Tuesday, July 5, 2011

Quote of the day

Zvi Bodie:
The length of your time horizon has nothing to do with your willingness to take risk. Stock are just as risky in the long run as they are in the short run.

This quotation reminded FLG of a comment Andrew Stevens made on this blog a while back arguing that making risk decisions based on age was questionable. Risk decisions should be made on a person's risk tolerance.

Anyway, FLG just read Bodie's book. In it he argues that the best way to save for retirement, at least to save the minimum necessary funds, is to use TIPS and I bonds. Basically, Bodie says, don't leave anything to chance, instead of assuming average rates of return for a diversified portfolio, just figure out how much you need for retirement and then back into a savings plan in inflation protected treasury bonds. It's one that almost certainly requires more than what a equity-based plan would, but with the added benefit of zero risk. (Assuming Uncle Sam doesn't default, obviously.) Makes sense and all.

Previously, FLG had always figured he'd use TIPS as a way to hedge against inflation while in retirement, not for retirement, but he may need to reconsider that. Then again, FLG is pretty accepting of risk. Maybe too accepting.

UPDATE: One product that FLG did learn about from the book was a CD that returns the rate of private college tuition inflation. Sounds great, until you realize they take a 1.5% margin on the return. Nevertheless, FLG think about this.

3 comments:

Andrew Stevens said...

If somebody dumped money into my lap sufficient that I believed I could fund my retirement entirely using TIPS or other government bonds, that is precisely how I would invest it. My age wouldn't have anything to do with it. If, for example, you told me that I would be given a bunch of money, but I had to preprogram my investment right now and never change it again until I received it all at age 65, would I program it to start out risky and get less risky as I aged? Of course not. So age doesn't have anything to do with it.

The reason why you might use a riskier investment is because you might need higher returns to fund your retirement than Treasuries will give you or because you're willing to take on risk in the hope that you will achieve a greater level of wealth (to retire earlier or live more extravagantly or whatever). Your risk tolerance, however, may very well change as you age. The closer you get to having as much money as you calculate you need, the less risk you should be willing to take on. (When you have enough, you should be taking on as little risk as possible.)

Personally, I believe that just about everyone, regardless of risk tolerance, should have at least 20% of their portfolio in some sort of bonds. (I'm sure it's possible to come up with people in unusual circumstances who are exceptions.) The lion's share of your bonds should be Treasuries. I am less convinced that all of your bonds, or even all of your Treasuries, should be in TIPS. Keep in mind that inflation expectations are built into Treasuries or any other kind of bond. If inflation outpaces expectations, then TIPS will do great. But if inflation is lower than expected, then you'd have been better off in conventional bonds.

The most important criticism of Bodie's argument is that, with yields on TIPS as low as they currently are, 100% TIPS is just not a viable investment plan for most people. The amount of money you'd have to invest in TIPS today in order to fund your retirement is prohibitively large.

FLG said...

Andrew:

"The amount of money you'd have to invest in TIPS today in order to fund your retirement is prohibitively large."

Yeah, there's a chart in the book that assumes a 3% real rate of return, which looks ambitious, but not unreasonable. But an updated chart at current rates would be downright impossible.

Andrew Stevens said...

3% real? Man, he doesn't have any standing to criticize equity boosters for their excessive optimism if he's using projections like that to bolster his case. (I have no doubt that TIPS probably was paying 3% real when he wrote the book, but that's not much of an excuse.)

I do think that Bodie's general logic is sound, even if I find his conclusions ridiculously conservative.

 
Creative Commons License
This work is licensed under a Creative Commons Attribution-No Derivative Works 3.0 United States License.