William J. Bernstein
Zvi Bodie and the Keynes’ Paradox of Thrift
Most finance writers eventually violate the famous paradox of thrift described by Lord Keynes in the concluding chapter of The General Theory of Employment, Interest, and Money. To wit, many virtuous activities, while good for the individual, are bad for society, prime among which is saving—good for the security of the individual, but bad for the overall economy.
I plead as guilty as anyone. While extolling the virtues of indexing, value loading, and rebalancing, I freely admit that if everyone indulged, all these techniques would instantly stop working. (This is one of the arguments, in fact, against value investing, since it violates Rekenthaler’s Rule: if the bozos know about it, it doesn’t work any more. I tend to disagree, since this would have predicted a narrowing of the valuation gap between value and growth stocks during the 1990s publicity surrounding the value effect, and assuredly that did not occur, as growth stocks soared versus value stocks. But that’s another article.)
Academician, raconteur, and all-around good guy Zvi Bodie crosses this line in style with a noteworthy new publication, Worry Free Investing, assisted by veteran journalist Mike Clowes. The book combines Bodie’s nonpareil grasp of the financial markets with Clowes’ prose skill, providing solid advice to anyone seeking guidance on retirement saving. Stocks, he points out, are riskier than they seem, with expected returns far lower than the spectacular realized returns of the past seven decades. Investors also need to be cognizant of the covariance of the risks of their investment capital and their human capital. (That is, stockbrokers should own less equity than other investors, since their jobs already provide them with plenty of exposure to market risk.)
The major focus of the volume is Treasury Inflation Protected Securities (TIPS), which insulate investors against the hazards of inflation. So far, so good. TIPS are a wonderful asset class, with reasonable expected real returns and near total safety. In fact, when The Intelligent Asset Allocator was published in 2000, TIPS were yielding 4%. While I briefly toyed with—and rejected—the idea of an all-TIPS portfolio, I did recommend a healthy allocation to them. Bodie, on the other hand, comes much closer to embracing the idea of an all-TIPS plan, arguing that if an investor has saved enough to retire on, then his primary goal should be to safeguard his real standard of living with these vehicles, or their close cousins, stable-value funds. Yes, Bodie says, you can invest in stocks if you’re highly risk tolerant or have more than enough. But TIPS should form the core of your portfolio.
I do have several quibbles with the core-TIPS concept. First and foremost, Bodie’s fondness for I-bonds is puzzling in the extreme. Currently, they yield a real 1.1%, and although they are tax-deferred, the owner will find herself taxed on both this yield as well as the underlying inflation component at maturity, making a negative real after-tax return nearly a certainty for most investors. Add to this the all-too-common long-term storage and loss problems with savings certificates held by the elderly and other less cognitively intact individuals, and I-bonds rapidly become nonstarters at current rates. An inexpensive tax-managed equity fund would have to see exceptionally poor stock returns to come out behind I-bonds, assuming that the 15% capital gains and dividend rates remain in effect. Finally, your children will find it a lot easier to retrieve your fund account data than those I-bonds you hid between the pages of Grisham novels lying around the house.
Relying on tax-sheltered plain-vanilla TIPS (rather than I-bonds) is not bad advice for the individual. But Bodie goes further, both in his book and other forums—everyone should be offered, and follow, the TIPS route for retirement. Specifically, investment companies should make available massive amounts of innovative vehicles packaging not only government but corporate and mortgage debt in inflation-protected format for the legions of investors seeking retirement safety and income.
What’s wrong with mass-market inflation-protected intermediation? Unfortunately, everything. First, TIPS, while relatively risk-free in the long run, can be rather nasty actors in the short run. As of this writing, the 29-year bond yields a real 2.7%; the 10-year bond, 2.1%; and the 5-year bond, 1.5%. To get those returns, the investor has to be willing to take about 12%, 6%, and 3% of (standard deviation) risk, respectively—not chopped liver, particularly at the long end. Bodie makes the same mistake here as his foils James Glassman and Kevin Hassett, who in Dow 36,000 postulated a new species of homo economus impervious to short-term volatility. At some point in the future, there will be a grinding bear market in TIPS (it may already have begun!), and it is a forgone conclusion that tens of millions of savers will sell out at the bottom, just as they have done historically and repeatedly with stocks.
But there’s an even more fundamental problem with TIPS as the national core investment: lack of supply. When investors purchase stocks, they are syndicating corporate investment risk by allowing the companies’ owners to offload risk onto them in exchange for a risk premium. In effect, they are acting as companies’ insurance agents. With TIPS, the situation is far more complex, but mainly in the opposite direction. Here, it is the seller who is assuming risk, indemnifying the buyer against the risk of inflation. For the Bodie plan to work, the government, corporations, insurance companies, and mortgage suppliers must be willing to underwrite trillions of dollars of inflation-protection risk for retirement savers. Whether this is even feasible is anyone’s guess, but what is certain is the price paid by investors for such an amount of protection would be enormous.
Bodie sagely points out that stocks do indeed become more risky with time, the proof of the pudding being that equity puts become more expensive with maturity, and not the other way around. The same, unfortunately, is true of inflation risk. Similar to stock puts, the nominal yield curve is usually positive, for exactly the same reason: with time, the risk of inflation rises. While one may be reasonably certain that we shall not see hyperinflation in the next five years, one cannot be so sure about the next three decades. Insuring against inflation for the next 30 years is a dandy idea and, at the moment, it is even reasonably cheap. But if demand mushrooms, prices will rise and yields will fall. In an extreme case, negative yields in the secondary market for Treasuries and in the primary non-government markets are entirely possible. (For those having a hard time imagining a negative TIPS yield, imagine what coupon would have been demanded by investors in Germany and Hungary in the 1920s for an inflation-protected investment.)
As pointed out by Rob Arnott and Ann Casscells in the January-February issue of Financial Analysts Journal, stocks and bonds are merely a medium of exchange between retirees and workers. (In January, I discussed the Arnott/Casscells argument in these pages.) At any point in time, there are x number of workers producing goods and services for y number of retirees. If there are too many retirees and not enough workers producing goods and services for them, it does not matter how well the retirees have saved in the aggregate—their standard of living will fall as the prices of their securities—TIPS included—deteriorate and the wages of workers rise.
The grim reality is that improvements in intermediation of the sort suggested by Bodie, while helpful, cannot avoid being overwhelmed by the twin bogeymen of human financial nature and demographics. The quantity of long-dated inflation-protected debt required by the mass-market core-TIPS approach is simply not feasible and, even if it were, bond yields would not be adequate to support the retirement needs of the looming wave of boomers.
Copyright © 2003, William J. Bernstein. All rights reserved.
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