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| The Basics | Should you give up on stocks?
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Most retirement planners preach that you can't afford to miss the growth potential of stocks. Then there's Zvi Bodie, who argues that investors can't afford the risk of losing everything.
By Liz Pulliam Weston
What if stocks arent the best way to save for retirement?
There have always been contrarians who argued against the conventional wisdom that stocks are the best choice for long-term investors. With the market still behind where it stood in 2000, some of these contrarians are getting a lot of notice.
Boston University finance professor Zvi Bodie is one of them. A book he co-wrote, Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals, was published in 2003 by Financial Times Prentice Hall. Pension fund managers are still debating his ideas, which would radically alter the way corporations as well as individuals save for retirement.
Specifically, he takes issue with the oft-repeated idea that the risk of stocks declines over time. Not so, he says -- the risk of stocks actually increases over time. He takes particular issue with the idea that young people can afford to take on more risk in their portfolio than older people.
A flawed belief exposed
The idea that the optimal allocation of stocks in a portfolio is the same (based on age), no matter who you are and no matter what your tolerance for risk, is fallacious, he said. Its fundamentally flawed.
Bodie has plenty of theoretical underpinnings for his point of view, backed up by such economic heavyweights as Paul Samuelson and Robert Merton.
For our purposes, though, his ideas can be summed up as follows:
Its true that the probability youll fall short of your investment goals when you invest in stocks lessens over time. But the severity of the potential loss actually increases. A string of back-to-back annual losses could all but wipe out your portfolio. Looking only at the probability of loss and not the severity gives investors an overly rosy view of the markets, Bodie says.
Investors tend to view the past as a guide to assessing future risk. But with only 120 years or so of modern stock market history to go by, it's nave to say that the Depression years represent the market's worst possible returns. The truth is that there's no way to know just how bad a bear market can get or how long it could last.
Would you bet your retirement?
To put it another way: the probability a tossed coin will land heads-up 20 times in a row is less than one in a million, but would you bet your retirement on it not happening? If not, then youre ripe for Bodies advice.
Obviously, theres a big gap between what the theoreticians say and what practitioners are telling people, Bodie says. But the market is what it is. (You can deal with it or) you can say, Im going to take my chances in the long run and pretend that the risk of stocks goes away.
Bodie contends that money you really need for retirement shouldnt be placed at risk at all. Instead of investing heavily in the stock market, you should figure out the minimum income you need to retire and guarantee youll have that money by investing in super-safe, inflation-proofed Treasury securities.
These securities, known as I-bonds and Treasury Inflation Protected Securities, or TIPS, were introduced by the U.S. government in 1997. I-bonds and TIPS have two rates of return: a fixed rate thats set at the time you purchase them and a variable rate thats adjusted for inflation. In other words, your principal is bumped up at the inflation rate, and you receive an additional fixed-rate payment based on that new principal.
The opposing view from planners
These relatively new investments give individual investors a way to save for retirement, Bodie says, without the risk theyll lose their principal either outright or to the erosion of rising prices.
The only people who should invest heavily in stocks, he believes, are those who want the possibility of retiring early but who are willing to postpone their retirements for several years if their stock bets are wrong.
Most financial planners, of course, disagree strongly with the notion that age doesnt matter. If nothing else, youth offers the advantage of time. If your portfolio is wiped out when youre 30 or 40, you have decades to rebuild your nest egg. If it happens at 50 or 60, youre in much deeper trouble, since you have fewer working years to recoup your losses. Thats why most planners recommend young people start with a significant exposure to stock, ratcheting back as they age.
That darned fly in the ointment
Then there are the practical aspects of trying to save when youre not taking much risk. The real fly in Bodies ointment is that the less risk youre willing to take, the more money you need to set aside to reach your goal.
For example, someone who wants to accumulate $1 million for retirement in 30 years would need to put aside:- $381 a month if she expected to get the stock markets historical average return of 10.7%, or
- $671 a month, if she ratcheted back her expectations to 8%, but
- $1,490 a month if she based her savings on a total yield for I-bonds of just 4.08%.
Bodie actually advises approaching the calculation a slightly different way, but the results are much the same.
Since I-Bonds and TIPS guarantee youll keep up with inflation, you only need to factor in the fixed-interest rate youre being paid, not the inflation protection component.
Step up on the bond ladder
So if you expect to need $30,000 in today's dollars in your first year of retirement, starting 30 years from now, you would purchase about $19,000 in I bonds this year, when the fixed-rate on a 30-year I bond is 1.6%. If the rate rises to 2% next year, youd buy about $17,000 in I bonds to cover your second years retirement income. And so on, building a "bond ladder" to pay for your retirement.
Thats still a massive amount of money for most people.
Lets take a more detailed example. Say youre 40, make $50,000 a year and want to retire on a minimum of 70% of your current income. You expect Social Security or another pension to chip in about $19,000 when you retire at 67. The conventional approach would have you saving about $6,101 a year on the expectation that your portfolio will return an average annual 8%. If you buy I-bonds, however, youd need to save $10,423 -- more than 20% of your gross income.
That leaves the average investor in quite a pickle. In order to retire, most people would need more than what Social Security and their pensions, if any, will provide. Yet they would be hard-pressed to set aside enough of their current income to guarantee theyll get that minimum amount in retirement.
Subsistence-level income vs. comfort
Bodie doesnt dispute that. People need to save more, he said, and they shouldnt have been told otherwise. A whole generation of investors became addicted to the notion that 10% average annual returns would bail them out. But Bodie thinks many are ready to listen.
That generation, . . .is starting to question the veracity of the wisdom they were preached, Bodie said.
Bodie, who has advised the governments Pension Benefit Guaranty Corp. and sits on the Wharton Schools Pension Research Council, wishes corporate America would listen as well. He believes companies are using unrealistically high estimates of future returns to severely underfund their pension plans.
Are Bodies ideas valid? The idea of guaranteeing a minimum income in retirement is certainly attractive, but it, too, involves risk. By giving up the potential gains of stocks, you could be guaranteeing yourself a subsistence level of income when more exposure to equities could provide a far more comfortable retirement.
Look for TIPS
But if you like what Bodie has to say, there are ways of incorporating some of his theories into your retirement planning without entirely abandoning stocks. Among them:- Investigate using I-bonds or TIPS for the fixed-income portion of your portfolio. A few 401(k)s offer funds that invest in TIPS, but those, like other bond funds, can lose value if interest rates rise. Bodie believes most investors are better off buying and holding individual inflation-protected securities until maturity.
- You can buy I-bonds and TIPS on your own from the governments Treasury Department (see link at left). TIPS usually should be held in IRAs or other tax-deferred savings plans, since the increase in their principal is otherwise taxable. I-bonds are tax-deferred until you cash them in, so you dont necessarily need the tax-deferral of an IRA.
- Dont expect high stock market returns to make up for inadequate saving. Leading financial planners expect stock market returns to be modest, at best, for at least the next decade. You may need to boost your savings rate to compensate for lower expected returns.
- Look for jobs that offer traditional pensions. Pensions, like Social Security, offer guaranteed streams of income in retirement. Large companies, companies in heavily unionized industries and governments are most likely to offer jobs that come with pensions.
- Build up the equity in your home. You can tap your equity through a reverse mortgage, which offers guaranteed payments for life in exchange for giving up some or all of your equity. You can put yourself in a good position for a substantial reverse mortgage by paying off your mortgage before retirement and not draining away your equity with loans.
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