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Common Stocks as a Hedge Against Inflation

Article  in  The Journal of Finance · February 1976

DOI: 10.2307/2326617 · Source: RePEc

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Zvi Bodie
Boston University
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 BODING WELL ON VOODOO FINANCE
Professor Zvi Bodie has long challenged conventional wisdom on retirement
saving. His textbook, Investments (co-authored by Alex Kane and Alan Marcus) is

Y
the market leader and is used by the CFA Institute and the Society of Actuaries.

ou have some controversial views on how
to save and invest for retirement. Professor
Bodie, in your opinion, what is wrong with
conventional wisdom?
Zvi Bodie: Well, it’s an axiom of modern finance that
if you hold stocks long enough, they are bound to
outperform all other asset classes. This is a fallacy. Paul
Samuelson exposed it back in the mid-60s. You should
not believe the risk of equities goes away in the long
is junk science. Stocks are as risky in the long run as
in the short run. In some ways, they are even riskier.
Does this have something to do with the
“Bodie paradox”?
One of my concerns is that people mistake the proba-
bility of a shortfall as the right measure of risk.
However, the probability of a shortfall is a poor
measure as it does not take into account the severity

?
run even though this is often promoted in so-called of the shortfall. In my work, I have offered an alterna-
investor education material. This is voodoo finance. It tive measure that takes into account both severity

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 FOCUS
and probability. This is based on the market price of
insuring against a shortfall using put-options.
If you graph this, you get what friends call “Bodie’s
Paradox.” What happens is that the probability of a
shortfall relative to safe assets does seem to decline
as the time horizon extends. This seems to imply less
risk the further out you go. But if you look at the price
of a put-option to protect against the shortfall, it is
exactly the opposite. It becomes higher the longer you
go. This reflects the fact that the potential severity of
the shortfall is becoming progressively worse. And this
is not taken into account when you just look at the
probability of a shortfall.
What factors should drive an investor's asset allo-
cation over time?
One has to take the trade-off between risk and return
seriously. You start off by deciding what is essential for
your needs in retirement and, if part of plan is to have
a solid base that you can rely on for retirement income
and to have it protected against inflation, then you
ought to match that with investments that will deliver
that type of income. In the US context that means infla-
tion protected bonds and annuities.
How should individuals invest and
spend in retirement so they don’t
outlive their assets?
I am a fan of life annuities. In the last
couple of years a few have emerged
offering inflation protection. I
recommend them
The
risk in
stocks will
decrease over
time: for most investors
this is strategy, for
Bodie it is like relying
on magic for returns.
View publication stats
ZVI BODIE
Zvi Bodie, born in 1943, is a professor of finance at Boston
University. An advocate for risk-free retirement investing,
Professor Bodie has published widely on pension finance,
investment strategy, and safe approaches to personal
finance. He holds a PhD from the Massachusetts Institute of
Technology and has served on the faculty at the Harvard
Business School and MIT's Sloan School of Management.
to my older relatives because they’re guaranteed not
to outlive their income stream and not to have it eroded
by inflation. But annuities have heavy load fees.
The 4% annual withdrawal rule is one piece of
wisdom, is this also flawed?
My main criticism of the 4% rule is that it is one-size-
fits-all. We need an efficient and relatively inexpensive
way of customizing solutions for different people. The
industry needs standard configurations that can be
tailored to individuals in different situations.
What is wrong with target date funds? How would
such a fund be constructed to match your ideal?
Target-date funds are misleading. The name implies
retirement is made secure by matching the date of the
fund to a planned retirement date. But TDFs offer no
guarantees. What happens at the target date is that
the customer gets whatever the current value is. The
customer assumes all the risk. That is exactly the kind
of incentive structure customers don’t need or want!
I think our new, sobering financial reality provides
convincing proof that you cannot rely on equities to
provide a safe target date for a portfolio. So surely, guar-
anteeing some minimum level of inflation-protected
retirement income should be a prerequisite for certi-
fication as a qualified default investment.
Are “Absolute Return” Funds a suitable recom-
mendation for retirement savings (intending to
provide protection and upside participation) and
should they be preferred over life cycle products?
What is needed is guaranteed lifetime income that is
protected against inflation. As they approach retire-
FOCUS
ment employees should convert part of their retire-
ment assets into inflation-linked life annuities. Such
annuities should be a “qualified default payout alter-
native” at retirement. I believe that in the next decade
we will see a transition to more end-user oriented
investment products. There will be a whole new gener-
ation of retail life cycle products. One current emerging
example is inflation-indexed life annuities. The next
stage will be various types of guaranteed products that
have equity kickers that let an investor participate in
the upside in a very controlled way – a way the investor
and the investor’s advisor can easily understand.
You’ve used the analogy of surgery to explain the
dangers inherent in average
people making complex asset de-
cisions. Are we expecting too
much from the average investor?
One of the fallacies of our current
»
...we pretend
system is that we pretend that ordi-
nary people can make sophisticated
that ordinary
financial decisions. Most people people can make
work, raise families, spend time with sophisticated
friends, volunteer in the local
financial
community and so on. Yet, on top of
all that, they're supposed to know
decisions . . .
how to allocate investment assets for I don’t think that
when they retire up to 30 years from is realistic.
now. I don’t think that is realistic,
Z VI BOD I E
«
even for people who may be brilliant
in their own fields of endeavor. If
defined contribution investing was
medicine, we’d effectively be saying
“Insurance no longer covers surgery, so you’ll have to
do it yourself after reading this brochure.”
What is the alternative? Do you think employers
should take a stronger fiduciary role for employ-
ees when it comes to the design and organization
of retirement products?
We need plans with DB features that provide guaran-
teed income for people, but don’t think it should be
private sector employers that offer them again. I think
we need financial intermediaries to do that for people.
The 401(k) plans are moving in that direction with
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target date accounts where people are not in charge
of their own asset allocation. This recognizes that
people want the process automated. They don’t want
to or are not able to plan on thier own.
What minimum features should a “Default Option
Investment Strategy” of a DC pension plan have?
The default choices offered in self-directed retirement
plans should have principal protection. In the US,
corporate plans never offered inflation protection, and
were never really safe or portable. Yet, for people who
lack investment knowledge, this is exactly the features
you want. It is something resembling a DB plan
without the limitations, an insurance-like benefit –
only better because it is portable.
With an individual account you’ll be
able to take it with you even as you
change employers.
Does this imply financial advisors
will play a more important role in
people’s personal finances?
I think competition will develop
during the next decade as baby
boomers reach retirement, receive
all this money from 401(K) or other
plans and search for greater security
so they don’t outlive their assets.
Financial innovation is on the way
because of the technology revolution
and major advances in the theory
and practice of financial risk
management. Inflation-proof per-
sonal pensions will become widely available to all. The
challenge will be to produce and distribute them effi-
ciently. I think the role of financial advisors will be to
explain these products to people, to keep abreast of
the latest developments in the field and guide clients
towards the products that make sense for them – not
spend their time explaining asset allocation mixes.
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Further information at
www.zvibodie.com