---R.H., by e-mail from Camp Zama, Japan
A. Make one kind of risk disappear and another kind of risk will replace it. Put all your money in FDIC insured CDs, for instance, and you will eliminate market risk. Unfortunately, it will be replaced by inflation risk. While money market fund, CD, and short-term Treasury yields have risen in the last year, most are still well below the rate of inflation. Basically, you can only eliminate market risk by accepting a slow loss of purchasing power.
That's a rude reality. It's also why asset managers urge diversification.
But there is another way to skin this cat. Some big pension managers do it. It's called "immunization." Think of it as Extreme Risk Aversion.
Instead of setting an investment return goal, the pension managers ask how much cash they must deliver to retirees in each year going forward. Then they buy zero coupon Treasury bonds that will be worth that much money at maturity.
Suppose, for instance, you knew that you would need $50,000, in today's purchasing power, in each of the next 5 years. How would you make it certain?
If you had the money in a tax-deferred account, you would buy a Treasury inflation protected security that would deliver the equivalent of $50,000 for each year. In the current market, for instance, you would need about $50,000 in cash for the current year. Since near term TIPs currently provide inflation adjusted yields below 1 percent, you'd have to invest about $49,600 for year two, $49,100 for year 3, etc.
Each year that you "buy" ahead is an assured source of cash, with inflation protection. (Sorry, you'll still have to pay taxes so there is no protection from "tax risk.")
The more security you want, the more years of future income you would have to buy. Using an Excel model I built to approximate such things, you would need to invest about $480,000 to secure your purchasing power for 10 years, and about $690,000 to secure your purchasing power for about 15 years. How long you do this would be determined by how risk averse you were--- and the size of your portfolio.
And that's the rub.
Since Treasury inflation protected securities provide low returns after adjustment for inflation, it takes a lot of money to have an assured future income. You can only reduce the amount of money required by taking risks and seeking a higher return.
Fortunately, while you are buying years of secure funding, something nice is happening. Stocks are terribly volatile in any one-year period--- but the longer you hold your investment, the greater the probability you will earn a high inflation adjusted return. According to data from Ibbotson Associates in Chicago, the worst 15-year period for a portfolio of 50 percent large common stocks and 50 percent bonds (1929-1943) would have provided an annualized return of 3.82 percent during the period, beating the 0.1 percent inflation rate by 3.72 percent. The highest 15-year period was 1984-1998, 15.64 percent.
As a consequence, the remainder of your money--- if there was any--- could be invested in a mixture of stocks and bonds with high assurance of a greater than inflation return.
Is this a practical solution? Hardly. It only works if you have a ton of money.
The rest of us pick some amount of risk and try to live with it.
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