Stock market volatility and lingering fallout from the 2008 market collapse have many investors thinking "safety first" when it comes to deciding where to put their money. Boston University professor Zvi Bodie and financial consultant Rachelle Taqqu say that's just what they should be doing. In their new book Risk Less and Prosper, Bodie and Taqqu argue that many investors continue to take on too much risk when investing for important life goals such as retirement and saving for college. They spoke to Morningstar.com about their approach.
1. In the book, you distinguish between risk capacity and risk tolerance. What's the difference, and which should take precedence when creating an investment plan?
You are putting your finger on a common source of confusion in the popular understanding of personal finance. Personal investing is very personal. It's all about you. It's much more effective to figure out who you are and where you are going before you plunge into the market. If you don't know where you are going (and why), chances are you aren't going to get there anytime soon.
So, before you start to consider investment opportunities, you're well-advised to understand your goals, wants, and needs, along with your lifetime resources, values, and preferences. As you reflect, you don't expect to capture your essential self with any single adjective. Yet industry advisors often do just that when they overuse an investor's so-called risk tolerance almost as a proxy for the full range of the investor's individuality.
To make matters worse, there are many problems with the whole notion of risk tolerance as it is currently used. Assessment tests are often laughably short and shallow. Their conclusions allow for little nuance; you are usually judged to have low, moderate, or high risk tolerance. Period. Also, there are serious questions about whether we are confounding a trait with what might really be just a passing state. (Investors who thought they had a high tolerance for risk changed their minds in 2008, for example.)
And to complicate matters further, even psychologists who think risk tolerance is a personality trait have argued that attitudes to physical risk differ from their appetite for financial risk and that both are distinct from a person's willingness to take social and ethical risks.
These reservations all suggest that personal risk tolerance is an unreliable driver of a personal investment plan. It can play a role, but it is not a key driver.
Risk capacity, on the other hand, is very important to understand. A good measure of your risk capacity is the relative strength of your safety net. Do you have enough safe investments--and a secure prospect of future earnings--to provide you with your goals at their bare-minimum levels? To the extent that you have your basics covered, you are in a good position to take some financial risk. Risk capacity is more objective than risk tolerance.
In Risk Less and Prosper, you can find out how high (or low) to dial your own risk set point. The book goes into a lot more detail about how to assess your risk capacity in light of your personal goals and resources.
2. Your book is critical of the stock market, or more accurately, investors and advisors who place too much faith in its ability to produce consistent long-term gains. What role, if any, do you think stocks should play in investors' portfolios?
Stocks are risky, no matter how long the investor's horizon. But if you have a strong safety net in place, you can buy stocks or other risky assets. How much (and how adventurously) you participate depends on how strong your safety net is.
4. You say that, in the long run, dedication to stocks actually increases risk, which seems to run counter to the conventional thinking that over time stocks outperform other investment types. Although it's true that during the course of decades, the risk of a major calamity--something like we saw in 2008--increases, can't this danger be muted by reducing one's allocation in stocks the closer one gets to when the money is needed, the way target-date funds do, for example?
Let's take this in two parts. First: Over time stocks do outperform. We don't dispute that. But stock prices also fluctuate. These two statements are not at odds.
The flaw in the conventional wisdom is to assert that the inherent riskiness of stocks diminishes (dramatically, some say) if you hold them for a very long time. That is simply not true. Think of the weather report. Uncertainty grows over time. It does not diminish. Most of us know that in our bones.
What is true is that the longer you hold stocks, the greater your odds of earning the average (superior) return, but also the greater your exposure to severe loss. There's the rub.
This brings us to the second part of your question: Can't you pull a rabbit out of the hat simply by waving your magic wand at the end date? Stay in stocks. Move the goal post to a little before the money is needed and sit out the end time in relative safety.
But if you reflect just a little on this strategy, its flaws become evident. What if calamity strikes not at the time you need the money, but a couple of years before, just as you are shifting your allocations? The problem with the target-date strategy is that you have no guaranty you'll be even close to your goal when you reach the reset date. Too many people have found this out the hard way. It's like taking a plane with an arrival time but no known destination.
5. In the book, you suggest Treasury Inflation-Protected Securities and I-bonds as key portfolio building blocks. What do you say to investors who might be concerned that the long-term returns on these investment vehicles just aren't enough to fund major life goals such as college or retirement, particularly given the very low yields available on Treasuries of all types right now?
Real returns on I-bonds are currently zero. On all but the longest-term TIPS they are negative. And the Federal Reserve's recent announcement that short-term interest rates will remain close to zero through 2014 suggests that real rates are going to remain low for a while. As we argue in Risk Less and Prosper, TIPS and I-bonds are the best building blocks for an investor's safety zone. But if rates are to remain at today's low level for a while, the math has obviously changed. At today’s low real rates, investors might no longer be on track to reaching their goals with relatively low risk.
What's a prudent person to do? The most obvious solutions are perhaps the least palatable: spend less, save more; plan on retiring later; work a second job. But they are worth considering. Still, in today's high-unemployment economy, these steps might not be feasible for everyone. You could also opt for more risk, but that would expose you to an even worse outcome than you could withstand.
There is another alternative, and that is to carefully rethink your basic needs. This requires careful and honest introspection, as well as a lot of consulting with the key partners in your life. Ask yourself whether a community college is a viable alternative for your child's first two years out of high school, or whether your child might participate more in paying for college than you'd once expected. Other things to consider are whether you'll be able to lower your expenses in retirement by cutting your standard of living a little, moving to a less expensive location, downsizing your residence, traveling less or not at all, and so on. Essentially, you are confirming that your safe investment zone can still work for you in today's low-yield environment.
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