Managing Downside Risk in Retirement Planning

The bear market of 2007-2008 caused widespread concern among investors about the long-term downside potential of equities in retirement planning.  Investors who were largely or completely invested in equities were painfully exposed.

That need not have been the case.  Boston University professor Zvi Bodie has advocated a strategy that offers investors some of the upside potential in equities tempered with downside protection against bear markets and a low-risk inflation hedge via heavy allocation to TIPS.  While I expect few adopted Bodie’s strategy, those who did likely remain well-positioned to reach their retirement goals.

Since its introduction in 1995, Bodie’s strategy has not gained much popularity or acceptance.  Its merits, however, became clear during the recent bear market, a textbook example of something Bodie warned about in his paper: While the probability of stocks under-performing bonds declines with holding period, the severity of the worst-case downside scenario actually increases with time. 

In a recent article, I reviewed Bodie’s arguments and showed how Monte Carlo simulations reinforce his point.  Because of the potential for severe losses relative to inflation-protected bonds (TIPS), even over long time horizons, Bodie proposed in a 2001 paper that investors should have the majority of their holdings in TIPS. They should invest a smaller fraction in call options on the S&P500, he argued.  The high allocation to TIPS provides the security of government bonds, along with inflation protection so that an investor can protect his or her purchasing power. 

Bodie called his strategy the 90/10 strategy: 90% of holdings go into TIPS and 10% go into call options on an equity index.  The idea is conceptually simple, but it is sufficiently different from the common practice of most investors (and advisors) that his approach is not well understood or widely applied.  Monte Carlo simulations explain and demonstrate the value of Bodie’s 90/10 approach. 

The obvious appeal of Bodie’s 90/10 strategy is that there is an absolute floor on portfolio losses that a decline in equities can cause, even in the worst market conditions.  (This does not, however, mean that the portfolio cannot lose more than 10% of its value.)

It is possible that the lack of popularity of Bodie’s approach is due to its reliance on TIPS, but the effectiveness of the strategy in creating a floor for the portfolio does not require that all bonds in the portfolio be TIPS.  Investors and advisors can use a mix of nominal and inflation-protected bonds in the fixed income portion.  The option portion of the portfolio gives investors some of the upside of equities if the markets rise.  Using options to gain equity exposure, rather than simply buying an index fund, gives the investor exposure to almost as much of a bull market’s upside as a portfolio of equities would.

Many advisors and investors do not understand options or how they really work, and that too may be inhibiting the wide adoption of Bodie’s approach.  The leverage afforded by options is a key component — but understanding this requires that investors understand options and how they work.  For those with a good grasp on options, Bodie’s 90/10 strategy and its variants can be a very important addition to the suite of portfolio management strategies.

Baseline 90/10 Portfolio

One of the challenges for the 90/10 strategy is to make the approach really concrete, so let’s start with an example that uses real numbers.  I have created a Monte Carlo analysis of the 90/10 portfolio that has been adjusted so that its projected market volatility is consistent with long-dated options on SPY.  Long-dated options on SPY provide an estimate of the market’s expectation of future volatility.  By making sure that the Monte Carlo model generates a similar level of volatility for the S&P500, we have a sanity check for the performance of this strategy. 

I ran the Monte Carlo analysis using the trailing three years of market data to account for the higher correlations between asset classes that have been observed. I also adjusted the performance of equities to a fairly conservative level, consistent with the best available estimates of the future equity risk premium (see here).

I assumed that the options portion of the portfolio is invested with strikes at-the-market (meaning that the strike prices of the call options are right around the price of the underlying index fund) and with a two-year expiration horizon.  I have ensured that the options premiums are consistent with what similar options are selling for today.  A call option on SPY with a strike price of $110 expiring in December of 2011 has 2.2 years until expiration.  As of this writing, this option costs $13.90 and SPY is at $109.  When I price this option using the Monte Carlo simulation, the simulated fair price is $13.80.  The simulated volatility (risk) and the prices of options are consistent with market levels.  This is obviously an important check if one is considering pursuing this strategy. 

The Monte Carlo analysis accounts for the current dividend yield of the market, which affects the attractiveness owning options for your equity market exposure because the owner of a call option does not receive dividends.