Sunday, January 16, 2011

Should I hold 280% Stocks or 0% Stocks? I'm confused!

Let's meet two well-respected and well-published academic financial economists, Moshe Milevsky of York University and Zvi Bodie of Boston University.  Professor Bodie may have a slight edge in overall fame, but both of these men can lay claim to being leading financial scholars.  They've even both been featured in the 10 Questions column of the Journal of Financial Planning (Milevsky in November 2009 and Bodie in February 2010).  They both produce rigorous academic research published in leading academic journals, and they both also write books geared toward household investors.  They could hardly be more similar, except that when it comes to the issue of asset allocation for long-term retirement savers, they could hardly be more different!

Zvi Bodie and Michael Clowes contribution is the 2003 book, Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals. In this book, they advise readers to invest their retirement savings 100% in TIPS.  No need for stocks.  Someone should only consider investing stocks when they've already saved enough to cover their expenses and otherwise have additional funds that they can afford to lose.  Since most households tend to not be saving enough for retirement, this means that most households should be invested 100% in TIPS and 0% in stocks.

On the other hand, Moshe Milevsky's contribution in the 2009 book, Are You a Stock or a Bond? Create Your Own Pension Plan for a Secure Financial Future. This is an accessible discussion of relatively recent developments in financial economics that human capital should be considered as a part of one's asset allocation.  The future salary of an investment banker is more like a stock, because job prospects are very much tied to the fortunes of the stock market.  But the future salary of a tenured professor is more like a bond.  Every year the tenured professor will receive a bond coupon payment (their salary) that has little risk and has little relation to the stock market.  Asset allocation should consider the nature of one's salary, and those whose salary behaves more like a bond can afford to take on more risk in their investment portfolio.  On page 69 of his book, Milevsky indicates that a tenured professor who is 45 years old and who has a dependent spouse and children should have a stock allocation of 280%.  Personally, I'm much younger than 45 so I guess I should be borrowing very heavily to buy stocks on margin, according to Milevsky's advice.

How can two men who are otherwise so similar arrive at such different conclusions about asset allocation for retirement savers?  That is a bit of a puzzle to me. Any thoughts?


  1. One's a gambler and the other a chicken?

    Just kidding, but it's an amazing contrast indeed.

  2. Do these people do exactly what they preach? I'd like to know what they actually hold in their portfolios. Maybe bars of gold :D - Tammy

  3. Both are ignoring the effect of valuations and seeing different aspects of the story of stock performance that presents itself to those who do so.

    Stocks are an extremely volatile asset class for those who ignore valuations. Bodie focuses on the fact that middle-class people cannot handle seeing their wealth change so dramatically over a short amount of time. He's right.

    Milevsky is focused on the fact that on average stocks provide far higher returns than other asset classes. His conclusion (that those with a secure income should invest in stocks to the maximum to increase their wealth) follows logically. Siegel makes the same point in Stocks for the Long Run. He points out that, going strictly by the numbers, investors with a moderate risk tolerance should be going with a stock allocation well in excess of 100 percent.

    It all makes sense when you factor in the effect of valuations.

    Stocks are really a high-return, low-risk asset class. The risk of stocks is concentrated in those time-periods when valuations are high. Stay out of stocks at those times and you can hardly go wrong (even if you go with an allocation over 100 percent).

    However, stocks are exceedingly risky for those not willing to adjust their allocations in response to big price swings. That group (the Buy-and-Holders) will sooner or later be going with a stock allocation wildly inappropriate for investors with their risk profile and will be financially ruined in a short amount of time (it is this appropriate fear that drives Bodie's caution).

    For so long as we hold back from discussing the effects of valuations frankly, we both underestimate and overestimate the riskiness of stocks. Stocks are an insanely risky asset class, but most of the risk is optional. It is only Buy-and-Holders (those not open to considering price when setting their allocations) for whom stocks are truly risky.