Conventional wisdom holds that a balanced portfolios of stocks outperforms over time… that time itself has a smoothing effect on your holdings and further, that time lowers risks. Conventional, yes. Wisdom? Not so much.
A careful look at statistics would prove this to be false. The chances of flipping heads or tails is 50% each time. Just because you flip for years and years doesn’t change the odds one bit.
Risk in investments is no different- if there are odds today that an allocation to stocks has an X% risk of loss, absent any other changing forces, it’ll still be X% of risk next year or 10 years from now. Just because you held on to the investment thru 10 years and did OK doesn’t mean the 11th year will also be OK.
That’s the premise of forward thinking economists like Zvi Bodi- a student of the MIT Professor Paul Samuelson. Further, rather than using time as a measure of risk mitigation and risk tolerance, Samuleson and his students would have you measure your risk tolerance in terms of your own human capital- your ability to rebuild from losses. High income earners and high income potential earners- or younger savers and investors- each have higher resilience in terms of human capital to recover, and can ‘afford’ more risk. Of course, personal preferences must also play into the equation so if risk is not tolerable, it should not be tolerated!
I first read on this subject in Moshe Milevsky‘s excellent book ‘The 7 Most Important Equations For Your Retirement’ and was reminded again by a recent Wall Street Journal article, a series of reader questions and answers from Bodi and Toqqu. The original article appears Here and quoted below are some of the Q+A
The authors, Zvi Bodie and Rachelle Taqqu, argued that stocks are always a risky investment, and the longer you hold them the better your chan ces of getting blindsided by a downturn. Diversification, they argued, holds no guarantees, and even the best diversified portfolio retains significant volatility because its components all share exposure to marketwide risk. In addition, investments don’t always move the way we want in relation to one another.
Instead, they advocated homing in on how much you need and then investing in instruments that guarantee this amount, such as inflation-protected bonds. They also described how options may be used to hedge risk.
We asked Drs. Bodie and Taqqu to respond to a representative selection of comments and questions. Dr. Bodie is the Norman and Adele Barron Professor of Management at Boston University, and Dr. Taqqu is a financial consultant in the Boston area. They are co-authors of the book “Risk Less and Prosper: Your Guide to Safer Investing.” They can be reached at email@example.com.
Reader comment: I was surprised with the content of this article. If the focus was on a 50-something-year-old, I would agree to make conservative investments for retirement. But for younger people? To put a part of their savings in conservative funds for 20 or 30 years? The way to amass wealth is through investing. Simply saving will not amass wealth.
The authors reply: It’s commonly thought that “investing” is about amassing wealth and taking risk, while “saving” is not. From an economist’s perspective, though, saving means setting aside current income for future spending. And investing means choosing which assets to hold, selecting from a spectrum of safe and risky assets.
Seen in this light, investments include both wealth-preserving safe assets as well as return-enhancing risky ones. The challenge for investors is to choose the mix that’s right for them. This decision is best driven by how much confidence you have in your future earnings potential.
We agree that age matters, and that younger people can usually assume greater risk—but not for the conventional reasons. The risks of the stock market don’t diminish over time. Rather, younger people have a longer time horizon to build wealth through work. When you are young, the largest asset in your lifetime balance sheet is usually your future earning power. The safer your human capital, the more risk you can take in your investment portfolio. But if your earnings capacity is quite uncertain or near its end, the opposite will be true.
Reader comment: With a little time and thought, it has been very easy to find stocks that are a sound investment, with a much greater return than your strategy. One might say stocks are even safer than your strategy, because the probability of generating more income is greater.
The authors reply: Probability alone is not a good measure of risk. The other dimension is consequences. How much do you stand to lose? How severe would that loss be?
The most practical way to deal with the problem of severity is to separate your goals into needs and wants. A slightly different way to think about this is to consider whether you expect to have enough money, taking your saving rate and future earnings into account. If there is a surplus, taking risk with your extra dollars can make sense. If you don’t see a surplus, investing in risky assets can jeopardize your standard of living.
As for your confidence in security selection: Multiple studies have concluded that for developed markets, passive index funds outperform actively managed portfolios.
Reader comment: You recommend TIPS and I-Bonds, but if you look at the true inflation rate—how prices have gone up for food and energy—TIPS and I-Bonds will not give you the return you need to beat inflation.
The authors reply: To measure inflation, TIPS and I-Bonds use the CPI-U index (Consumer Price Index for All Urban Consumers). Price changes for food and energy are included in the CPI-U, so no worries there. Of course, no average is likely to match an individual’s exposure to inflation 100%. But TIPS and I-Bonds are the safest investments we have, and it’s unwise to allow the perfect to be the enemy of the good.
Reader comment: My wife and I are in retirement. We require about $85,000 a year in addition to Social Security. How much would have to be invested in TIPS to provide $85,000 a year? How does one ladder TIPS in a tax-deferred account, when the Treasury Department does not sell to IRAs? Does a TIPS mutual fund or ETF have any laddering effect?
The authors reply: With real rates so close to zero, you’ll get a good estimate by simply multiplying $85,000 (or the income you need) by the number of years you expect to need it. Another approach is to price an immediate real annuity. We don’t recommend that you put a huge chunk of your savings with just one or two providers, but you’ll get a good gauge of how much money is required today to provide the future income you need with relative safety.
While you are correct that TreasuryDirect does not allow you to purchase TIPS directly in a tax-deferred account, it is possible to buy TIPS from a brokerage account in an IRA. For laddered TIPS funds with guaranteed payments, you may wish to look at PIMCO’s real-income funds. These are not the same as nonladdered TIPS funds, which do not guarantee any level of payments and whose value may fall if real interest rates rise.
Reader comment: The recommendations ignore real-world investment performance, investor experience and call for strategies too complicated for the majority of investors. For instance, they note bonds have outperformed stocks since 1981. But 1981 marked the end of a decade of rising inflation and exorbitant interest rates. They imply bonds can repeat this performance, a position not only improbable but irresponsible.
As to their idea of a zero-cost collar, few investors have the time or temperament to employ such a strategy.
The authors reply: We don’t dispute that equities carry a risk premium but simply argue that the trade-off between risk and return must be taken seriously. And we were advocating for real-return TIPS and I-Bonds, not for nominal bonds of any stripe.
We agree that managing a cashless or zero-cost collar takes the kind of diligence that only a few DIY investors have. But it’s an approach that all investors should get acquainted with, because risk-management tools of this type are sure to become a growing part of products on offer.