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Zvi Bodie pushes TIPs again...

Major piece in today's Wall Street Journal, "Why Stocks are Riskier Than You Think" by Zvi Bodie and Rachelle Taqqu
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(Of course, Bodie and Taqqu are also hoping that this article will lead a lof of people to buy their recent book, "Risk Less and Prosper". Bodie and Taqqu's own retirement plan likely hinges on profits from book sales at least as much as from their portfolios?)
Like a broken record, Bodie again says (mostly) to avoid stocks and to buy inflation-protected bonds. I say "mostly" because they do allow for the suggestion that one may fund one's "aspirational goals" with balanced portfolios which may include stocks (and/or options or more complex hedged funds).
What they don't focus on is exactly how much one needs to save if one is putting one's entire essential retirement savings into TIPs. Given that the "real" return on them (ie. the return after inflation) is now zero - you got that - nothing whatsoever - it means that every inflation adjusted dollar you plan on spending in retirement needs to be saved today. There is no allowance for growth. If you've saved 20x your cost of living, then you will have 20 years and then be broke. And given longevities now, we have to allow for the likelihood that retirement, especially for the survivor of a couple, may last well over 30 years.
That all said, Bodie is right in that folks often invest in stocks without fully understanding the risks. But that doesn't mean that folks shouldn't have more in stocks than he's saying, either. He seriously underplays the risks inherent in bonds, especially given today's ultra-low interest rates.
At the end of the article, they describe, effectively, a zero-cost means of hedging exposure through a "zero-cost collar". If you buy SPY at $136 and you buy a put with a strike at $116 (limiting you to a 15% loss) and sell a call with a strike at $143 (which has the same price as the put you've bought, so the prices of the options cancel each other out), you've bought the S&P500 and limited your downside to a maximum 15% loss but you've also limited your upside to a 6% gain over the following four months. This is a pretty good illustration of how expensive that "loss insurance" is - you limit your upside to less than half your downside. You could limit your upside less -- at a cost -- by either not selling the call or selling a call with a higher strike price (and thus getting less cash to offset the cost of your puts). Bodie makes an example of getting a higher upside by also hedging with a worse downside risk. It's a great illustration of some of the mechanics of equity hedging and its costs (though of course, it also ignores taxes and dividends - both of which may have substantial impact on the net result).
Bodie has also, in the past, suggested a portfolio consisting of TIPs plus buying long-dated call options on the equity market. He suggested that, if I recall correctly, at a time when in fact TIPs had a non-zero real return and his explanation was that with the real yield from the TIPs was enough to pay for the options. That way you guaranteed a real return of at least zero (ie. no real loss) but also bought some potential equity market up-side as well in the case that equities performed well. That strategy won't work now, of course, as there's no real yield available from the TIPs to fund the equity part of that strategy.
Anyway, while I don't necessarily agree with the advice he's giving, especially for folks with long time horizons and any appetite for risk, I do think his article is well worth reading and some good food for thought.
And I really liked the collar illustration. It's something worth understanding and may be nice to actually take on its own and illustrate better for people, especially when they ask just how the annuity business can afford to guarantee limited downside -- it shows the *costs* of downside limits pretty nicely (even if that's not exactly how an insurance company actually does it).
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David S. Meyers, CFP®
http://www.MeyersMoney.com
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Reply to
David S Meyers CFP
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Zvi Bodie came to my attention through his book "worry free investing" in which he advocated TIPS. Unfortunately, he wrote it at a time when TIPS were at 3% plus inflation, but by the time it was published it was less than half (the 3%) and close to zero now. At 3% real return, my math showed a 16% savings rate would have worked to achieve his goal. You can pull the calculator from his site
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and find that the savings rate required is absurd.
I mean this in a nice way - his proposal was sound, but didn't take into account the very low real rates TIPS would eventually yield.
Even after the naughty-naughts, I'm not avoiding stocks.
Reply to
JoeTaxpayer
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David, I appreciate your posting this. Bodie has not sold me on his strategy, but what he is trying to sell is interesting and helps me probe at my own strategy (diversify enough that one is betting more-or-less on the entire world economy). Bodie seems to over-emphasize the hypothetical of a person buying only an S&P 500 index fund and only at the S&P's peak in 2007 (or 2000, if one prefers). These assumptions are enormous. Still let's entertain his doomsday analysis. With dividends re-invested and diversified simply into 60/40 stocks/bonds using VBINX,* the historical numbers belie his claims. E.g.
2012 SPY = 138 VBINX = 23
October 2007 SPY = 143 VBINX = 20
March 2000 S&P Peak SPY = 125 VBINX = 15
The strike and call strategy so as to limit losses to say 15% and gains to 6% bothers me because Bodie does not say what the strategy is after one has sold at the 15% loss or the 6% gain. I guess one sits out after these sales until things look "more favorable" (whatever that means in the context of the instant one is looking at stocks)? Sounds like timing and hindsight to me.
*This hearkens back to Tad B's posts on the performance of index funds such as SPY vs. VBINX, a 60/40 stock/bond fund.
Reply to
honda.lioness

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