Wednesday, January 30, 2008

“Worry-Free Investing” Book Review, Part 1

This is a review of the book “Worry-Free Investing” (Prentice Hall, ISBN 0-13-049927-7), by Zvi Bodie and Michael J. Clowes. This book is aimed at Americans, but many of the ideas are relevant to Canadians as well.

The authors are clearly very knowledgeable about a wide range of practical investment matters as well as academic work on investing. The book contains a lot of useful information and practical advice explained clearly. In this regard, it is much better than most investing and personal finance books.

The main drawback of this book is the overemphasis on safety. The authors recommend extremely safe investments that, unfortunately, offer low returns. To meet typical goals such as an adequate retirement income and paying for children to go to college, the safe investments recommended by the authors require people to save large amounts of money every year because they will get low returns.

The particular investments the authors recommend are Inflation-protected Bonds (I Bonds), and Treasury Inflation-Protected Securities (TIPS). The equivalents in Canada are called Real-Return Bonds (RBBs).

The idea of these investments is that they pay a guaranteed rate above inflation. So, if the guaranteed rate is 2% and inflation turns out to be 3%, you get 5%. But if there is some economic upheaval that drives inflation up to 10%, you will get 12%. This gives you inflation protection.

Many people will not be able to save as much as needed to make the authors’ investment strategy work. The result for these people is that they will be guaranteed to fail to save enough money. Riskier investments such as stock index funds offer the kinds of returns that give these people a much better chance of saving enough to meet their goals.

We have to question how the word “risk” is used in the financial world. It is used to mean the degree of uncertainty in how much money an investment will make. The value of stocks jumps around a lot and are therefore risky. Bank deposits are very predictable and are said to have low risk. But, if I don’t save enough in low-risk investments, then I will have a 100% risk of not having enough money when I need it.

Taken to the logical extreme of low risk, even I Bonds carry the risk of default by the US government. An even lower risk strategy is for you to give all your money to me. This gives you a guaranteed return of minus 100% with no uncertainty. Most people have to take at least some risk to achieve their financial goals. The challenge is to figure out what risks give you the best chance of getting what you want in life.

See part 2 of this book review in the next post.

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