Major piece in today’s Wall Street Journal, “Why Stocks are Riskier Than You Think” by Zvi Bodie and Rachelle Taqqu

http://online.wsj.com/article/SB10001424052970204795304577221052377253224.html?mod=googlenews_wsj

(Of course, Bodie and Taqqu are also hoping that this article will lead a lot of people to buy their recent book, “Risk Less and Prosper”.  Bodie and Taqqu’s own retirement plan likely hinges on profits from book sales at least as much as from their portfolios…)

Like a broken record, Bodie again says (mostly) to avoid stocks and to buy inflation-protected bonds.  I say “mostly” because they do allow for the suggestion that one may fund one’s “aspirational goals” with balanced portfolios which may include stocks (and/or options or more complex hedged funds).

What they don’t focus on is exactly how much one needs to save if one is putting one’s entire essential retirement savings into TIPs.  Given that the “real” return on them (ie. the return after inflation) is now zero – you got that – nothing whatsoever – it means that every inflation adjusted dollar you plan on spending in retirement needs to be saved today.  There is no allowance for growth.  If you’ve saved 20x your cost of living, then you will have 20 years and then be broke.  And given longevities now, we have to allow for the likelihood that retirement, especially for the survivor of a couple, may last well over 30 years.

That all said, Bodie is right in that folks often invest in stocks without fully understanding the risks.  But that doesn’t mean that folks shouldn’t have more in stocks than he’s saying, either.  He seriously underplays the risks inherent in bonds, especially given today’s ultra-low interest rates.

At the end of the article, they describe a zero-cost means of hedging exposure through a “zero-cost collar”.  If you buy SPY at $136 and you buy a put with a strike at $116 (limiting you to a 15% loss) and sell a call with a strike at $143 (which has the same price as the put you’ve bought, so the prices of the options cancel each other out), you’ve bought the S&P500 and limited your downside to a maximum 15% loss but you’ve also limited your upside to a 6% gain over the following four months.  This is a pretty good illustration of how expensive that “loss insurance” is – you limit your upside to less than half your downside.  You could limit your upside less — at a cost — by either not selling the call or selling a call with a higher strike price (and thus getting less cash to offset the cost of your puts).  Bodie makes an example of getting a higher upside by also hedging with a worse downside risk.  It’s a great illustration of some of the mechanics of equity hedging and its costs (though of course, it also ignores taxes and dividends – both of which may have substantial impact on the net result).

Bodie has also, in the past, suggested a portfolio consisting of TIPs plus buying long-dated call options on the equity market.  He suggested that, if I recall correctly, at a time when in fact TIPs had a non-zero real return and his explanation was that with the real yield from the TIPs was enough to pay for the options.  That way you guaranteed a real return of at least zero (ie. no real loss) but also bought some potential equity market up-side as well in the case that equities performed well.  That strategy won’t work now, of course, as there’s no real yield available from the TIPs to fund the equity part of that strategy.

Anyway, while I don’t necessarily agree with the advice he’s giving, especially for folks with long time horizons and any appetite for risk, I do think his article is well worth reading and some good food for thought.

And I really liked the collar illustration.  It’s something worth understanding and may be nice to actually take on its own and illustrate better for people, especially when they ask just how the annuity business can afford to guarantee limited downside — it shows the *costs* of downside limits pretty nicely (even if that’s not exactly how an insurance company actually does it).

[As usual, none of this is intended as investment advice.  This note is for educational purposes only.  Please see a professional for actual advice.]