Exposing Fallacies in Investment

Business Times - 09 Dec 2009

Exposing fallacies in investment

That's the mission of Boston University professor Zvi Bodie, who is enraged at financial advisers' 'misinformation', reports GENEVIEVE CUA

A US-BASED professor yesterday slammed the financial industry for perpetuating investment 'fallacies' that do little to educate retail investors about risk and return.

These fallacies include the oft- repeated maxim that diversification reduces risk, and that risky assets such as stocks become safer as the holding period gets longer.

According to Zvi Bodie, Norman and Adele Barron Professor of Management at Boston University: 'In the US, there is a movement towards consumer (financial) literacy which is completely misdirected. The idea is to make consumers capable of deciding how much to save for retirement over time, and how to invest money. But the professionals don't even know how to do that.

'It's silly and counter-productive and disingenuous. It's a kind of fraud, an excuse for transferring risk from the corporate sector to the consumer sector.'

Prof Bodie singled out 'target date' retirement funds in particular as flawed instruments that only further the fallacies and ultimately do little to provide investors with a secure stream of income in retirement. He was speaking at a public lecture organised jointly by the Centre for Asset Management Research & Investments (Camri) and the Singapore Centre for Applied and Policy Economics. He is a visiting professor at Camri at NUS Business School.

Target-date funds, also called life-cycle retirement funds, are designed to mature at a point in time that should coincide with one's retirement age. Asset allocation and rebalancing are done automatically, so the allocation to equities reduces with age. In the US, such funds are a default option in retirement accounts.

They have, however, come under scrutiny since the financial crisis last year. Citing Morningstar data, Bloomberg has reported that target-date funds labelled 2000 to 2010 lost an average 23 per cent last year, with some dropping as much as 41 per cent. The average 2050 fund declined 39 per cent in 2008, while the Standard & Poor's 500 Index fell 38 per cent. There are a number of target-date funds here, including those managed by Fidelity and UOB Asset Management.

Prof Bodie says target-date funds are a misnomer and misleading. This is because they are mutual funds, and some allocate money to other mutual funds, which do not have a maturity date. This is unlike bonds, which pay income regularly and at maturity will deliver an investor's capital.

'What consumers want and deserve is a pension, where they make contributions and the contributions can vary,' he said. 'The end result at retirement should be a secure lifetime income that lasts as long as they live, with inflation protection.'

Prof Bodie contends that the technology exists to create such a product, but it will require active government involvement, and not just the private sector. 'We have the technology to do the right thing to satisfy the requirement for at least some minimum level of guaranteed inflation-protected income at that stage in people's lives when they are most vulnerable to risk,' he said.

Prof Bodie cited three common investment fallacies. One is that saving is for the short run and investing for the long run. But according to financial economics, saving means income minus consumption. Investment means selecting a portfolio of assets.

A second fallacy is that the only way to reduce risk is to diversify. In finance, however, the way to reduce risk is to hedge, insure or hold safe assets.

The third fallacy is that stocks become safe in the long run due to 'time diversification'. But if this were true, stocks would not carry a risk premium, says Prof Bodie.

An indication of how risky stocks are, the longer the horizon, can be gleaned from the pricing of put options. The price of such protection rises with the time horizon - a put option that matures in 25 years costs five times as much as a one-year option, says Prof Bodie.

He argues that conventional advice based on the mistaken principle of time diversification leads to portfolios that are riskier than consumers realise.

The starting point for a retirement portfolio should be 100 per cent inflation-proof guaranteed annuities, he reckons. This, however, is a big challenge in Singapore, where there are no inflation-linked bonds. Even CPF Life, the CPF's new annuity scheme, fails to provide any inflation protection.

Even with US Treasury Inflation Protected Securities (TIPS), the real yield has dropped; on 10-year TIPS, it stands at about 1.3 per cent.

Prof Bodie has written a book titled Worry Free Investing: A Safe Approach to Achieving your Lifetime Financial Goals. In the WFI toolkit, risk is defined as the possibility of earning less than the risk-free interest rate, and reward as the possibility of earning more.

The instruments are a set of default-free bonds of all desired maturities and a market index fund. The investor hedges essential cash flow requirements with bonds, and buys mutual funds to gain exposure to the market index.

That's my dilemma as well. Do I really need to take all the market risks when I can generate enough from bonds alone.

My conclusion was that it was well worth taking the risks if we are invested in well-capitalized blue-chips companies that have been consistently paying dividends, provided you have set aside an appropriate amount to generate the minimal income required from bonds. Diversification does not take away the market risk(systematic risk), but it does minimize company-specific risk(non-systematic risk).

But I agreed that time diversification (ie stocks will be safer over the long run) is a fallacy. If you have boom/bust cycle, the longer you hold your stocks, the more market(systematic) risks you are exposing your portfolio to, unless as he rightly points out, you hedge your portfolio. If you can't hedge, you take money off the table (that is my hedge). Even if it means I might have taken only half out of the market before it's too late, you would still be less devastated than having all your money in the market when bear comes.

Sorry for sounding like a market timer.. but... I like to think of it as know when to jump out of the way when you see an incoming train approaching.