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.