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Zvi Bodie on Stocks and Annuities in Retirement

August 10, 2010

by Dan Richards

The major proponent on the contrary side, most people would agree, is Jeremy Siegel of Wharton, whose very well-known book, Stocks for the Long Run, is sometimes cited as one of the top 10 most influential books on investing ever.  His research going back to the early 1800s would draw a different conclusion, that stocks are risky in the short term, but the longer you hold them, based on nearly 200 years of data, the lower the level of volatility and risk.  How do you respond to that?

The difference between our positions on this is a lot smaller than you might think.  Jeremy has never said that stocks become safe in the long run.  At least when I am debating him he is very careful and how he states it.  He says, stocks are not as risky as you might think they are.  He believes there is a kind of mean reversion which doesn't make them safe.  It just makes them safer than they otherwise would be.

In my view, stocks are still very risky.  Jeremy wouldn't disagree with that.  When it comes down to actual policy decisions, like what should your mother be investing in when she retires, Jeremy supports the idea of inflation-protected annuities based on TIPS.  But he is constantly reminding people, and I agree, that means you're probably settling for a low rate-of-return in return for reducing your risk exposure.  But that's what investing is all about.  It's trading off risk and return.

Say you were talking to a 60- or 65-year old investor and they were to ask what scenario they should be most concerned about – inflation, a double-dip recession, or the market crashing further.  What would your answer be?

My answer would be that you always want to look at several scenarios, and then try to assign probabilities to them.  One of the mistakes that a lot of analysts make is to consider only one scenario.  You hear this all the time on television in an interview with someone who is bullish, and then someone else who is bearish.  How do they possibly know?  Why aren't they considering probabilities?

Let's take inflation as an example.  We've had this tremendous run-up in government debt in the United States and everywhere in the world.  Some people are saying that's going to have to be monetized.  That means we’re going to have runaway inflation or at least very high rates of inflation in the next few years.  Prominent analysts are saying that.  Then the next guy or woman makes the case for why, because we've had such a severe recession, we're going to have prolonged unemployment.  It's going to be like Japan, with a long period of deflation.

I don't know about you, but I think both of those things are possible.  I wouldn't go with either one of them as the most likely scenario.  In fact, I probably would average them out and say we are going to have inflation that’s somewhere in the middle, but there is a high degree of uncertainty about it. 

That is the spirit that a risk manager brings.  That's the essence of risk.  It constantly amazes me that people in the finance field who study markets and have seen in the past how wrong their forecasts can be, as recently as the last decade, still make point forecasts of the future with absolute certainty and great confidence.  It seems nuts to me.