fair? Yeah. And while I appreciate Doge's efforts and I appreciate the efforts that we're looking at all forms of spending, I don't understand this critique of, I believe in foreign aid. I just want to put that out there. But people are like, who cares if we're wasting money with certain foreign aid programs? It's a small bit of the budget. It's like, well, it's still part of the budget and the stuff does add up. So I'm glad we're taking a hard look at government and our spending. But at the end of the day, it is pennies compared to entitlements.

9:03Before I transition to entitlements, because you have a lot of interest in pension, your sub stack is very pension focused. So we're definitely going to touch on that. But I want to get your opinion, an economist's opinion, but also someone who has worked in the asset management side on people worry about their portfolios and the U.S. debt. What would you tell someone who owns bonds, owns U.S. bonds of all kinds, treasuries, corporates, whatever? How would you think about the U.S. debt, its absolute level, how we are addressing it from the perspective of a bond investor? Well, I would expect yields to go up, so prices to go down.

9:36On the other hand, the best way to deal with that might be, as I said, to think about your duration risk and possibly hedge that. So I guess it's the counterintuitive advice to maybe go into long bonds if you have a long-term investment strategy and get serious about inflation protection. Well, I think one of the things that people think when they hear the word debt crisis is, and this is just an opinion, and please by all means disagree with it if you do, the crisis would be a big jump in yields. Not that we actually default on our debt. Not that we actually don't pay the interest. I'm not worried that we're going to have a massive default.

10:10Well, it depends how you define default. Well, the government chooses not to pay because they don't raise a spending. Or we can't. It's not Greece. But I mean, there's different ways you can default. I mean, you can default by, I would call inflation, letting inflationary pressure be a form of default. Okay. Because it eats away the value of it. Sure. So I mean, in that sense, we do. But yeah, I'm not worried about the U.S. just saying, you know what, we can't afford to pay our debts. Too bad bondholders. We're not Argentina or they used to be. But yeah, I do think that it could take the form of interest rates jumping suddenly, having less control.

10:43And then that means our interest payments are higher and that eats into more of our spending and that leaves less money available for other services. One thing I've observed is that when you do have a debt problem, there's this hierarchy of who gets paid first. And I think people don't realize that pensioners do get paid first. So they're number one. So we will always make social security payments. After that are bondholders and after that are people who rely on goods and services from the U.S. government. So you can imagine where we're going to fall out if interest rates go up. And if interest rates grow up, there is a way to respond.

11:15And it isn't always happy responses, you know, cutting benefits and such. Or inflating it away. Or inflating it away, which is A good tie into something I wanted to touch, at least briefly, is monetary theory, which largely says inflation is the risk of spending. But spending isn't a problem as long as it's going to the right places and doesn't cause too much inflation. How do you feel about that? I'm not sure what any of that meant. And that's not me being snarky to you. It's more like me being snarky on modern monetary theory. OK. Well, can you dig in a little and help people understand? I don't understand it at all because I think it's like a nonsensical argument.

11:51OK. Not what you just said, but just the whole philosophy. So it's an overfit model, like trying to build a model around what they've seen today. It also just seems like stunningly ignorant of financial markets. It seems to assume that, and again, I don't understand it at all because there's no model. And to be clear, it's not like you haven't studied and like sought to understand it. It's just after having looked at it, it doesn't make sense. Well, because there's no model. Like economists do communicate with models because it's a very sort of clear and unambiguous way to sort of frame your argument.

12:21So it's sort of like a lot of these things, a lot of bad economic arguments, which starts with like a true observation. Like we print our own money and, you know, people want to buy our debt. Those things are true. But that doesn't mean that interest rates don't change over time. It doesn't mean we control the whole yield curve. There is a risk premium. There's things like that. And like inflation isn't some trivial thing. I think they believe that we'll get rid of inflation by increasing the tax rate, which is also completely unfeasible. I mean, politically. Sure. It's confusing and it's a mess of things that I think people like the sound of.

12:53I'm glad if there's one thing I'm happy about with rising interest rates and the return of inflation is I like to think we've sort of put this idea to bed. Well, and part of, I think, why we've experienced such low inflation is that global trade, maybe we've underappreciated the benefits of global trade. And by the time this all comes out and published, we're recording at the beginning of February. Tariffs are in the news. Now that I've sort of timestamped us, we might as well talk about tariffs. Anything you want to share on your views with tariffs? Well, I mean, I'm not a fan. You're an economist.

13:24Why would you be a fan? I know. Well, yeah, I went to Columbia. I'm appreciating how this is a bad market outcome. Bad earnings report. I was going to say, we are live from the New York Stock Exchange. Bad earnings report. Yeah. I was trained to think about tariffs a very particular way. And I think I'm trying to be open to things I think we all should be, that maybe I'm a little dogmatic about tariffs being just the most evil thing you could have in economics. And I'm not sure. my training really got me thinking about a country like China being in the world trade system that does manipulate their currency.

13:55And as the result of that, we are very dependent on them for a lot of goods that we are highly dependent on. Like during the pandemic, we discovered they make 90 % of the ingredients for antibiotics. It is a problem. And I do think tariffs might be more effective than sanctions. I think we did just see from the theatrics over the weekend that, you know, they could be useful leverage for some political things. So I don't love them, but I'm trying to be more open-minded by their use in more limited ways. That said, I felt like under the Biden administration, this philosophy of we are going to use tariffs for global diplomacy became popular.

14:33And was it Jake Sullivan talked about this walled garden where we would be thinking about them very thoughtfully. But I think you also, like as we're now seeing with Trump, once you open the door, It is hard to keep that in the wall of garden. So I'm trying to be less dogmatic about it and have more mixed feelings about, all right, in this situation, maybe, you know, we could think about tariffs, small tariffs in some ways being somewhat useful. But it's hard for me to get on board with high tariffs that are broad. Just to sort of put something in my own words and not necessarily say this is what you're saying.

15:04But is it a little bit like when I studied economics and finance in school, there was no behavioral finance aspect of it and everyone was a rational investor. And so tariffs, we know from an economics standpoint, like in the textbook, that that's not a rational choice. But if there are less rational, people are cheating the system. It can be a rational choice. I mean, if, for instance, the Chinese government is so determined to keep their manufacturing going and they would eat the cost of the tariff. OK, sure. I think more I worry about, if we use them as a tool of diplomacy, I don't doubt, like say Mexico, Canada, Europe, that they are rational actors and they will do what's in their economic best interest and they won't do crazy retaliatory tariffs.

15:45You never know, but I think they are. Good base case. Yeah. But I'm not entirely sure about China's motivations and China being fully rational in their economic policy. So that's something as well, if we're thinking about them as a way to use political tools, something to think about. Very interesting. Let's refocus back on the U.S. I'd mentioned earlier Social Security. I want to be very open-ended here and just get your general thoughts. When you have to think about or talk about Social Security, what are the risks you see? What are the ways that those risks should be framed in terms of risk-reward?

16:18And what are actions you feel like need to be happening? Well, like I was saying, I think one of the ways we get risk wrong is we get confused about safety. And Social Security, when I think about it, in the role it plays in people's retirement portfolio. So I think one thing we get wrong when we think about entitlements is it's part of a larger retirement system. When people retire, they have different sources of income. Social Security, they've got money from their 401ks. Maybe they have money from other forms of saving. Maybe they have an old DB plan lying around. So Social Security is supposed to be the foundation, sort of the risk-free source of income that you can count on no matter what.

16:53So the danger is with entitlements is everyone knows we're not going to have the revenues to fully cover Social Security. So people start thinking of it as a risky stream of income when it really isn't. As I said, I think we'll default on our debt before we default on Social Security. That's just my assumption. Maybe I'm wrong. So Social Security is going to be there. But people have this sort of weird cognitive dissonance with it, which is, I don't know if it's going to be there for me. My mother's in her 70s. She says that. And I'm like, they're not going to cut your bet anyway. Right. They're not going to politically, if you're over the age of, I'm just going to randomly say 55, something's going to be there for you.

17:27Yeah, exactly. I think it's going to be there for everyone in some form. Sure. It's supposed to be that foundation, but people will assign a risk on it. But at the same time, they're also incredibly reluctant to have any sort of reform, even if the reform would hit people under 40. Right. People see it as this thing. They're very upset about it. They also don't want anything done. Like one thing that I find interesting is a lot of sort of new Republicans, the new right, the new economic right are like, you know, Donald Trump is really smart. So you realize Social Security reform, entitlement reform is unpopular.

17:57So we stopped doing it. Unlike Romney and Paul Ryan. I'm like, well, I could have told you it's unpopular in 2010. No one likes having to pay higher taxes and getting lower benefits. This is what it's going to entail. There's really just how the math works and everyone knows it. Yep. So saying I'm not going to do this unpopular thing any way it needs to be done, I don't think is some like political revelation or it certainly isn't, say, leadership. I mean, I don't know. I've heard theory like I know Scott Besson, the Treasury Secretary, is very serious about debt reduction. I was on a panel. I don't know how credible this is.

18:28Last year at Davos with Kevin Roberts, who's part of 2025, and he was quite adamant that Donald Trump was going to take on entitlement reform, largely because he is a lame duck president and he seems to be wanting to fix big problems. So maybe we will get something. My advice for entitlement reform is to think of it holistically as a system. So if you're going to reform Social Security, you should also reform fine contribution 401k market too, so they move together. So people don't have this complete perceived drop in income or just increase in taxes, but it's offset in other ways. Well, and it is useful for people to see how other countries are doing it.

19:03I believe Canada has a program that they're very proud of and such. I know that was actually a panel that I watched of yours and Davos. But there's a lot of countries like that. It just, it wasn't. Although they all have problems. There is no perfect answer. Well, everyone has an aging population. Any country that has a mature pension system has an aging population. Right. And you need population growth, whether that's through immigration without being political. Yeah. You need population growth and your population's aging otherwise. Immigration is a tool to fix that. Exactly. Because pay-as-you-go pensions, and most countries have some form of that, which is younger people pay for older people, is sort of how we've created the foundation of risk-free income.

19:39And so, I mean, that is a bit of a time bomb. So everyone's dealing with that to some extent. Well, the one thing that struck me and was disappointing about the campaign trail is that our debt wasn't an issue at all, which is probably why no one's going to address the entitlements to begin with. But when you think in your background of pensions, I mean, beyond Social Security, what is it that you see about pensions and the retirement system beyond Social security that people ought to be thinking about? I think they need to be thinking about income and retirement. I think actually, I'm very bullish on our 401k market.

20:13I think it's actually done a pretty good job. There's certainly things that could be improved, but people have more money for retirement than ever before. I mean, most people are surprised by that because I think everyone has this romantic notion that everyone used to have a defined benefit plan. If they did, odds are they weren't participating in it. It was only 30 % of people were active participants any one time. So before it was worse and somehow we got through it. I mean, granted, people didn't live as long. They didn't have the same long-term care needs, but somehow people managed to survive.

20:43So I think the defying contribution move definitely expanded access, expanded retirement wealth. So I think that's great. I think we're pretty close, especially with the latest secure acts to expanding access to plans, even for small employers. I think we've done a pretty good job at getting people to save more. And that's kind of the hard part. But there is also the challenge of, OK, you have this pile of money and now you're retired. And what do you do with it? And I don't think we've thought very carefully or thoughtfully about that, particularly that the whole investment industry is very geared towards are you saving enough and what's your return this year and what's the pile of money you're going to have on day one, but not how are you actually going to deal with that money into retirement?

21:25Well, what's interesting to me is that if you make decisions. When you manage a retirement plan, you have a fiduciary duty to like the average participant. And someone might ask, well, who's the average participant? But when I think of what the average American is, they would benefit from the guaranteed income that something like an annuity might bring. I think the challenge for a lot of advisors is that for advisors who traditionally would say that doesn't optimize, maximize wealth, which is a true statement. True, but it's a different problem. Yes. And the average person isn't solving for wealth maximization.

21:56They're solving for living a life of dignity and respect. But no one realizes this. And this is partially because wealth management industry, and I don't blame them for this. We had a wealth management industry that was geared towards rich people. And then we sort of handed them the 401k problem. So they did what they knew how to do. Right. Well, and I think advisors in the wealth management industry often don't get paid on annuities. And as a result, they don't like them. And now they were high cost. They're actually coming down. And I think some of the research around annuities is interesting.