Think of Boston University management professor Zvi Bodie as the cautious dad of the investing world. For years he’s warned investors: Stocks are risky, period. Use the lowest-risk government bonds (TIPS and Series I saving bonds) to cover your basic needs and invest in stocks only with additional money that you can afford to lose. He’s back with a new book, Risk Less and Prosper, co-written with financial consultant, Rachelle Taqqu.
Like any parental advice, Bodie’s sounds overprotective, until suddenly you’re trying to retire in 2008 and you realize your “safe in the long run” stocks are the equivalent of playing in the street. When you’re talking about getting run over or having your retirement ruined by a market crash, “it probably won’t happen” isn’t good enough.
MintLife’s Matthew Amster-Burton talked with Bodie about the new book, how to build a safety net to support your trapeze act and why diversification is overrated.
Is diversification overrated?
MintLife: You can go to pretty much any website or financial advisor and hear that you should own a diversified portfolio, heavy on equities for growth—especially if you’re young—and in the long run, you’ll probably come out just fine. What’s wrong with that?
Bodie: What’s wrong is that, for many people, the purpose of investing is really to have a safe nest egg. That is to say, you want to lay down what we call in the book a “Safety Zone,” or a low-risk zone, where you pretty much are trying to ensure that you’ve achieved some bare minimum essential standard of living. That’s going to be very different for different people, so it’s very much about figuring out who you are and what you need.
The way I often talk about this is: When you think about your retirement nest egg, do you think of it as insurance or do you think of it as some sort of a speculative venture?
MintLife: Probably the young guy with the 90/10 portfolio is going to say, “I don’t think of it as a speculative venture but I’ve got 40 years to invest. Of course stocks are going to outperform over 40 years, right?”
Bodie: That’s what I call false confidence. We all know that over 40 years, so many things can change, that the risk is greater in the long run than it is in the short run. But it doesn’t matter so much for someone who’s young—let’s say, less than 40 years of age—essentially because their investment portfolio is typically very small relative to their human wealth or human capital. So, as long as their human capital is flexible enough—by which we mean, they can postpone retirement, or they can work a double job, or they’re a two-earner family, things like that—they have the capacity to bear more risk in their investment portfolio. And typically for a young person, they don’t even know yet what standard of living they want to maintain in retirement.
Retirement planning during a financial crisis.
MintLife: You wrote an earlier book in 2003 and a few things have happened in the world of money and finance between 2003 and 2012. How has the financial crisis informed the new book?
Bodie: In nine years—and these have not been good years for the stock market—two major things have happened. First, the stock market has not performed well. Second, a lot of people who were approaching retirement, or who were way before retirement, are now much closer to retirement. In many ways, they’re different people today. Not to mention the fact that the financial crisis of 2008 has really done damage to their sense of confidence and their ability to continue earning a decent salary.
I’d say the risk tolerance and the risk capacity of the vast majority of Americans have gone down considerably and, at the same time—and it’s probably somewhat related to that—the yield on TIPS and I-bonds has gone down quite a bit. So, whereas I could confidently say, even as recently as a couple of years ago, the rate of TIPS is going to be roughly 2% more than inflation, now in the shorter maturities it’s negative, which means you’ve got to basically pay an insurance premium for that inflation protection. I’ve been busy telling everybody to make sure you buy all of the Series I savings bonds that you’re entitled to, because they’re the best bet out there.
Changing the message about stocks.
MintLife: Why do you think so much of the investment coverage out there is blind to the fact that these inflation-protected investments exist, or is hostile to them? Motley Fool, for example, recently wrote, “This inflation fighter is too expensive … There’s nothing that sounds more ludicrous than accepting a negative interest rate on your money.”
Bodie: First of all, I think people are reluctant to change what they’ve been saying for decades. If you’ve been an investment advisor or you’ve been the Gardner brothers at Motley Fool, and you’ve been saying you can’t beat stocks in the long run, how are you going to start telling people, gee, stocks are damn risky, even in the long run? So there’s that, the reluctance to change the message.
I don’t like to ascribe negative motives to people, but let’s face it: If everybody starts investing in I-bonds and TIPS, both of them are buy-and-hold investments. How is the investment professional community going to make money? Now, I have an answer to that, but from their point of view, it’s really been easy money up until now. All they’ve had to do is say, 60% in stocks and 40% in bonds, and collect, let’s say, 1% of assets under management. The whole asset management industry has really had an easy life for the past 20 or 30 years.
Safety over diversification.
MintLife: You said you have an idea for how advisors can make money even if they’re putting people into TIPS and I-bonds. What’s your idea?
Bodie: It’s a different paradigm. The different paradigm is basically laid out in our book. And that is: stop talking about diversify and diversify and diversify. Yes, diversification is important as an investment principle. But the first principle of investing should be: lay down your safety net. Just like a trapeze artist, if you’ve got a very strong safety net, you can actually do some more adventurous, risky things up on the high wire or on the trapeze.
So it’s really a very different paradigm that says, get away from this notion of “60/40 and diversify across all asset classes.” And start thinking of: how high and how strong do you want your safety net to be? Get that in place, and then there are lots of ways that you can go for the high wire, and maybe get rich, or at least achieve a higher standard of living. But without that safety, I for one would not be willing to do it.
MintLife: That’s a tough conversation, especially now, because for a lot of middle-class people, that safety net is going to be a substantial percentage of their savings. At current yields, you’ve got this conversation where people are saying, on the one hand, okay, I can insure my basic needs in retirement by earning 0% real, or over here, I’ve got these seductive risky assets that historically have earned 6 or 7% real. That’s a huge gap. It puts me in a tough place mentally and behaviorally. Is there anything you or I can tell people to make them feel better about this situation?
Bodie: Well, first of all, what I typically say to people is: are you healthy? Do you like your current job? Because you ought to be thinking of continuing at least part time. The benefits people are talking a lot these days about phased retirement, which I think actually is probably a healthier approach to old age than just going from full-time to zero participation in the labor force.
Secondly, there’s the question of reexamining what you really need in your safety net. Maybe you don’t need as much, so you can narrow the safety zone a bit.
I also predict that a lot more people are going to start opting for annuities as a payout option, as a withdrawal option. I’m talking here about insurance company-guaranteed life annuities, simply because what you’re doing is drawing down your principal gradually over time and the insurance company is pooling the longevity risk. The last time I checked, even though I’m not earning any real interest on my TIPS portfolio for retirement right now, if I buy a life annuity with inflation protection, I can still get 4%. But that’s not an interest return, that’s simply spreading out my principal over my expected lifetime with an insurance company guarantee that it will last as long as I live.
The matching principle.
MintLife: What do you say to people who are concerned about treasury bonds as an investment, in terms of solvency risk, or just that it feels undiversified to have so much of their overall asset allocation in a single type of investment?
Bodie: My answer to that is: They’re absolutely right that nothing is perfectly safe. There’s no such thing as a pure vacuum. You can’t reach absolute zero. But in concept, we know what it is and I think that the risk of a US treasury bond defaulting for an American citizen is tiny when compared to the risk of many of the alternatives. This is certainly true when compared to the stock market, compared to gold, you name it. And so, in that situation, what are you gaining by diversification?
We can talk about diversification, but really, the right way to think about lifetime investing is really matching the safety of your assets to the urgency of the need in the future.
MintLife: Can you expand on that?
Bodie: It’s called the matching principle, and we’ve referred to it as “matchmaking,” as opposed to diversifying. The clearest example of that is buying insurance. What you’re doing there is, if you have something you really are afraid of and you want to be sure you’re covered for it, you match that with an insurance policy. In a way, that’s a kind of investment. You pay a premium and you get the protection.
MintLife: That’s either an unfamiliar concept for people, with regard to their investment portfolio, or it seems familiar because it sounds like we’re talking about insurance company investments.
Bodie: When you think about your lifecycle needs and how to deal with them through a strategy of saving and investing, it’s really combining traditional forms of insurance with traditional forms of investing. It’s lifetime risk management, is really what it is.
MintLife: So what you’re saying is, instead of having a pool of bonds in your asset allocation as sort of a buffer for your stocks, that those bonds actually represent dedicated amounts of future spending at a known future date?
Bodie: Right. That’s the way to think about it. Unless you’re a high-net-worth individual and you’re really investing for future generations. That’s a different story.
MintLife: Thank you so much for your time. It’s always fun speaking with you.
Bodie: Same here, Matthew.
This interview has been condensed and edited for clarity.
Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.