Online Extra: Sleep Soundly without Stocks

Author Zvi Bodie says the safest possible approach to retirement savings is to stick closely to TIPS and I-Bonds

Conventional wisdom says buy stocks to save for retirement. Not necessarily so, says Zvi Bodie, a Boston University finance professor and co-author of Worry-Free Investing (FT Prentice Hall; $24.95). Bodie advocates risk-free investments, such as the U.S. Treasury's TIPS and I-Bonds. These are regular government bonds and savings bonds, respectively, that keep pace with inflation. Bodie recently spoke with Personal Finance Editor Anne Tergesen. Edited excerpts of their conversation follow. Note: This is an extended, online-only version of the interview that appears in the July 28, 2003 issue of BusinessWeek.

Q: Are most people taking too much risk in their financial lives?

A:

People who have been following conventional investment advice are probably taking more risk than they should and don't even know it. They've been told not to worry about the stock market going down because in the long-run, stocks are going to beat everything else. That's a fundamental fallacy.

Q: How risky are stocks?

A:

The probability that stocks will perform worse than risk-free investments, such as TIPS or I-Bonds, gets smaller the longer you hold them. After 30 years, there is a 95% chance that stocks will beat TIPS. But the severity of a possible shortfall gets bigger. For example, say you have $500,000 and are three years away from retirement. If you suffer three years of 15% losses, your savings will be almost cut in half -- and your retirement will be jeopardized. Of course, the longer the string of losses continues, the larger the shortfall will be.

Q: Please explain.

A:

The consensus view -- and this is based on estimates -- is that over the next 30 years, if you were to invest in a diversified portfolio of U.S. stocks, you'd beat inflation by about 4 percentage points a year. But there's a tremendous amount of uncertainty surrounding that -- not just in the short-run but in the long-run.

Historically, stocks' standard deviation has been 20%. That means you shouldn't be at all surprised if you lose 16% rather than gain 4% in a given year. If you start out with $100,000 and lose 16%, you'll have $84,000 at the end of the first year. Then, if you lose another 16%, you'll have only $70,560 left, and so on.

This risk explains why the longer your time horizon, the more expensive it is to buy put options [which are like an insurance policy that protects you against the risk of a stock market decline].

Q: How do you assess risk tolerance?

A:

Age should not be the first consideration. Instead, you need to assess how much risk your career exposes you to. If you are a stockbroker or are starting a business that you intend to take public, your income is very vulnerable to a stock market decline. Without investing a dime of your retirement savings in the market, you already have a huge exposure to stocks.

Q: Should most people avoid stocks?

A:

Some people should be investing in the stock market. If you work for a large company and your skills are fairly transferable, your career is pretty well insulated from the market. But those who invest in stocks should do it in a sensible way that keeps the consequences in mind. For example, you've got to be willing to postpone retirement if you fall short of your goal.

Q: What kinds of investments do you recommend for retirement savings?

A:

If you want to be worry-free, take care of your basic goals -- such as securing a basic standard of living in retirement and providing an education for your children -- with TIPS and I-Bonds, which are risk-free investments. Unless you are very wealthy, make sure you have enough invested in those safe assets to meet your needs. Once you've taken care of the things you really care about with TIPS and I-Bonds, you can afford to take a flier [on stocks]. [You can find a variety of retirement calculators on BW Online's Investing channel.]

Q: Although I-Bonds are tax-efficient investments, TIPS are not. As a result, they're best placed in a tax-deferred accounts, such as 401(k)s and IRAs. The problem is, many 401(k)s don't offer a TIPS option.

A:

If you have a 401(k) plan, you should take advantage of it, especially if your employer matches some of your contributions. Talk to your employer about adding a TIPS option. You can also invest in stable value funds, which guarantee your principal. [Unlike with TIPS, though, these funds don't lock in an interest rate above inflation.]

Q: Your book lays out six steps for worry-free investing. What are they?

A:

First, set goals. An example is a secure retirement.

Second, specify a target, such as saving enough to replace 70% of your current salary in each year of retirement.

Third, calculate what percent of your salary you'd have to save if you take no investment risk. That can be done by saving with TIPS and I-Bonds. [Remember, you'll be able to supplement your savings with Social Security. To project your benefit, go to www.ssa.gov/planners/calculators.htm.]

Fourth, determine your risk-tolerance. If you have a high tolerance or are saving more than you need to in order to reach your goals, you can put some of your savings in stocks.

Fifth, for those who can afford to, select a stock portfolio. I suggest a well-diversified portfolio of stocks or no-load mutual funds.

Sixth, minimize taxes and transaction costs. Here, it makes a lot of sense to shop around. Never buy a load mutual fund. And be very careful about things like tax-deferred annuities, where selling costs and back-end fees can be high. You can buy annuities directly from BRKdirect.com, a subsidiary of Berkshire Hathaway. If you don't go through an agent, you can save a lot.

Q: What's the biggest lesson investors can learn from the bear market?

A:

Don't fool yourself into thinking that your basic needs are being taken care of in the long-run with a stock market portfolio. Much of the conventional advice about investing is dangerously misleading.

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