I wasn’t ready for this book when it was published in 2012. Shame on me. This is a better approach to goal-based investing than blindly focusing on accumulating a pot of money. It’s better because the focus is not on the probability of achieving a particular number, but instead on the consequences of not achieving enough for your minimum needs. Finance is about risk, and this is a more rational approach to risk.
Book Review: Risk Less and Prosper: Your Guide to Safer Investing
Amazon Link to book by Zvi Bodie and Rachelle Taqqu
Part of my problem was that this new approach includes concepts of hedging and insurance. Don’t get hung up on these words like I did. For me they invoked the idea of salesmen, and I have an aversion to being sold. Instead, come at this open to the idea that these concepts are something you might want. Learn the powerful role they can play in helping you achieve your lifetime financial goals.
In short, I highly recommend this book for everyone making investment plans. (And that should be Step 1 for all working Americans.)
What is a safety-first portfolio?
What I see more clearly now is that stocks and bonds can be an adequate approach for those wealthy enough that they can still meet their minimum requirements if the markets go south at the wrong time, or stay south for an unfortunate period. But it happens and it probably will again. Most Americans must depend on their savings being there when they need it.
Three big risks:
There are a lot of risks in retirement. These are not new to me. But now that I am retired, these risks are shouting a lot louder than I heard them before. In short:
- The stock market is risky in the long run. It does not get safer over a long investment period. It can essentially lose half its value any year, and a sequence of bad years near the beginning of your retirement can be devastating. This is not commonly understood.
- Inflation is a big risk. The only solution to this problem are assets that will adjust with inflation. For instance, your Social Security benefit does. And, certain specific U.S. Treasury bonds do.
- You don’t know how long you are going to live. They call this longevity risk, or the risk that you will out-live the money you are planning to need.
Have clearer dreams
The safety-first approach you’ll read about here also calls for goal-based investing and clear priorities.
It encourages you to picture your destinations as clearly as you can. It begins by estimating the price tag of your visions, deciding how much of your vision you need to keep safe. This involves paring your goals down to the bare essentials. Imagine the minimum you will absolutely need.”
Preface: Risk Less and Prosper by Zvi Bodie and Rachelle Taqqu
This approach to a safety-first portfolio reframes risk. The conventional approach defines risk as volatility, and it addresses volatility with diversification. That’s all good, but a better definition of risk—especially for the unwealthy—is your money not being there when you need it. It’s the chance of missing your own goals.
So by identifying the minimum you will absolutely need as you prioritize your goals, you have the opportunity to create a plan that removes the risk for financing these bare essentials – before considering whether you want to take additional risks for your needs/wants that are above this floor.
This sounds difficult. It is, if saving is difficult. But you are likely only to have a few important financial goals – the book lists the ten most common ones.
I’m a firm believer in starting with a draft plan now and then improving it iteratively over time. Take a shot at this. There are no wrong answers. And I guarantee that next year your plan will be even better; more thoughtful. Give yourself permission to dream. Goals, after all, are our dreams with deadlines. Make a goal to create a financial plan that is realistic.
Hedging is just common sense
Hedging simply means finding out what is the safest way to invest for a particular goal.
A hedge is a trade-off. To protect your basic needs, you can cut your exposure to loss by investing in safer instruments. When you hedge in this way, you don’t pay anything, but you give up possible extra gains beyond the yield of your safe investments.
Book: Risk Less and Prosper, p. 13
So if it’s retirement, it’s going to be inflation protected bonds (iBonds or TIPS). Hedging doesn’t cost anything because you’re just changing your allocation to U.S. Treasury bonds. It is unknown whether you are going to earn a lower rate of return because you are moving from a risky asset (uncertain return because of inflation) to a guaranteed fixed rate of return.
Professor Zvi Bodie, presenting to FI360 conference, April 2019.
You can purchase TIPS bonds on regularly scheduled auction dates for no fees at major houses like Fidelity, Vanguard, etc. Or, you can purchase iBonds anytime with no fees direct from the government at the TreasuryDirect website.
Insurance is just common sense
Insurance is paying to eliminate the downside. For example, a risk that we all have is that we might live longer than average, and outlive the money we have saved. An annuity is a form of insurance against this — longevity insurance. You exchange a lump sum of money for a stream of money that will last your entire life.
Insurance creates a valuable benefit by pooling money. When you buy fire insurance for your home there is a small premium, and the people who don’t have a fire subsidize paying for those who do. Similarly, with an annuity, those who live shorter lives subsidize those that live longer than average.
The alternative is to save more than you need to—just in case you are long-lived. Most people can’t afford this luxury, or would be sacrificing some happiness (from spending or leisure) to accomplish it.
Your Social Security benefit is an annuity that, additionally, adjusts to protect you from inflation. Many point to the great benefit of delaying your Social Security benefit until age 70 to maximize this benefit.
Diversifying
Diversifying is the traditional approach to risk management. It refers to both spreading risk (don’t put all your eggs in one basket) and to taking advantage of poorly correlated returns (Modern Portfolio Theory). Additionally, it attempts to address life-cycle needs with rules-of-thumb like “Own your age in bonds.” However, this does not guarantee retirement income, guarantee sufficient returns, protect against inflation, nor eliminate longevity risk.
Can I reach my goal with safety-first?
If people restrict themselves only to “safe investing” and don’t take a certain amount of risk, isn’t it likely that a lot of them will never reach their investment goals by the time they reach sixty-five?
ANSWER: That’s right; they won’t. In the past, with the establishment of Social Security and private defined-benefits pensions, a certain cohort of people was able to retire at sixty-five. That won’t be true in the future. … People born in 1970 won’t be able to collect full Social Security until they reach sixty-seven. The date is continually being pushed back. With a life expectancy of eighty-five or so, we are being unrealistic if we expect the system will provide enough income for everyone to retire at age sixty-five. It just won’t work, and information that says it will work can’t be trusted.
Professor Zvi Bodie
So be realistic. Your plan might include saving more, retiring later, or accepting more risk. You’ll sleep better if you can guarantee a floor level of income and then consider how much risk you want to take for the upside.
My one complaint…
The end of the book’s Preface points to a website for extra e-freebies related to this book. That website seems to be abandoned. It’s a little disappointing, but don’t let this stop you from buying the book! Investing in yourself and your knowledge of the basics is the best investment you can make. At the very least, grab this book from your library!
Related Article
Retirement Income Planning & Life Cycle Finance
