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Stocks: Even Riskier Than You Thought?

It is a fundamental tenet of popular financial theory: a long-term investment horizon makes the stock market a safe place to invest. It is a notion that brokers, investment advisors, financial planners, media pundits, mutual fund companies and independent online investment advice services rely upon when counseling individual investors to sink a large percentage of their retirement savings into the stock market. And it is, according to Zvi Bodie, Professor of Finance and Economics at Boston University's School of Management, a bunch of bunk. Stocks are never a truly safe investment, he says, because regardless of what they have done in the past, they can always go down-and that can put the retirement savings of the average Janes and Joes of this world at risk.

Bodie outlined his controversial views, which defied conventional wisdoms, sounding a bit like the Dr. Atkins of the financial world. The difference is that Bodie's work is highly regarded by his professional peers, whereas Atkins work has only recently received with some professional favor. Bodie's Investments textbook is used in university courses across the country. Unlike Atkins, it is primarily among practitioners that his views are deemed controversial.

Much of the backing for the "time makes stocks safe" argument relies on the groundbreaking work of economist Harry Markowitz and his mean-variance model, which was designed to optimize wealth at a specific end period. The historical long-term returns generated by stocks have not hurt, either. The respected research and consulting firm Ibbotson Associates has produced the definitive data series on US stock market performance since 1926, and it shows that since that time there has never been a 20-year period during which the US stock market has posted a negative return. But using this analysis to argue that long-term investments in the stock market are safe for retirement investors is flawed, Bodie says, because it assumes that investment success or failure is measured by the likelihood of reaching or not reaching some fixed level of assets by retirement age. Under that scenario, an investment plan with a mere five percent chance of not meeting the end goal might be considered acceptable. To Bodie's way of thinking, it is not, because the analysis does not take into consideration the degree to which the goal might be missed.

Conventional advice is to mitigate risk through diversification: by holding many stocks rather than a few, for example; by holding multiple asset classes (stocks and bonds); and by holding all those assets for a long rather than short period of time. Bodie says it is not enough. He says people also should use hedging and insurance to protect their retirement nest eggs. In his new book Worry Free Investing, he told forum attendees, he recommends that people invest their savings for basic retirement needs in relatively riskless investments such as inflation-indexed bonds, deferred annuities or Stable Value funds, and only turn to riskier assets once they have funded their basic needs entirely. Conservative investments such as bonds, annuities and Stable Value funds historically have yielded less than equities, of course, and Bodie concedes that as a result many people would need to save more than they are saving right now. However, he says, they should sleep easier at night.

"If you are saving enough to cover your basic needs, great," Bodie concluded. "Then buy lottery tickets or out-of-the-money call options with your assets that are above and beyond your basic needs. But do not believe the folks who tell you that by buying and holding equities, you are safe. That is what I call faith-based investing. It has no basis in science."

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