Stay Away From Stocks
The subprime lending crisis is what finance quants call a "fat tail." The colorful term describes a low-probability, high-impact event that roils the financial markets and shows up on a statistical graph as an abrupt change in direction. Zvi Bodie, professor of finance at Boston University, says fat tails are more common than many assume, putting at risk the retirement, education, and other long-term savings of millions of Americans. His solution: Stay away from stocks. Contributing economics editor Chris Farrell got in touch with Bodie while he was vacationing on Cape Cod to talk about his unorthodox investing approach.
Should all investors worry about the stock market?
It depends on wealth. If you are wealthy enough, your standard of living is not in jeopardy when the market goes down. With people like Bill Gates and Warren Buffett, nothing they do in the stock market will affect their standard of living, though it may affect the charities they give to. But if you're like Zvi Bodie, you have to pay attention to the downside.
So what do you do?
Lock in the essentials by investing safely. It means investing some portion of your money—perhaps the bulk of it—in something risk-free. This is simply not mentioned in most of the conventional literature on investing.
What do you mean?
They'll always say that investing is what you do for the long term and savings is what you do for the short term. That's nonsense. Savings is the difference between income and consumption, and it has nothing to do with time horizons. Investing is all about how much of your savings goes into safe assets and how much into risky assets. They'll also tell you there is no such thing as a risk-free investment.
You don't agree?
It's a lie that there isn't a risk-free investment. In the U.S. context, Treasury inflation-protected securities, or TIPS, can protect your money from inflation for 20 years, the Series I savings bond for 30 years. That's a long time.
What investment strategy do you advise?
I never recommend the stock market. I say, load up on Series I bonds in taxable accounts (because taxes are deferred until cashed in) and make sure you have plenty of TIPS in your retirement account (to steer clear of paying taxes on accrued interest). Then no matter how wild the markets get, you don't have to worry.
But with this strategy you give up the chance of making money in stocks.
If there's a fat tail event on the upside, buy an out-of-the-money call option on a market index. [A call is a bet that the market will rise. Calls are "out of the money" when the strike price is greater than the market price of the underlying security.] It has a low probability of paying off, but if it does, you'll make a killing. I implement this in my own retirement portfolio. I have about 95% in TIPS and 5% in out-of-the-money call options that go out as long as three years on the market.