Zvi Bodie's asset allocation

I read his book "Worry Free Investing" and wrote a page on my site some months back,

His book revolves around the assumption that the real TIPS rate is 3%. i.e. 3% + CPI. When I wrote my article it was down to 1.6% and is now 1.2%. I wrote "Had I read the book in 2003 and been sold on this plan, from a savings rate of 16% (which I wouldn't worry about), I'd find, that as the real rates dropped, the new bonds I purchased would require a saving rate over 27%. This is worry-free?"

The 25X (4%) rule based on historical data for stock/bond returns, needs to be adjusted up if one expects those returns to be lower. On a real rate of 1.2% how much would one need to save? My link above provides a further link to both a spreadsheet (provided by Prof. Bodie) as well as the link to the Treasury direct site, where the 1.2% is quoted. JOE

I tend to agree with Zvi Bodie's philosophy.

If one can't save 27% and one is investing in the stock market _hoping_ the lower savings rate will generate the returns needed, then that is indeed a very risky option. There's a reason why every bank & investment house has the fine print that "past performance is no guarantee of future returns". Basically, if one has trouble putting away 27% or whatever other number comes up based on the returns of risk-free investments, then one is most likely going to be in trouble.

Living well within one's means is the first step to financial freedom.

Anoop

"Will Trice" wrote snip for brevity

I want to read more about those call options, for one, if only to contemplate the probabilities to which Bodie alludes in your article.

Bodie is compared to Paul Samuelson in

. Which to me means he deserves some consideration. OTOH, for all the criticism he seems to ladle out, it seems to me the sound bite "real world example" (based on stock market movements c. 1970s) of his in the econprinciples article could stand some qualification.

As has been raised here before (by me, if no one else), Robert Shiller seems to think a lot like Bodie. From Shiller in 2002:

"If someone had to pick -- all my money in the stock market or all my money in index bonds," Shiller says, "TIPS would win hands down. But very few people are able to keep that perspective right now. There's just so much excitement around the stock market and so many varied games to play, and for many people it's a part of their lives -- you know, it's just fun to watch, and index bonds can't compete with that."

That portfolio generates some interesting numbers. Some quick back-of-the-envelope (ok, spreadsheet) calculations based on SPY at 135, and Dec2010 calls at $22/ea and assuming TIPS net a nominal 4.5%:

that portfolio beats a 100% tips portfolio when SPY goes up anything better than about 5.7%/yr. When the SPY goes up at 10%/yr, the 95+5 portfolio averages about 5.8%/yr and when the SPY goes up at

20%/yr, that portfolio goes up at a touch over 9%/yr. And in the worst (equity) case, when the SPY does not go up at all over the three years, that portfolio ends up a touch over +2.7%/yr. There's basically no downside, but you are trading a little teeny risk for a slice of the upside of the market.

Tax consequences are messy, as is managing this thing (do you split the options portion into thirds and roll them like a bond ladder?). But it's an interesting, though very very conservative, portfolio.

The tradeoff is minimal 3-yr downside risk for severely curtailed upside potential. If you have a longer time horizon, while you cannot guarantee much better than that, you can get yourself some pretty decent odds on it.

Something interesting to think about. I don't know that many folks could really plan a retirement on the basis of such low long-term returns, not, at least, without saving a huge proportion of one's income along the way. But it's certainly interesting to think about.

(options price grabbed from today's yahoo quotes and calculations are very quick and dirty)

I sense this thread going on a bit in a few different directions. I'll stick with the focus on the options. If the S&P is somewhat flat (less than 5.4%/yr over a 3 year period), Bodie loses the 5% option each year. If TIPS are 4.5%, he just negated their entire purpose, to provide a safe worry free return. And when that market is on a tear, as the it was in the 90's, he'd miss out on much of the market return. As you went on to post, I'd need to understand his exact strategy with the options. Their use seems counter to what his original premise is.

JOE

Out of curiosity, are you 100% invested in TIPS/I-Bonds (or were you until you hit your minimum required for retirement)?

-Will

william dot trice at ngc dot com

I've read this before, but I took it as Shiller expressing his concerns over current (as of this quote) market conditions, not as a general investing philosophy. Do you think he meant it generally?

-Will

william dot trice at ngc dot com

Thanks for putting some numbers to this!

It seems like taxes may partially defeat the intentions of the inflation adjustment on these securities, since the variable interest earned on the inflation component is taxed just like the fixed portion. I have to think about this some more...

-Will

william dot trice at ngc dot com

Given the current 3% (?) Inflation rate, at 25% marginal bracket, .75% is lost to taxes. With a 1.2% 'real return', 4.2% * .75 = 3.15% or a ..15% return. And the tax is due on the inflation factor (if held in a post tax account) each year, the actual net is that .15%. i.e. you'd need to sell off some principal each year to spend. A bit higher inflation, it's 0%.

Compare this today to DVY, yielding 3.66% with favored dividend rates. And while not guaranteed, one can imagine that in the long term the prices of the DVY stocks should at least keep up with inflation.

Back to Bodie - the spreadsheet on his book's site offers the need to save 31% of one's gross from 21 to 62, to get a 70% replacement rate. Tell me that for most people a 50% rate is fine with SS picking up the difference. Ok, you only need to save 22%. That sheet also fails to make the adjustment you observed above. Expected inflation, the tax on which can wipe out the real return, is ignored almost completely. His calculator is at

JOE

They were very rough, but interesting.

As Zvi pointed out (and I'd have complained about it had he not), the TIPs should only be held in an IRA (or equiv). Outside of an IRA, one can use Series I savings bonds (though subject to the strict purchase limit).

In a high-inflation environment, TIPs outside of an IRA stink. The inflation adjustment gets taxed every year along the way, (as well as the interest). Taxing the inflation adjustment partially defeats the purpose of it.

Series I savings bonds, however, have the same (similar) inflation adjustment, but they all the interest *and* inflation adjustments are tax-deferred until such a time as one cashes them in - up to 30 years. They were a pretty sweet deal about 7 or 8 years ago with "real" rates (before inflation adjustment) of over 3% (but nobody wanted them at that time since everyone thought folks make 30%/yr in stocks). Nowadays, at about 1% "real" rate, they're a bit harder to digest, though, again, outside of an IRA, the free tax-deferral (and being exempt from State income taxes) still makes them somewhat attractive compared to some other options.

I'm not exactly sure what the tax treatment of the SPY options would be - I'll have to look it up. In an IRA, of course, it's not an issue. But in a taxable account, I just don't know off the top of my head.

"Will Trice" wrote snip for brevity

paragraph from the economicprinciples.com site seems to imply he means generally:

I agree that's how I read his quote, but the article cited was dated May

2002. At that time the TIPS were prices at a real rate of 3.5%, much closer to the 4% withdrawal rate we count on from stock/bond mix. (To be sure, a chunk is still lost to taxes, but 3.5% is much better than 1.2%.) JOE

My 401(k) doesn't offer TIPS as an option so for now I'm largely in a stable value fund. I had a large portion in S&P 500, but have been gradually moving more and more to stable value. Outside of retirement I have little in stocks -- most stuff left over from the

2000 stock bubble. :-)

Outside of retirement, I was primarily buying I-bonds, until the rates became so dismal that I could do better with an online savings account.

When I see the kind of volatility we're seeing these days, I know I'm not a stock investor. With all the corporate scandals how can one even start to evaluate companies? The balance sheets are all cooked with companies restating earnings. I expect that to only get worse with time.

Anoop

The $30K annual purchase limit makes it hard to change large portfolios to and from iBonds. You could gradually accumulate a large amount.

"joetaxpayer" wrote

snip per newsgroup guidelines

I hear both Will and you. From my reading, I do not think Bodie and Shiller think exactly alike. What I glean is that Shiller has long felt (for maybe ten years or so) stocks have been overvalued. He bases this on in-depth study of historical company fundamentals, if memory serves something like ten-year earnings etc. averages. OTOH, the mere fact that he looks at valuation indicates to me that he must think there are times to buy stocks. A Sep. 2, 2001 NY Times article quotes Shiller:

If you thought it was harder with 30K, it even harder now since the limit for I-bonds has been been reduced to

5K. If you're willing to do acrobatics like buy online and paper bonds, then you can get 10K.

Anoop

Not really. It uses a combination of rent and "owners equivalent rent of primary residence" which values the shelter services provided by an owner-occupied home.

There are plenty of things to complain about the CPI - things like the fact that each individual consumer has his own effective CPI because he buys a different basket of goods than every other one - but as a broad measure, the OER is a reasonable estimate for what it's purpose is.

Now, if you want to propose, say, a different CPI for young folks versus older folks - which might have a much bigger impact on financial planning - that might make sense (especially since older folks are hit with much higher impact from increasing healthcare costs, for example). But the rent thing isn't really a problem, I don't think.

That much I agree with, and pretty strongly. To the point where I actually own some of Vanguard's Dividend Appreciation ETF (VIG).

I'm still digesting the notion of increasing the cash/TIPS portion of a portfolio and supplementing with calls. I'm still skeptical, but the quick and dirty numbers I got yesterday were certainly interesting. If I had a lot more time, I'd have liked to dig up annual returns of various strategies - including, say, short term investment grade corporates - and compare over time.

Thanks. I think the notion of adding a little upside exposure by calls might have a place in all this, but I'm just not sure what that place is yet, nor if those strategies can be implemented cheaply enough (ie. without paying professional managers 200bp/yr to do it!) for Joe Average Investor to make use of.

Yes, I know this. I do not see that the "owners equivalent rent" makes a difference. I own my home outright. The market for tenants seems to me to vary quite a bit more, and hence so do rental rates.

But it's not just rent. I think I live differently than the typical American. Like my guzillion year old car which I maintain myself and that runs perfectly. I ski only half-days and also bring my own food. This sort of thing.

[on stocks with healthy and increasing dividends)

Good to hear. I continue to scour ETF offerings for promising dividend funds. Vanguard is a big draw, for its reputation. I own two Vanguard ETFs and no others at present.

I looked at your comments more closely. They seem to jive with Bodie's claim about how this is low risk for high reward.

As your time allows, I'd be interested in your response to Joetaxpayers' post on this in particular.

General aside for the thread: I should clarify that Robert Shiller makes more sense to me than Bodie. Bodie is not in the big leagues of financial sages the way I feel Shiller is. This is probably because I am a Ben Graham disciple, and Shiller is too, IIRC.

On every issue, individual situations vary. As an "older person", I don't see myself getting any higher impact from increasing healthcare costs. We have excellent insurance for which we pay no premium, and which includes very low (or zero) cost prescription drugs, for instance. And, as Elle points out, when you own your home free and clear, housing inflation is nearly non-existent.

Elizabeth Richardson