It’s not sexy. It flies in the face of conventional wisdom. But Zvi Bodie says it’s possible to prosper and to do so with less risk.
That’s the big idea behind the Boston University finance professor’s just-published book, aptly titled “Risk Less and Prosper.” (Published by Wiley, to be released Dec. 27 with co-author Rachelle Taqqu.)
“This is essentially a different approach to investing for ordinary people who are saving and investing for retirement, kid’s tuition, but essentially investing over their whole life,” Bodie said in an interview. “What we try to stress is that you should always start from the least risky end of the spectrum, which really is insurance. You want to make sure that you have your basic needs covered.”
According to Bodie, the basic idea is that you should save and invest so that you match your future liabilities or expenses with assets designed to pay for that obligation, and to do so with investments that are guaranteed and that — at a minimum — keep pace with inflation.
And the sort of investments that you might consider include Treasury Inflation Protected Securities (TIPS) and I-Savings Bonds. “You are trying to make sure that whatever you save maintains its purchasing power,” Bodie said. “Those are the starting low-risk end-of-the-spectrum instruments. And that is the natural starting place.”
Though it’s contrary to popular opinion, Bodie said, much of what is considered to be in the realm of investing today actually really belongs in the realm of insurance. And that investing — which involves risk-taking — is much more akin to speculating.
“Do you want to speculate with your kid’s college tuition?” he asked.
The answer, according to Bodie, is no.
But that’s not what happens today. Today, many people invest in risky assets, stocks in particular, in the hope that their investments will appreciate enough in value to pay for future needs, be it college or retirement. And that strategy could lead to less prosperity, not more prosperity, according to Bodie.
So, according to Bodie, the first step to risking less and prospering more however starts with human capital. “The issue of counting your human capital, your human wealth in the form of your future earning power as a central element in your portfolio,” is critical said Bodie. “It’s our human capital that constitutes most of our wealth. And so the riskiness of that human capital and how procyclical it is, how secure you feel your career is, how long you can continue in that career, maybe on a part-time basis. Those are the key determinants of how much risk you can take in the rest of your portfolio.”
From his point of view, it makes no sense to just look at one’s stock and bond portfolio separate from one’s human wealth.
To be sure, there’s a cost associated with implementing the risk less and prosper strategy. And it might mean work longer rather than saving more. “If you are not saving enough to cover your needs in retirement, I would say for most people, the easiest thing to do, instead of changing your savings rate is to plan to work longer … even if that means part-time,” said Bodie. “That will add an awful lot to your human wealth.”
Saving more is important, but he said the vast majority of American might not be able to do that. “It’s hard to do,” he said.
Given that, he said many Americans would benefit from investing in learning to improve their future earning power. “When you invest in learning different skill so that let’s say you can switch to a different job in your later years, that you like more, or that’s less demanding physically, that’s investment. It doesn’t count as saving because you are spending on taking courses.”
So how then can one risk less and prosper?
Figure out how much you would have to save to afford your retirement plans, your consumption, spending in retirement years. If you earn zero in real terms (such as with I Savings bonds) anything that you contribute will maintain its purchasing power, but it won’t grow in terms of purchasing power. “That’s where you should start,” he said. “So let’s say anything I contribute, anything I save is just going to maintain its purchasing power, how much would I have to save or when can I afford to retire? And then you ask: ‘Suppose I invest half the money in the stock market so how does that affect things?’”
“Well that means you will likely earn a higher rate of return, but you could earn a much lower rate of return,” he said. “And that’s what taking risk means. If you don’t like the results you get using just I Savings bonds and other inflation-protected Treasury securities because they are not going to beat inflation, because they are just going to keep pace with inflation, and you say I can’t afford to do that so I’m going to invest in the stock market, you can actually do worse, you could do a lot worse by investing in the stock market.”
To be fair, Bodie is not suggesting that one shouldn’t invest in the stock market. Rather, investors should be aware that this is the speculative part of investing. “That’s what taking risk means,” he said. “And it doesn’t matter how long your time horizon is. So often, you will hear the wildly-believed fallacy that if you have a long time horizon, the risk of investing in stocks goes away, that is not true.”
To prosper while risking less, according to Bodie, is to invest in inflation-protected securities to the point it can cover for one’s minimum standard of living and then invest the balance in index funds. “That’s the way to do it,” he said. “It can be implemented very easily.”
Robert Powell is editor of Retirement Weekly, published by MarketWatch.