Zvi Bodie and the Keynes' Paradox of Thrift
Signal, Noise, and Success
Bigger Than a Breadbox
Link of the Month: Luigi and Raghuram Do It Again
Location: http://www.efficientfrontier.com/ef/903/index903.htm or here for a pdf version http://www.efficientfrontier.com/ef/903.pdf
Some quotes from Zvi Bodie and the Keynes' Paradox of Thrift
What's wrong with mass-market inflation-protected intermediation? Unfortunately, everything. First, TIPS, while relatively risk-free in the long run, can be rather nasty actors in the short run. As of this writing, the 29-year bond yields a real 2.7%; the 10-year bond, 2.1%; and the 5-year bond, 1.5%. To get those returns, the investor has to be willing to take about 12%, 6%, and 3% of (standard deviation) risk, respectively - not chopped liver, particularly at the long end. Bodie makes the same mistake here as his foils James Glassman and Kevin Hassett, who in Dow 36,000 postulated a new species of homo economus impervious to short-term volatility. At some point in the future, there will be a grinding bear market in TIPS (it may already have begun!), and it is a forgone conclusion that tens of millions of savers will sell out at the bottom, just as they have done historically and repeatedly with stocks.
I have been giving some thought to how TIPS should be evaluated in the portfolio and SWR. How important is the SD if you are okay with the original YTM and intend to hold until maturity a security issued by the US gov't? As % allocated to Tips increases, the importance of SD increases due to a lowered ability to withstand economic shocks/unexpected outlays and finding the need to sell prior to maturity.
As pointed out by Rob Arnott and Ann Casscells in the January-February issue of Financial Analysts Journal, stocks and bonds are merely a medium of exchange between retirees and workers. (In January, I discussed the Arnott/Casscells argument in these pages.) At any point in time, there are x number of workers producing goods and services for y number of retirees. If there are too many retirees and not enough workers producing goods and services for them, it does not matter how well the retirees have saved in the aggregate - their standard of living will fall as the prices of their securities - TIPS included - deteriorate and the wages of workers rise.
Actually I think TIPS may be one of the few good investments in this scenerio as it will allow you to purchase the same quantity of goods & services at maturity.
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.
If bought before November, I bonds are a reasonable choice if you will need your $ in 1-2 years. FYI - After this year, you wil no longer be able to purchase paper savings bonds.
I Bonds:
4.66% for 6 months
3.10% est (1.1% fixed+ 2% inflation) for 6 months - 3 month penalty
About 3.1% for a year (assumes you sell after 1 year)
Good reading!
Oliver