Monday, December 23, 2019

"Zvi Bodie and the Keynes’ Paradox of Thrift"

We will be talking about the Paradox of Thrift next year and I thought we should reprise one of the most lucid writers on topics fin/econ, William Bernstein as he applies the broader idea to a specific investment class.
First though, our introduction to a 2010 piece that referenced Bodie v. Bernstein:
I think it was Boston University's Zvi Bodie* who, shrugging off the restraints of his MIT PhD, pointed out to the "expected return" crowd that if it were true that the risk of negative returns decreases as the time frame increases, the cost of long-term puts should decrease the farther out you go.
Kind of an Emperor has no clothes thing to say....
*William Bernstein (No slouch either, M.D. Neurologist, PhD. Chemistry, dabbler in Modern Portfolio Theory, Bestselling Author, etc.) in one of his Efficient Frontier pieces, "Zvi Bodie and the Keynes’ Paradox of Thrift" described the professor as "Academician, raconteur, and all-around good guy Zvi Bodie...".

Then he rips his lungs out. Very typical in the academy:
From double Doc. William Bernstein's Efficient Frontier back in 2003:
Most finance writers eventually violate the famous paradox of thrift described by Lord Keynes in the concluding chapter of The General Theory of Employment, Interest, and Money. To wit, many virtuous activities, while good for the individual, are bad for society, prime among which is saving—good for the security of the individual, but bad for the overall economy. 

I plead as guilty as anyone. While extolling the virtues of indexing, value loading, and rebalancing, I freely admit that if everyone indulged, all these techniques would instantly stop working. (This is one of the arguments, in fact, against value investing, since it violates Rekenthaler’s Rule: if the bozos know about it, it doesn’t work any more. I tend to disagree, since this would have predicted a narrowing of the valuation gap between value and growth stocks during the 1990s publicity surrounding the value effect, and assuredly that did not occur, as growth stocks soared versus value stocks. But that’s another article.)

Academician, raconteur, and all-around good guy Zvi Bodie crosses this line in style with a noteworthy new publication, Worry Free Investing, assisted by veteran journalist Mike Clowes. The book combines Bodie’s nonpareil grasp of the financial markets with Clowes’ prose skill, providing solid advice to anyone seeking guidance on retirement saving. Stocks, he points out, are riskier than they seem, with expected returns far lower than the spectacular realized returns of the past seven decades. Investors also need to be cognizant of the covariance of the risks of their investment capital and their human capital. (That is, stockbrokers should own less equity than other investors, since their jobs already provide them with plenty of exposure to market risk.) 

The major focus of the volume is Treasury Inflation Protected Securities (TIPS), which insulate investors against the hazards of inflation. So far, so good. TIPS are a wonderful asset class, with reasonable expected real returns and near total safety. In fact, when The Intelligent Asset Allocator was published in 2000, TIPS were yielding 4%. While I briefly toyed with—and rejected—the idea of an all-TIPS portfolio, I did recommend a healthy allocation to them. Bodie, on the other hand, comes much closer to embracing the idea of an all-TIPS plan, arguing that if an investor has saved enough to retire on, then his primary goal should be to safeguard his real standard of living with these vehicles, or their close cousins, stable-value funds. Yes, Bodie says, you can invest in stocks if you’re highly risk tolerant or have more than enough. But TIPS should form the core of your portfolio. 

I do have several quibbles with the core-TIPS concept. First and foremost, Bodie’s fondness for I-bonds is puzzling in the extreme. Currently, they yield a real 1.1%, and although they are tax-deferred, the owner will find herself taxed on both this yield as well as the underlying inflation component at maturity, making a negative real after-tax return nearly a certainty for most investors. Add to this the all-too-common long-term storage and loss problems with savings certificates held by the elderly and other less cognitively intact individuals, and I-bonds rapidly become nonstarters at current rates. An inexpensive tax-managed equity fund would have to see exceptionally poor stock returns to come out behind I-bonds, assuming that the 15% capital gains and dividend rates remain in effect. Finally, your children will find it a lot easier to retrieve your fund account data than those I-bonds you hid between the pages of Grisham novels lying around the house.

Relying on tax-sheltered plain-vanilla TIPS (rather than I-bonds) is not bad advice for the individual. But Bodie goes further, both in his book and other forumseveryone should be offered, and follow, the TIPS route for retirement. Specifically, investment companies should make available massive amounts of innovative vehicles packaging not only government but corporate and mortgage debt in inflation-protected format for the legions of investors seeking retirement safety and income.

What’s wrong with mass-market inflation-protected intermediation? Unfortunately, everything....