New Issue of Efficient Frontier by William J. Bernstein

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Oliver
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New Issue of Efficient Frontier by William J. Bernstein

Post by Oliver »

A new ssue!

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
Kramer
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Post by Kramer »

Thanks for posting the quotes, Oliver.
Oliver wrote:
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?


I think the part that is important to the SD is the yearly taxable inflation adjustment portion. If I remember correctly, the principal is adjusted annually, and you must pay income taxes on this adjustment in the year you receive it, even though you receive no cash for it since it is just an accounting entry. So that is the "lumpy" part of the distribution, your distribution is effectively reduced in real terms in eras of higher inflation because of taxes due. Overall, though, that means your effective SD is pretty low, lower than the actual figures quoted in the article, as long as you do not sell before maturity.

Oliver wrote: 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.


Right, if you can get them with a decent real return. But Bernstein's point is that you will not be able to purchase TIPS at much of a real return above inflation adjustment because of limited supply, and when you throw in taxes for either TIPS or I-bonds combined with moderate inflation, you effectively can end up with negative purchase value over the long term.

This article was certainly illuminating for me. I have always regarded the TIPS return as a lower bound for the SWR. However, it appears that reinvestment risk is much higher than I anticipated.

Also, I wonder what the extent of our demographic issues will really be (apart from TIPS)? I know there is a lot of immigration into the US, and the boomers' kids will be entering prime money making years after awhile, and apparently boomers might be working longer. Also, it appears that the primary demographic effects Arnott & co. talk about are not increased taxation (for instance to fund medicare and SS), but just plain fewer people working and the subsequent inflation.

Kramer
peteyperson
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Post by peteyperson »

In the UK, we have treasury inflation-protected gilts which carry an inflation return free of taxes (so free that you are no even required to put the investment on a tax return) and the 2-2.5% coupon is taxable.

Still have to read the UK Gilts PDFs to see how these are bought.

Petey
Kramer wrote: Right, if you can get them with a decent real return. But Bernstein's point is that you will not be able to purchase TIPS at much of a real return above inflation adjustment because of limited supply, and when you throw in taxes for either TIPS or I-bonds combined with moderate inflation, you effectively can end up with negative purchase value over the long term.

This article was certainly illuminating for me. I have always regarded the TIPS return as a lower bound for the SWR. However, it appears that reinvestment risk is much higher than I anticipated.

Also, I wonder what the extent of our demographic issues will really be (apart from TIPS)? I know there is a lot of immigration into the US, and the boomers' kids will be entering prime money making years after awhile, and apparently boomers might be working longer. Also, it appears that the primary demographic effects Arnott & co. talk about are not increased taxation (for instance to fund medicare and SS), but just plain fewer people working and the subsequent inflation.

Kramer
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ataloss
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Post by ataloss »

Also, I wonder what the extent of our demographic issues will really be (apart from TIPS)? I know there is a lot of immigration....


Scenarios look bad if past trends continue (early retirement, increasing benefits for seasoned citizens, delayed entry to the workplace due to education, training for young people) something has to give. Probably it will be a combination of things. I am not entirely sure that the government couldn't finesse the cpi since it will have lots of obligations (pensions, ss, tips) tied to that rate. I read a Canadian article (can't recall if I posted it) suggesting that the dependency ratio nonworkers/workers in the future will be similar to the baby boom in the 50s (but the big growth in dependents was in the childhood range at that time) Obviously there would be political problems with deciding to adjust ss, tips at less than cpi but I see no reason that the "basket" of goods and services couldn't be manipulated :wink:
Have fun.

Ataloss
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Post by wanderer »

Obviously there would be political problems with deciding to adjust ss, tips at less than cpi but I see no reason that the "basket" of goods and services couldn't be manipulated

Someone said something to the effect of, "We have gold because men can't trust governments." VGPMX, here I come! :wink:
regards,

wanderer

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Re: New Issue of Efficient Frontier by William J. Bernstein

Post by raddr »

Oliver wrote: 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.


Hi Oliver,

I'd like to believe this too but I'm very leery of our (US) govt. underestimating inflation and manipulating CPI numbers to TIPS's detriment. While govt. TIPS obligations are pretty small, SS obligations are huge and our govt. has to pay inflation adjusted benefits. By biasing CPI numbers downward a bit the govt. would save a boatload of cash over the coming decades. :P
Oliver
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Post by Oliver »

FYI

Oliver
Zvi Bodie's reply to Bill Bernstein. Reprinted with permission.

Dear Bill:

I just read your essay "Zvi Bodie and the Keynes' Paradox of Thrift" at http://www.efficientfrontier.com/ef/903/bodie.htm. In it you both praise and criticize the new book I have written with Michael Clowes, Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals. Naturally, I enjoy the praise, and I thank you for it. I enjoyed the criticism a bit less, but I thank you for it too.

At first it struck me as odd that you would criticize the book for not doing what it was never intended to do. After all, WFI is a guidebook intended to inform individual investors about the new inflation-protected bonds that have emerged since 1997. It is not about market equilibrium or public policy. Upon reflection, however, I have concluded that we should have briefly addressed the general equilibrium and public-policy implications of the investment strategies we presented. If there is a second edition, we will surely do this.

I must say that I do not agree with the conclusions in your essay. As you are probably well aware, the issuance of inflation-protected bonds by the U.S. Treasury has long been advocated by respected economists from both ends of the ideological spectrum. It was one of the few policy issues on which both James Tobin and Milton Friedman could agree. In an earlier era, Irving Fisher advocated it too.

I am not sure what Keynes thought about it. My guess is that he would have approved. The vast majority of economists believe that general welfare improves when the number of distinct competitive markets increases. A market for inflation-linked bonds makes possible improved price discovery and a broader set of opportunities for the trading of risks. The real interest rates which clear this market are not completely predictable and will change over time in reaction to all sorts of demand and supply factors. I do not know what the "best" level for these rates is.

One thing I do know for sure, however, is that Keynes meant his "paradox of thrift" to apply only to a situation in which there is substantial involuntary unemployment as in the early 1930s in the UK and the rest of the economically developed world. His later writings --from the World War II period-- make it clear that he did not think it relevant to an economy experiencing full employment. I would argue that in the U.S. we are currently much closer to a situation of full employment than to the situation that existed during the 1930s.

Best Regards,

Zvi Bodie
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VGPMX

Post by bubbabill »

Wanderer said:

Someone said something to the effect of, "We have gold because men can't trust governments." VGPMX, here I come!

The Vanguard web site says that VGPMX is "closed to all investors".Scudder,Fidelity, and American Century all have gold funds that are open.

Bubbabill
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