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The stock market is doing better. The rise in stock prices is a relief for the millions of Americans who poured their savings into equities over the past decade to fund their retirement, children's education, and other long-term goals, only to watch much of it vaporize during a three-year bear market. But is it time to hike your commitment to stocks and make up for lost financial ground? You can find lots of stocks with mojo -- or at least that's the impression I got from a finance TV show I had on while writing this commentary in a hotel room in Pasadena, Calif.
I'm in the camp that believes this isn't another false rally. It's not what Wall Street likes to call a dead-cat bounce, like what happened in the fourth quarter of 2001 and 2002. No, this momentum is genuine, reflecting widening corporate profit margins and an economy on the mend. Still, I would hold off betting big on stocks to fund lifetime financial goals until you've had time to read Worry-Free Investing by Zvi Bodie and Michael J. Clowes. The authors are a finance professor at Boston University and editorial director of Pensions and Investments and Investment News, respectively.
NO HEAVY LIFTING. Worry-Free Investing is a book for the times. Much as Wharton finance professor Jeremy Siegel's 1994 book Stocks for the Long Run was associated with the once-in-a-lifetime bull market of the '90s, Bodie and Clowes' investment advice resonates with the harsh lessons of the recent bear market. Instead of asking "How much money will I make?" their fundamental financial question is "How much can I afford to lose?" They believe stocks, even when held for long periods of time, are too risky for many people to achieve financial security.
Instead, their idea is to lock in a long-term standard of living while taking as little risk as possible. Their preferred investment is U.S. government inflation-protected securities that preserve the purchasing power of a dollar against the ravages of inflation. Other investments they highlight include the value of Social Security, annuities, and a home. Worry-Free Investing is simply written and well-illustrated with examples. The authors walk you through the mathematics of their computations so you can do them on your own with a simple calculator.
Their timing may be on target, but their basic message is timeless. The economic idea underpinning the book is that most people don't want to get rich, or perhaps more accurately, aren't willing to take the risks that could just as easily lead to bankruptcy as a flush bank account. No, most people want to sustain their standard of living throughout their life. The way to accomplish that is to limit downside risk and preserve the value of money set aside that you'll tap in your golden years.
ROLLING THE DICE. "If you want to sleep nights secure in the knowledge that you will achieve your savings goals, you must invest in a way that eliminates the possibility that inflation will undercut your efforts," write Bodie and Clowes. "If you try to do it by saving less and expecting the stock market to do the heavy lifting, you may not get there at all."
Of course, this means you would have to save more than many people plan on or hope for. Let's take their example of a 35-year-old expecting to retire in 30 years and live 20 years after retirement. The current income in the example is $50,000 a year. The person has no assets. Two other key assumptions is that this 35-year-old will always earn $50,000, after adjusting for inflation, and that she'll need to replace only 70% of her income in retirement to maintain her standard of living.
The money she saves goes into inflation-adjusted securities, such as I-bonds, and she'll earn a real 3% on her money. How much does she have to set aside? A hefty 21.25% of her income, say the authors. That's crazy, right? Well, Bodie and Clowes argue it's not quite that bad since she needs to set aside only 11% of her income every year after taking Social Security into account. That's still a high hurdle to meet, but it's also realistic.
The authors don't dislike stocks. They just think stocks are much riskier than conventional wisdom holds, and that it's sensible to roll the stock market dice only after locking in your baseline financial goals. The trajectory of stock market returns is far more complicated than what's suggested by a casual glance at a graphic charting average annual gains of 10%-plus from 1926 through 2003, they say.
WALL STREET WANNABES? Bear markets follow bull markets, and stocks can languish for lengthy periods of time, which can seriously cut into retirement income. The Kennedy-Johnson-era bull market peaked in early 1966 with the Dow Jones industrial average hovering around 1,000. But it was still struggling to break though the 1,000 barrier 17 years later. The Dow declined by some 60% during that period after taking inflation into account. Imagine if you had retired in 1966 expecting to largely live off a stock portfolio.
Personally, I remain convinced that a broad-based equity index fund should form the core of any long-term portfolio. But I still like this book's emphasis on maintaining living standards and preserving the value of capital. I also think far too much investment advice assumes the average worker secretly harbors an ambition to be a Wall Street trader, cashing in on the next hot stock. I don't know many people who work hard for their living, volunteer in their community, and spend time with family and friends who also enjoy staying up late at night poring over a stock prospectus.
Instead, most of us periodically invest in the markets through a 401(k) plan or a 529 college savings plan. We're taking out an insurance policy against running out of money in retirement or forcing our children to borrow too much for their education. Worry-Free Investing shows you how to do just that.
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online Edited by Beth Belton
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