The recently-published book by Zvi Bodie and Rachelle Taqqu, Risk Less and Prosper: Your Guide to Safer Investing, provides a unique perspective on how to meet the challenge of long-term financial planning. The book is well-organized into a number of steps required for identifying and organizing long-term goals and thinking through how to meet these goals. The presentation is built around a narrative in which a group of people meet to try to figure out how to meet their long-term goals and how to deal with the uncertainty associated with both their lives and their investments.
For those who are not familiar with Zvi Bodie, a professor at Boston University, some history is in order. Dr. Bodie has a long history of challenging the conventional wisdom that individuals saving for their future needs (most notably retirement) need to maintain a substantial allocation to risky asset classes such as stocks. His research, buttressed by that of others, suggests that investors tend to take on far too much risk in their investing and do not really understand the nature or magnitude of the risk that they bear.
The standard view of investing for retirement is that investors need to own stocks and other risky asset classes in order to accumulate sufficient wealth to someday be able to retire. A corollary to this notion is that while stocks are risky in the short term, they become less risky the longer you hold them so long-term investors can handle the short-term volatility because it will pay off in the long-term. Another key assumption that is often part of the standard thinking is that we can have confidence that stocks will soundly out-perform other possible investments in the long-term. Jeremy Siegel, a professor at Wharton who has often debated with Bodie, is the author of a book, Stocks for the Long Run, which champions this standard view.
Bodie argues from a very different perspective. He agrees with the idea that, on average, an equity-heavy portfolio can expect to out-perform less risky investments over an extended holding period and that the degree of this expected out-performance increases with the holding period. The problem that Bodie has noted for years is that while the probability of a bad outcome diminishes the longer you hold a portfolio of stocks, the potential severity of the worst outcomes increases with holding period. I did my own analysis of Bodie’s argument a couple of years ago, using a Monte Carlo simulation, and I concluded that he was correct that the severity of potential downside events increases with the holding period, even as the probability of these events decreases.
The answer, Bodie concludes, is that investors should focus on saving and investing to provide for their basic future needs with as little investment risk as possible. If there is investable capital beyond what an investor needs to be on track to meet her basic future needs, this money can be invested in risky asset classes. The core of the portfolio needs to be as low risk as possible. There is one asset class that is the best match to investors’ future needs, and that is inflation-protected bonds (TIPS). These are government-issued bonds that will maintain their purchasing power to keep up with inflation, as measured by the Consumer Price Index (CPI). Bodie believes that TIPS should make up the vast majority of most individual investors’ portfolios. Bodie has presented this part of his thesis in an earlier book for individual investors, Worry Free Investing.
While much of Risk Less and Prosper focuses on making the case for taking little investment risk, the book is broader than this one topic. There is an exploration of how to make a long-term plan with specific goals and how to think through dealing with the contingencies that may arise. In my extended analysis of Bodie’s argument that investors should put most or all of their portfolios into TIPS, I concluded the following:
The best solution, given all of the uncertainties, is for investors to build portfolios that provide the maximum sustainable income streams, but also to ensure that worst-case outcomes are tolerable. This notion is receiving more attention, but is still not widely understood. An important part of a balanced investment process is to be aware of all of the risks, and the potential for severe under-performance of equities over extended periods of time is a risk that often gets overlooked. A person near retirement who has little or no flexibility in when they retire and how much income they need in retirement must have less exposure to risky asset classes.
Nothing that I have examined since I wrote my piece in 2009 has changed my perspectives on this. Bodie’s position is that individual investors do not have an understanding of the potential worst-case outcomes for their portfolios and thus should lock in a basic standard of living using TIPS. I wholeheartedly agree that people do not have a solid understanding of risk and, particularly, that a portfolio of risky assets does not become essentially riskless if you hold it long enough. This does not, however, mean that I agree with Bodie that a 100% TIPS portfolio should be the baseline portfolio. That said, Bodie and Taqqu have staked out important ground in terms of reconsidering the basic paradigm for long-term saving and investing and presenting a new approach in an engaging and thoughtful manner. I would encourage individual investors to challenge their own assumptions and beliefs by reading this book.
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