Book Reviews, Methodologies, Value Investing

Book Review of Worry-Free Investing by Zvi Bodie and Michael Clowes

The full title of this book is Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals by Zvi Bodie and Michael J. Clowes (2003).

Zvi Bodie is a very famous finance professor and co-author of a widely used textbook Investments. Michael Clowes is Editorial Director of Investment News and of Pensions and Investments.

Normally I would skip a book with such a title, but decided to give it a go as I was interested to see what Zvi Bodie has to say about actual investing. The book covers 3 areas: (i) investing for retirement, (ii) investing for children’s college education, and (iii) leveraging on your home equity for retirement.

So in terms of investing for retirement income, the logic flows like this.

  • Stock investments are too risky to be used as a reliable source of income for retirement, especially because you need to be able to consistently draw down funds for living expenses regardless of whether the markets are doing well or poorly.
  • You also need the amount you withdraw to be able to keep pace with inflation.
  • Hence the instruments that (i) keep pace with inflation, and (ii) are able to provide safe, predictable cash flows, are I-Bonds / TIPS.
  • So keep saving up today so that at the time of retirement, you can use I-Bonds / TIPS as a form of annuity to draw down.

The logic is simple and sound, and the guideline of replacement income being 70% of your pre-retirement income is a good guideline to maintain one’s standard of living.

It is interesting how many people are touting sophisticated trading and market timing techniques, while you have people like Warren Buffett recommending index funds, Mark Cuban recommending cash unless you have some informational advantage, Zvi Bodie recommending TIPS, and HFT traders placing their own money in index funds.

I’ll end with some quotes from Warren Buffett:

You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. 

Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.

I have good news for these nonprofessionals: The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th century, the Dow Jones industrial index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st century will witness further gains, almost certain to be substantial. The goal of the nonprofessional should not be to pick winners — neither he nor his “helpers” can do that — but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.

That’s the “what” of investing for the nonprofessional. The “when” is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs’s observation: “A bull market is like sex. It feels best just before it ends.”) The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never sell when the news is bad and stocks are well off their highs. Following those rules, the “know-nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.

My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.

Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm [i.e. keep holding if it is a solid business with good long-term prospects].


Six Steps to Worry-Free Investing

  1. Set a list of specific goals.
  2. Specify the amount of money you will need to achieve each goal.
  3. Figure out how much you need to save as a fraction of your earnings on the assumption that you take no investment risk (count your house as a retirement asset).
  4. Determine your tolerance for risk, based on your willingness to postpone retirement if necessary, and the security of your future earnings.
  5. Choose your risky asset portfolio after deciding how much of your wealth you are willing to put at risk.
  6. Minimize taxes and transaction costs.

Two Important Goals

  1. Achieving a minimum acceptable retirement income.
  2. Paying for a child’s education


Invest in Inflation-Protected Bonds

  • The safest way to assure that you don’t fall short of your goals is to invest in inflation-protected bonds.
  • No one can accurately predict the rate of inflation.

Features of I-Bonds

  • U.S. Treasury securities backed by the U.S. government
  • Sold at face value and grow with inflation-indexed earnings.
  • Can be redeemed into cash after 6 months.
  • Federal tax on interest earnings is deferred, state and local income taxes are exempt.
  • Fixed rate is announced twice a year, at the beginning of May and November.
  • Pays monthly with a composite rate (fixed rate + semiannual inflation rate based on change in CPI-U). Semiannual inflation rate announced in May is the % change in CPI-U from September to March. Semiannual inflation rate announced in November is the % change in CPI-U from March to September.

Features of Treasury Inflation-Protected Securities (TIPS)

  • Principal amount is adjusted for inflation, but inflation-adjusted principal will not be paid until maturity.
  • Semiannual interest payments are based on the inflation-adjusted principal at the time the interest is paid.
  • At maturity, securities are redeemed at the greater of their inflation-adjusted principal or par amount at original issue.
  • Interest payments are taxable when received. Inflation adjustments to the principal are taxable in the year in which such adjustments occur even though they will not be paid until maturity.
  • Only redeemable at maturity.
  • Can avoid paying taxes by holding them in a retirement account, e.g. IRA or 401(k) plan.

Calculate Annual Savings Required to Reach Your Target Retirement Income

  • To maintain your standard of living, experts recommend you should aim for a replacement income equal to 70% of your pre-retirement salary before taxes.
  • Scenario
    • Expect to retire 30 years from now, and live for another 20 years.
    • Making $50K a year now
    • Your salary increases in-line with inflation
    • You are able to invest in TIPS earning a fixed rate of 3% a year at the time of your retirement
  • Result
    • You need 70% * $50K = $35K (real income) a year during retirement.
    • Amount you need 30 years from now = 1/0.03 * [1 – 1/(1+0.03)^20] * $35K = $520,712.
    • Annual contribution needed to get to $520,712 in 30 years time = $520,712 / { 1/0.03 * [(1+0.03)^31 – (1+0.03)] } = $10,626
    • Hence you need to save $10,626 per year in each of the next 30 years (first payment of $10,626 starts immediately, not end of year 1).
    • You need to save $10,626 / $50,000 = 21.25% of your salary each year.

Compare with Single Premium Immediate Annuity (SPIA) If Available

  • Look for SPIA whose payments are indexed to inflation.
  • From the calculations above, if you put in $520,712 you can get $35,000 a year. Compare with what you can get from a SPIA.

Mutual Funds Investing in TIPS

  • American Century Inflation-Adjusted Bond Fund (ACTIX)
  • BBH Inflation-Indexed Securities (BBHIX)
  • Fidelity Inflation-Protected Bond Fund (FINPX)
  • GMO Inflation-Indexed Bond Fund (GMIIX)
  • PIMCO Real Return Bond Fund (PRRDX)
  • Vanguard Inflation-Protected Securities (VIPSX)


College Inflation Exceeds General Inflation 

  • From 1982 to 2001, college inflation has always been higher than general inflation measured by CPI.
  • The difference ranges between 1% to 8%, with average difference of 4.33% per year.

Invest in CollegeSure CDs using 529 Plans

  • Your 529 investment grows tax-free for as long as your money stays in the plan. And when the plan makes a distribution to pay for the beneficiary’s college costs, the distribution is federal tax-free as well.
  • There are only two states that have a truly safe investment option in their 529 plans — Arizona and Montana. That option is CollegeSure Certificate of Deposits (CDs). They pay an annual interest rate tied to the rise in college costs each year.
  • Don’t invest in age-based portfolios (which vary the asset mix over time), look to CollegeSure CDs or I Bonds.


Two Types of Home Equity Conversion Plans

  1. Reverse mortgage
  2. Sale plan

Sale Plan

  • Bank/insurance company buys your home now but allows you to continue to live in it for as long as you live.
  • You sell the house at a discount of its current value, and you have obligations about maintaining and insuring the house.
  • The buyer gets the house at a bargain price and also gets to keep any appreciation on the house while you are living in it.
  • Once you die or move out, the buyer takes possession of the house.

Reverse Mortgage

  • You take a reverse mortgage loan using the equity value of your house.
  • You get a lump sum or receive monthly payments. Each payment you receive plus the accrued interest on previous payments is subtracted from the value of your house, thereby reducing your equity.
  • When you die, the total debt, principal plus accrued interest, is paid off, and your heirs receive any remaining equity value.
  • There are upfront origination fees and insurance premiums of around 3-4.5%, so if you plan to move in the next few years, a reverse mortgage is probably not right for you because you cannot make back your upfront costs.
  • Payments you receive from a reverse mortgage are not taxable unless you go the reverse annuity mortgage route (lenders keep on paying even if you are no longer living at home).


Stocks Are Not Safe in the Long Run

  • The proposition that stocks are safe in the long run is false, and one you can’t afford to count on if your objective is worry-free investing.
  • Nikkei 225 peaked over 40,000 in 1989 and plunged to 8,879 by 2003.
  • You can never count on the value of your stock portfolio being sufficient to cover what you absolutely need at any point in the future.
  • Following an age-based strategy of automatically switching from stocks to bonds or bills as you approach your target date does not solve this problem because you may just be locking in a loss rather than a gain.
  • Stock prices will fluctuate randomly because new information arrives unpredictably over time. It does not matter whether the market is efficient or not.
  • The only genuine worry-free solution is to lock in your target at the outset by investing in default-free inflation-protected bonds that match your needs in terms of timing and amount.

The Sequence of Rates of Return Matters When You Withdraw Money

  • If you withdraw money during a 30-year investment period, the sequence of rates of return matters very much (e.g. +10%, -5%, +20% vs. -5%, +20%, +10%).
  • Even if the average rate of return is 10% per year, it makes a big difference whether the higher-than-average returns occur early or late in the 20-year span. If the below-average returns occur early, you can easily run out of money way before your expected retirement period.

Stocks Are Not the Best Hedge Against Inflation

  • During the 1970s, stocks were returning 5.9% per year while inflation was eroding prices at a rate of 7.4% per year.

Asset Mix Depends on Circumstances, Not Age

  • If you have more than enough assets to guarantee a comfortable retirement, you can invest the extra money in stocks.
  • If you have only enough wealth to provide income for yourself and your spouse, you may want to hold safe assets such as inflation-protected annuities.

Worry Free Approach: Bonds + Stock Options

  • One approach to taking risk is to invest enough in safe assets to cover your principal and invest the rest in risky assets.
  • E.g. you have $100K, you can invest $100K / (1.03)^3 = $91,514 in 3% inflation-protected bonds over 3 years, and use $100K – $91,514 = $8,486 to buy 3-year LEAPS (call options) on S&P 500 index. At the end of 3 years, you are guaranteed your original amount of $100K from the bonds, while being able to participate in the stock movement.

Beware of Convertible Bonds + Principal-Protected Equity-Participation Notes (EPN)

  • Convertible bonds face the risk of default, and can only be converted into the particular company’s stock.
  • EPNs are not inflation-protected, have issuer default risk, and can be overpriced due to fees.




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