Zvi Bodie has long been a lone wolf in the financial services industry. The Boston University finance professor and veteran risk avoidance advocate, has himself risked being pelted with eggs, or worse, at industry gatherings more disposed to hearing his Wharton nemesis Jeremy Siegel’s message about stocks for the long run.
Now the author of the classic college text on investments has written a new book, out this week, targeted to the general public, and appropriately titled Risk Less and Prosper. In a year in which the U.S. stock market has trounced its world peers with a nearly 0% return, on top of a dismal decade of stock performance, investors’ heightened sense of risk may make them receptive to a message that was tuned out in previous bull markets. In an interview with AdvisorOne, Bodie discussed some of the ideas in his book, co-written with financial advisor Rachelle Taqqu.
How did U.S. investors come to be so risk-prone?
Because of the positive stock market experience of the ’80s and ’90s. People don’t have memories that go back that far, so they thought you can’t lose if you hold on.
But you shouldn’t think you’re going to earn a potential risk premium without taking risk. It was always a crazy idea to think that you could, but that idea was drilled into people’s heads by a whole industry campaign.
The vast majority of investment advisors are telling people: “History proves that in the long run you’re going to do best by staying in stocks. And the worst thing you can do is lose your nerve when the stock market goes down; on the contrary you should be doubling up.”
That conventional wisdom is very comforting to people who have lost money. But everyone has a finite horizon. You can only postpone using the money so long.
If you don’t need the money, you’re investing for future generations or some charity; those are the people who should be taking risks. Ironically, the people who are high-net-worth they’re the ones who make sure they have ironclad guarantees on their standard of living. [Not because they are smarter but because] people don’t like to see their living standard go down.
What is the message of your new book?
In my previous book, Worry-Free Investing, I started out by talking about inflation-protected bonds. In this book, I want them to understand that investing is all about you and your goal. I think we’re going to see a popularization of GDI investing [goal-driven investing].
LDI [liability-driven investing] is popular among institutional investors. LDI is matching your assets to your liabilities. In the individual investor world, the one advisors are concerned about, you don’t have liabilities, you have goals. Those are going to determine what you consider a risky or non-risky strategy. If you can save enough to cover your basic needs and lock them in, I believe that’s what people really want. And that’s a form of asset-liability matching.
Investment advisors don’t talk about asset-liability matching; they talk about diversification. But diversification comes in second. The first thing you want to do is cover your assets. In the book, we call it matchmaking.
Since investing is all about trading off risks and rewards, the natural starting point –the benchmark–is to say, “What if I want to take as little risk as possible?” That is where you should start the process. “Now that I know what it will take in terms of what I have to save, what’s the earliest date I have to retire?”
That involves matching. You might be 100% TIPS in that situation. “So what if I put 20% of my money into stocks? On the upside, that means I can save less or consume more; or I can retire earlier.”
But the downside is you could do worse than if you hadn’t done that. You have to look at worst-case scenarios. You won’t be able to retire till you’re 80. Or you have to save 30% of your income. [The financial services industry says] you have to take risk, but they don’t say that if you do take risk your outcome could be worse than they describe.
What do you think about financial advisors who recommend annuity products as a means of mitigating risk?
I am very much in favor of insurance products, but hey have a cost. So you have to ask the question: Is it worth it? In my view, [annuity products are] a better framing of the real trade-off than ignoring the risk which is what is being done now.
How can investors manage this trade-off between risks and life goals?
The core asset should be a TIPS ladder that is matched to the person’s spending needs. Young people don’t even know what level of consumption they’re going to have. Most of their assets are in human capital. So it doesn’t matter if they put it all in stocks. I’m talking about people over the age of 50 who have to start thinking what they want to lock in in retirement. They have to think of it like insurance, and if they’re putting it in all in TIPS, they’re not paying big fees.
What can financial advisors do to help ordinary investors?
The challenge that advisors face is to turn themselves into life coaches.
The way advisors are currently compensated is through assets under management. Even those who don’t take commissions, the so-called good guys, the fee-only advisors, are basically pretending to manage people’s assets. But most of these people are getting people to take more risks. It certainly is not the case that they’re doing more for the client than if the client would hold 80% of their portfolio in TIPS and 20% in a stock index fund.
If I convince [investors] at an intellectual level [to avoid risk], that’s only half the battle. The issue is how to you get it from the frontal cortex to the brain stem–the autonomic system where your feelings reside. Advisors could help these people.
How should people managing for risk as you advise invest in tax-deferred accounts?
With respect to a tax-deferred account, if you have a person who is investing both in stocks and in bonds, the taxable bonds should be held in a tax-deferred account and the stocks in a taxable account. With stocks, most of the gain is going to come in the form of capital appreciation. First, you can defer gain; the other reason is that inevitably you’re going to have losses in some years and in those you can realize the gain and get the tax-loss benefit.
Why are you often a lone voice calling for this risk-off approach?
If you were to talk to any other finance professor, you would hear the same thing. It’s just that there is this huge gap between the academic world and the advisory world today.