Zvi Bodie's asset allocation

Everyone has their own personal CPI that might vary from even from week to week. I don't drive much, so gas prices don't bother me much. But I just got back from a long driving trip. All of a sudden my CPI has changed.

A rule of thumb that I find useful is the operating costs of a house (utilities, taxes, maintenance, insurance, etc.) are five to six percent of the current market price of the home. Obviously, when prices are changing quickly, the operating costs are going to lag, but as a rule of thumb, it's not bad.

Just thinking for a second, a person who owns their home free and clear is less protected from housing inflation that one who has a fixed rate mortgage. A large part of the mortgage's housing costs are truly fixed for 30 years, while almost all the housing costs of a full owner are subject to inflation.

Mutter, mutter. No wonder there is so complaining about the CPI. It doesn't reflect anybody's rate, except by coincidence.

-- Doug

That's why I said "nearly" non-existent.

Elizabeth Richardson

Many companies are dropping supplimental medical for retires, including those already retired. You situtation doesnt apply for most new retirees.

Even if you own your home outright, you're still "paying" the owner's equivalent rent. If not out of pocket, in opporunity cost on the capital you've tied up in the house. Out of pocket, it may feel very different, but economically, it's quite similar and certainly sensible in the context of large scale statistical modeling of the economy.

As I said, CPI is a very broad generalization which doesn't reflect any single individual's inflation, and it may seem reasonable to split it into more sensible demographic buckets (certainly more sensible than CPI-U versus CPI-W (which nobody every seems to talk about - the CPI-W is for "urban wage earners and clerical workers").

Anyway, this is all an aside from the point about Zvi Bodie's suggested portfolios. As you and I agree, there are other, very likely better ways of keeping one's purchasing power in closer parity to the real inflation rate out there:

VIG's an interesting fund with a pretty sensible index underlying it, though it's a little spooky having the index be more of a "black box" than more typical broader indices out there. Nevertheless, the rough description of the rules they use sound great and the portfolio itself is a pretty reasonably broad representation of the market, with 10% in energy, 20% in industrial materials, less than 20% in financial services, 10% healthcare and

13% consumer services (and a smattering of other things). Unlike some other dividend heavy indices, they don't have a huge weight in sub-prime-endangered banks, nor in utilities. Most of the companies should be able to increase prices and earnings to at least track inflation and are all nicely profitable. All the companies have to have been paying (and increasing!) dividends for at least 10 years, with some custom screens to weed out dividend-paying stocks whos dividend growth rate is not sustainable. The part that's not clear is how they (quantitatively and mechanically) determine what constitutes a sustainable dividend growth, but whatever it is, it seems to be working, at least so far (noting, as I said, some of the obvious dividend payers which are absent from the portfolio). It's got a very short track record and my big concern about this is that it is an index-based ETF using what I'd really have thought of as something rather difficult to "indexify".

That all said, going back to owners equivalent rent, it's really actually more similar to these dividend paying stocks than you may have considered - a paid-for house pays you an imaginary dividend which is big enough to pay your imaginary rent - and that dividend tends to go up at a very similar rate to that rent (sometimes faster, sometimes slower). It's somewhat like saying "I use $100 worth of Procter and Gamble products each year, so I'll buy enough P&G stock that it throws off a dividend big enough to buy those products - that way, it's very likely that I've provided for the purchase of those products for as long as I'll need them - if soap and such doubles in price, it's very likely that my dividends from the soap company will go up enough to cover it - at the expense of having tied up that capital in P&G stock - capital which could have been used for other things if I weren't using it to provide for my current and future soap-buying".

I looked around for a bit more of what Bodie has to say and in some other interviews only a couple of years old, he actually suggests 85-95% TIPS and the difference in leveraged market exposure (ie. those call options). The 95% in the more recent article apparently is what he personally has done.

He also explains in more details that these highly risk-averse numbers apply not to your entire investment portfolio, but rather only to the part which you can't afford to lose - ie. the part for addressing one's *needs*. Presumably, in his book, he goes into more detail about that, but, having not read it, I'm going to assume that *needs* translates into things like the retirement expenses which are non-negotiable - like how much it costs to maintain your household, not retirement *wants* - like the $10k/yr you'd like to have as a travel and vacation budget.

If one can reasonably segment one's future retirement budget into those categories - needs and wants - of course it's more reasonable to plan on investing for needs a lot more conservatively -- freeing one up to invest more aggressively and taking more risk with the capital devoted to wants.

I've addressed this idea before here - and have talked about things like figuring out a reasonable estimate for needs, subtracting from that reasonably secure income (ie. SS, pension) and buying an immediate annuity adequate to cover the rest of needs - freeing one up to invest more aggresively for the rest.

[re: my numbers on Bodie's suggestion]

It looks like he basically came to the same conclusion as I did when he ran similar quick numbers. Neither of us had access to more specifics of Bodie's (ie. structure of the TIPs portfolio and call-option portfolios and how they are rolled forward) and both of us are, at least for the moment, going to have to assume it's all in an IRA, else taxes make a disaster of it anyway.

I don't know about "big league" but Bodie is certainly somone to take seriously. He's done some important work in pension economics. Shiller's work, especially in home price values (and some of his stuff about the overvaluation of the stock market), is certainly more well known and no less important, and he's certainly written more for the general audience than Bodie, but these guys are both the real deal (unlike certain other more prolific authors/tv personalities) out there. None of which really means that their work is directly applicable to the average wage-earner's personal finances. I think turning some of their insights into a usable personal financial plan is non-trivial and should be done with an eye towards details which are hard to cover in a general-reader's popular book.

[wow - this is a much longer post than I'd thought to write. My apologies to the mods if it's too long and if appropriate, I'll be happy to split it into two or three more focused posts since it seems to cover two or three specific topic areas.]

Do I really have a lost opportunity cost? I have that "rent" money in my pocket every month. I have the opportunity to spend that "rent" money anyway I choose, each and every month. Those of you who rent or have a mortgage don't have that opportunity.

Elizabeth Richardson

Sure. You could have had the income from investing you home equity.

-- Doug

Elle, I couldn't find the article online. I would really like to read it anyone happens to have a link handy.

Not having read the article, it seems that the study neglected one of our largest opportunity costs: time. The time dedicated to doing the repair one's self is time not spent doing something else. Frex, IF I could earn $300 an hour at my usual employ or save $200 by spending that hour doing home repairs, I effectively threw away $100 by NOT hiring the repairman. On the other hand, if my time is only worth $100 /hr I would be better doing the repair myself. I will be very disappointed in WSJ if they did not acknowledge this.

Absolutely, it's an opportunity cost. If you had your house's value in, say, bonds instead of the house, and you used the dividends to pay your rent, you'd be in a similar situation. And if instead of renting the house you're in, you'd rented a place half the size/cost, you'd actually have that cash to spend other ways.

A fully-paid-for house absolutely has a capital opportunity cost. The thing is that you also have to have a place to live - whether you rent or not - and the point is that the cost of your housing is either borne by paying rent out of pocket or by the income you'd otherwise have received from that invested capital which is currently tied up in the homeownership.

A fully-paid-for house does *not* mean your cost of housing is now zero. It's just hidden from your obvious cashflow. OER is a way to make it explicit when they compute the CPI. It's not perfect, but it's vastly better than pretending that your fully-paid-for house is free, since it's not.

"kastnna" wrote Elle wrote

Currently, one can see it at

. I think the themes stay pretty timeless. Someone (maybe it was you?) once again noted here recently that renting can be a superior financial investment to owning. The net has a lot of articles looking at this in the same vein as the WSJ article. I think a lot of folks still buy into the tax tail wagging the dog. Namely, the misapprehension that mortgage interest adds up to a lot of savings in taxes today. Not so. Renting can be a superior choice, strictly financially speaking.

Absolutely. Though I think we could attach other qualifiers like working with one's hands and remodeling are creative and therapeutic outlets for some. Or some of us think we do a better job than the guy to whom we might pay a lot for mediocre work. Or some do not like work guys in their home. Having to be home for the workers is an inconvenience that can cost money, too.

I should clarify that this is not a main theme of the article, so it is not examined in detail (read: dollars for time). The key paragraph may be:

"... [T]he only sure way to slash repair costs is to do the work yourself. Bruce Risser, a retired Navy officer, estimates that he has spent less than half of his $47,500 purchase price to keep his 28-year-old home in Bethesda, Md., shipshape. But he chose modest materials and did almost all the work on his own, including adding a bathroom, refinishing the basement, reroofing and recarpeting. But Mr. Risser says he doesn't recommend such an approach to others 'unless you enjoy soldering and such like I do.' "

I hate to get so far away from the main subject on which Will Trice wanted to gather thoughts. Fact is a lot of smart folks do choose an all bonds (high grade bonds; no junk) portfolio and at pretty young ages. Maybe this tells us it's all about risk tolerance. While we can tell someone that history says they would not do well by switching to all TIPS (or similar) twenty years ago, fact is that person is the one who has to sleep at night.

Historically, stock index options have had a "negative volatility risk premium" -- their returns are below what would be predicted based solely on their "delta" (stock market exposure). This will reduce the returns of the cited strategy. You can Google this newsgroup for "negative volatility risk premium" to find a message I wrote about it. I have worked as a derivatives quant.

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I think the themes stay pretty timeless. Thanks.

It was not me, but all the same, I am not die-hard one or the other. I think whether to rent or buy is situation specific and under the right circumstances either one may prove advantageous. I THINK you are of the same mindset.

Agreed. Being an economics major, I always had a difficult time working around the near impossibility of quantifying certain opportunity costs. Some people (myself included) take great pride in their own handywork and ENJOY doing home repairs. That's surely worth something. If I could include the kids, it would be a double bonus to do the work myself. In Econ, those intangibles are a component of "Utility". Unfortunately, everyone's utility is unique to their values.

That is eyebrow raising especially since only 12 index constituents have had changes out of 214 companies in the index. But perhaps the changes they list don't include removals/additions to the list?

Thanks for posting the relationship between Mergents and VIG. I actually use Mergent's publications to help me pick equities, but now I just might buy my first ETF...

I'll beat dd to it --- Graham considered banks as good as any other company for defensive investors:

"We have no very helpful remarks to offer in this broad area of investment [financial companies, in particular banks and insurance companies] - other than to counsel that the same arithmetical standards for price in relation to earnings and book value be applied to the choice of companies in these groups as we have suggested for industrial and public-utility investments."

Do you know his reasoning behind this advice?

-Will

william dot trice at ngc dot com

Ok, sales of similar housing in my area are $130k, but rents for a similar house are ~1150/mo. My insurance and taxes are less than $200/mo, so my "income" from my $130k is about 8.7%. If you're making that, then, yes, I have lost opportunity cost. But remember, that's an absolutely risk free

8.7%, and I don't know where you can get a risk free 8.7% return, so I'll continue to say a paid for house has no lost opportunity cost.

Elizabeth Richardson

Well, 30 year treasuries are yielding 4.39%, so you have at least that opportunity cost. You didn't mention maintenance, so your "income" is somewhat less than that, especially if you reserve for roofs, appliances, carpets...

I'm not anti-owning, I do. I'm not against owning free and clear, I do. But I don't see how it can be risk free and without opportunity cost. That kind of asset doesn't exist.

-- Doug

No, you still don't see. You have to have shelter, so if you don't own, you have outgo. I have eliminated much of that outgo by owning free and clear. Not having to pay most of my shelter costs puts that money in my pocket, effectively giving me "income" from that capital on which you say I have lost opportunity cost. Above, I say that effective income is at the rate of return of 8.7% - twice the rate of treasuries, not a lost opportunity.

Elizabeth Richardson

I think the expression implies a choice, not a judgment. In your case, you are indeed 'giving up' the 4.39% return Doug cites as opportunity cost, but your math shows it was and is a smart decision. I found this quote, "the opportunity cost of a decision is based on what must be given up (the next best alternative) as a result of the decision. Any decision that involves a choice between two or more options has an opportunity cost."

JOE

Well, I thought opportunity cost more like I choose to buy bonds rather than stocks. When I would have made more money on the stocks than I made on the bonds, the difference is lost opportunity cost. In the situation we have been discussing, there is no such loss, and therefore no cost.

I know you're trying to help me see it differently, but I don't think there is a different way of seeing it. I've never bought into the lost opportunity cost theory of having a mortgage and investing in the stock market. It's almost impossible to pre-pay your retirement shelter without having a mortgage while you're young. But your house is shelter, not primarily an investment. And it seems foolhardy to me to try to save enough when you're young to support, in retirement, both normal living expenses and a mortgage. I guess you're right. My lost opportunity cost by paying my mortgage is not having to pay a mortgage. But that's a circular argument, no?

Elizabeth Richardson

If I am choosing between any two places to put the money there is "opportunity cost". Even when the choice is pretty clear. You've done the math, you've proven by a wide margin that the choice you made was wise and economically well reasoned. From my quote, "the next best alternative" as suggested by Doug was the T-bond which had a much lower return than the rent-return you are achieving. Drop the word 'lost'. It may be what is confusing the issue.

As I have accepted your advice and am paying my mortgage at a rate to coincide with the Mrs and my retirement, my opportunity cost is simply the expected alternate return (had I used the money to invest in whatever that next choice would be for me). JOE

I think this requires further investigation, because now we have the following turnover figures for VIG:

dividendachievers.com fact sheet = 14% for the year ending Dec. 31, 2007 Vanguard VIG "Fund Holdings" site = 12% for year ending in January Yahoo's 42% Your source for roughly 12/214 =~ 6% turnover

I think the point merits attention for those considering VIG and like funds for a source of income that deals with inflation etc. I am too lazy to look into this at the moment. One of the regulars (I forget his name) at MIMF could nail this in minutes, probably.

I should have wrote that VIG duplicates the Mergent Broad Achievers Select index. It's not merely based on it.

The five-year dividend growth rate of 15% given for the index does impress. I go hunting for dividend achieving stocks, examining five and ten year growth rates of dividends. Given what's out there, any stock dividend rowing annually on average at about 10% or more for both five and ten years gets a "pass" from me for dividend growth. Meaning

10% is my crude anecdotal approximation for "above average" dividend growth for large, old companies, based on a lot of reading and quick calculating.

Re Ben Graham on banks, per my query:

Thanks much for the citation. I took some of the phrases above and googled for the source. I see this is from Graham's tome _Intelligent Investor_ (1949). Your paragraph above is also quoted at

Also quoted at this site, from Graham's 1934 _Security Analysis_:

"The securities analyst, in discharging his function of investment counselor, should do his best to discourage the purchase of stocks of banking and insurance institutions by the ordinary small investor."

As the web site proposes, this surely reflects the times. Namely, Graham wrote this in the Great Depression. As you know, banks were not as well regulated and credit was ridiculously rampant. And yet, I see some application today. Perhaps, for the investor interested in dividend achievement, we might argue that one be more conservative in the fraction of one's portfolio allotted to banks. I would want to continue to study the period from about 1990 to 1995 or so, when bank dividends (rationally, IMO) etc. took a hit.

His father :-) and subsequent experience with his own investing. The relative is in his 80s and has been picking stocks for 50+ years. He's a "Millionaire Next Door" type, frugal and hard-working. Specifically, my relative says his dad advised, "put your money as close as possible to the man who is making things." I had written the relative I'd taken a hit on my bank positions, and this was the gist of his response. He added his father had not followed his own advice rigorously. If the relative completely loathed banking, he would have said so.