Are You a Stock or a Bond?
Finance professor Moshe Milevsky has an important central message in his book Are You a Stock or a Bond?: your ability to earn money is an important asset that you must take into account when you decide how to invest your savings and plan for retirement. He calls this ability to earn money your human capital. The message that we should take into account our human capital is an important one, but I’m less impressed with some of the detailed messages in this book.
The basic idea of human capital is for you to look at the risk factors for your income and take them into account in constructing your portfolio. So, an investment banker whose income is “contingent on the vagaries of the stock market” might choose to invest a sizable portion of his savings in fixed income. On the other hand a tenured professor might choose a riskier portfolio.
In Milevsky’s tenured professor example, she has $250,000 and he calculates that she should borrow another $450,000 to invest a total of $700,000 in the stock market. He doesn’t say how he came up with this amount of leverage, but it looks a lot like the results you get when you misapply Modern Portfolio Theory (MPT). Some problems are that returns are not lognormally distributed, they are not uncorrelated over time, and you can’t borrow at the risk-free rate. Even just the interest rate on borrowed funds makes a big difference. MPT’s optimal amount of leverage is extremely sensitive to the borrowing interest rate. My guess is that a sensible amount of leverage for this tenured professor is far below $450,000. However, the main message that she should invest more aggressively than an investment banker makes a lot of sense.
Another part of the book that makes me uneasy is the positive talk about a number of financial products, such as index-linked notes, variable annuities, guaranteed minimum withdrawal benefits, etc. One section is devoted to methods of finding the right mix of such products in retirement. Milevsky says that many of U.S. versions of these products are good. The ones I’ve looked at in Canada are terrible. In principle, it is possible to design insurance products that change risk characteristics in ways that benefit both the client and insurance company. In practice, from what I’ve seen, such products are used to confuse people into giving away far too much of their hard-earned money.
On the positive side, Milevsky explains the importance of understanding longevity risk. Not knowing how long we will live forces us to be conservative with spending and we’ll likely leave much of our savings unspent unless we’re willing to risk running out of money. The alternative is to pool this risk in the form of a pension or annuity.
Other positives are the discussion of using insurance to protect your human capital, the benefits of diversification, and sequence of returns risk in retirement.
One interesting discussion concerned inflation. Milevsky says that as we age, our personal inflation rates are higher than the official inflation rate. He says “I assume that your required expenses and your personal inflation will increase by 5% to 8% per year.” So, he believes that your spending needs will rise faster than official inflation rates through your retirement. This directly contradicts the many commentators who say that we will all be content to spend less as we age. Personally, I will plan for spending that tracks the official inflation figure.
The title of one chapter is likely to raise some eyebrows: “Debt Can Be Good at All Ages.” Don’t worry, though. He’s not talking about overspending on credit cards or leasing cars. He’s talking about using leverage for investing in income-producing assets. I think he advocates leverage levels that are too high, but modest leverage can be used intelligently.
One particularly funny part of the book is a table of probabilities of a 50/50 event happening multiple times in a row: 50%, 25%, 12.5%, etc. A caption on the table attributes it to some other source. I don’t think it’s necessary to find a source for dividing by 2 a few times.
Another funny part was a discussion of “a stock, mutual fund, or investment that is expected to earn 15% on average, in the long run.” I haven’t heard anyone talk of long-term 15% returns with a straight face since the crazy tech bubble 15 or so years ago.
Despite my criticisms of parts of this book, it makes an important contribution in getting us to think differently about our human capital. I’m glad I read it even if I disagreed with some of the details.
The basic idea of human capital is for you to look at the risk factors for your income and take them into account in constructing your portfolio. So, an investment banker whose income is “contingent on the vagaries of the stock market” might choose to invest a sizable portion of his savings in fixed income. On the other hand a tenured professor might choose a riskier portfolio.
In Milevsky’s tenured professor example, she has $250,000 and he calculates that she should borrow another $450,000 to invest a total of $700,000 in the stock market. He doesn’t say how he came up with this amount of leverage, but it looks a lot like the results you get when you misapply Modern Portfolio Theory (MPT). Some problems are that returns are not lognormally distributed, they are not uncorrelated over time, and you can’t borrow at the risk-free rate. Even just the interest rate on borrowed funds makes a big difference. MPT’s optimal amount of leverage is extremely sensitive to the borrowing interest rate. My guess is that a sensible amount of leverage for this tenured professor is far below $450,000. However, the main message that she should invest more aggressively than an investment banker makes a lot of sense.
Another part of the book that makes me uneasy is the positive talk about a number of financial products, such as index-linked notes, variable annuities, guaranteed minimum withdrawal benefits, etc. One section is devoted to methods of finding the right mix of such products in retirement. Milevsky says that many of U.S. versions of these products are good. The ones I’ve looked at in Canada are terrible. In principle, it is possible to design insurance products that change risk characteristics in ways that benefit both the client and insurance company. In practice, from what I’ve seen, such products are used to confuse people into giving away far too much of their hard-earned money.
On the positive side, Milevsky explains the importance of understanding longevity risk. Not knowing how long we will live forces us to be conservative with spending and we’ll likely leave much of our savings unspent unless we’re willing to risk running out of money. The alternative is to pool this risk in the form of a pension or annuity.
Other positives are the discussion of using insurance to protect your human capital, the benefits of diversification, and sequence of returns risk in retirement.
One interesting discussion concerned inflation. Milevsky says that as we age, our personal inflation rates are higher than the official inflation rate. He says “I assume that your required expenses and your personal inflation will increase by 5% to 8% per year.” So, he believes that your spending needs will rise faster than official inflation rates through your retirement. This directly contradicts the many commentators who say that we will all be content to spend less as we age. Personally, I will plan for spending that tracks the official inflation figure.
The title of one chapter is likely to raise some eyebrows: “Debt Can Be Good at All Ages.” Don’t worry, though. He’s not talking about overspending on credit cards or leasing cars. He’s talking about using leverage for investing in income-producing assets. I think he advocates leverage levels that are too high, but modest leverage can be used intelligently.
One particularly funny part of the book is a table of probabilities of a 50/50 event happening multiple times in a row: 50%, 25%, 12.5%, etc. A caption on the table attributes it to some other source. I don’t think it’s necessary to find a source for dividing by 2 a few times.
Another funny part was a discussion of “a stock, mutual fund, or investment that is expected to earn 15% on average, in the long run.” I haven’t heard anyone talk of long-term 15% returns with a straight face since the crazy tech bubble 15 or so years ago.
Despite my criticisms of parts of this book, it makes an important contribution in getting us to think differently about our human capital. I’m glad I read it even if I disagreed with some of the details.
Every situation is different but I found for us, the sweat spot for leverage is arround 20%
ReplyDeleteMy debt is: low rate, long term, tax deductible, repayment is a tinny fraction of our income and it was used to invest into tax-efficient-productives-assets. In one word, this improve our cash flow
I admit we may reconsider this when we retire if this no longer make sense
@Le Barbu: Leverage is great when it works out well. If you maintained your 20% leverage and allocation to stocks through the 2008-2009 crash, then perhaps you have the right temperament for modest leverage.
DeleteWell, back in 2008-2009, our house was our biggest asset (55% of total), our portfolios were carrying a 2% MER burden. Our leverage (mortgage) was over 40% of our total assets, in fact, almost as big as our NW
DeleteNow, house is 30% of our assets, debt is 20% of assets (or 25% of our NW)average MER less than 0.20%
We could decide to choose the debt-free option but our big picture keep improving over years. What matter the most is our saving rate have been +/-40% for more than a decade now
We focus on saving rate (mimimize expenses), cash flow improvement, keep our taxes low, avoid fees and expenses when investing, keeping 3+ months EF in checking account etc
@Le Barbu: If I understand you correctly, you didn't begin taking on debt specific to investing until after the 2008-2009 crash. If this is right then you would have to consider yourself untested. The stock runup since 2009 has been so extreme that anyone who used leverage would feel like a genius. The recent small drop in stock prices has been only a very mild test.
DeleteSorry Michael, I dont pretend to be a genius (in fact, I just break even now)
DeleteCan you tell me what is the best situation between A, B and C:
A:household with a 200k$ debt, a 250k$ house and a 200k$ portfolio
B:household with a 200k$ debt, a 350k$ house and a 750k$ portfolio
C:household with 100k$ debt, a 350K$ house and a 650k$ portfolio
We were A back in 2008 and just chose to take the B path instead of the C one. To me, A is the worst of all 3 but B and C are pretty close.
@Le Barbu: It looks like I misunderstood your last comment because I thought your total debt (mortgage + any added leverage) was more today than it was back in 2008. In any case, I like C best, but B is good as well.
DeleteMichael, the difference between B and C is trivial and it's important to understand the pros and cons of each one. I choose B, you prefer C and it's ok.
ReplyDeleteWhat about my in laws (who think my "plan" is a silly one btw), lets call their D: 450k$ debt, 575k$ house, 50k$ portfolio, saving rate 5%. Household income about the same than our's. THIS would keep me up at nigth!
"Finance professor..."
ReplyDeleteAnd then I stopped reading.
I've come to prefer and seek out writings by actual market practitioners who encounter operational realities, instead of those who merely theorize about how a system could or should work.
@SST: I think you're missing out in this case because Milevsky has some interesting ideas on tontines. A tontine is the most efficient way I know of eliminating longevity risk.
DeleteAs I said, in theory...it might be efficient, but operationally?
DeleteWhy would you permanently forgo your capital? The baseline returns on a tontine would have to be much higher than an annuity (or even bonds) for example, to make that "swap" worthwhile.
And any tontine would most likely have to be administered privately to ensure a narrow section of participants (a public market tontine would be impossible to control). Even then, the returns of the fund would tip greatly in favour of those with even an ounce of actuarial knowledge. I'd simply search out a tontine populated by obese, heavy-smoking octogenarians and throw all I had into it.
@SST: The main advantages of a tontine over an annuity is that you could invest in equities and you wouldn't have to pay an insurance company to take on the risk of rising average longevity.
DeleteThere is no reason why you would have to put all of your money into a tontine, or any of it for that matter.
I think you're overstating the challenges of administering a tontine. If there were enough takers, you could just split them by birth year. Otherwise there would have to be some actuarial rules to handle different ages. Like annuities, you'd have to figure out who was still alive.
Interesting take on the book Michael. Seems high on academia but low on some common sense statements. I've read Pensionize your nest egg and 7 Most Important Equations by Moshe. I liked the first but as an average math guy the second one made my eyes glaze over.
ReplyDeleteI agree with you on some advantages of tontines and could be interested if these were properly administered and available at good cost/return.
SST, even if tontines were available its unlikely you would find the situation you describe with an effective tontine. One person trying to be significantly advantaged going in would defeat the nature of a tontine, and as Michael said some rules would have to apply.
@RBull: I'm always happy when a book makes me think about something in a usefully different way, even if I disagree with some parts. Thinking about a young person's human capital is definitely useful.
Delete