On Financial Peace of Mind

The death of the middle class has been greatly exaggerated.  It’s not that future generations of this great estate won’t find themselves tested in a changing world. But an enormous quantity of wealth has been built up in the sixty-seven  years since the end of World War II.

The retirement of the generation of the baby boom will dominate the investment business for the next twenty years.  Its experience will shape the industry for the rest of the twenty-first century and beyond.  The shape of the industry, in turn, will help determine if there is to continue to be a “middle class.”

Old rules of thumb in the US, intended to provide guidance over a lifetime – the “three-legged stool” of employment- based pensions, social insurance and private savings – have been undermined by globalization.  Corporate plans promising defined benefits have all but disappeared. The Social Security retirement system is threatened by political strife.  Personal savings have been volatile, thanks to two stock market bubbles that burst, and very low interest rates in the years since.

New rules haven’t yet emerged.

So the appearance of a pair of books on the future of finance by eminent professors of the subject is very timely.  Robert Shiller, of Yale, and Zvi Bodie, of Boston University, are each at the top of their trade: Shiller as author of five books, including Irrational Exuberance; Bodie, as author of Investments, a market-leading textbook.  For all that, their books could scarcely be more different.   They make an interesting comparison.

You don’t get very far in Shiller’s Finance and the Good Society before you recognize that he is addressing mainly his students (and those who want to understand his students), expanding philosophically on his Open Yale financial markets course. Indeed, the first half of the book, under the heading of “Roles and Responsibilities,”  reads a little like, as he might have it, a Whitmanesque Song of Occupations: chapters on chief executive officers; investment managers; bankers; investment bankers; mortgage lenders and securitizers; traders and market makers; insurers; market designers and financial engineers; derivative providers; lawyers and financial advisers; lobbyists; regulators; accountants and auditors; educators; public good financiers; policy makers in charge of stabilizing the economy; trustees and nonprofit managers; philanthropists. Publishers and journalists apparently play no part in “the modern system of financial capitalism.”

No matter:  Shiller knows those roles, too.  The second half of the book consists of a series of thoughtful essays (not unlike the monthly column he writes for The New York Times business section) on various features of the financial landscape:  “Categorizing People: Finance, Artists and Other Idealists”; “Some “Unfortunate Incentives to Sleaziness Inherent in Finance”; “Speculative Bubbles and Their Costs to Society”; “Inequality and Injustice”; and so on.  By temperament Shiller is an inventor: he admires Henry David Thoreau chiefly because, as manager of the family business, he invented a new method of making pencil leads. Among the innovations to which Shiller contributed is, of course, the Case-Shiller Index of constant-quality house prices, an ingenious combination of conceptualization and hard work that ultimately supplied the pin that was employed by savvy traders to prick the housing bubble in 2007; also, with John Campbell, of Harvard University, a famous chart of stock prices since the late nineteenth century with which he warned forcefully of a stock market bubble.  Shiller himself has much more imaginative designs in mind (on which he holds several patents): macromarkets for instruments representing many sorts of risk not currently traded, including slow business, unemployment, and occupational obsolescence.  Shiller is understandably disappointed (if not exactly surprised) that, as a result of the recent crisis, the pace of innovation has slowed.

Here is the interesting opposition to the Bodie book. In Finance and the Good Society, the customer only appears on page 235 (of a book with 239 pages), and then disguised as “the public.”   This public requires “reliable information,” which can only be provided by advisers, legal representatives, and educators, “who see their role as one of promoting enlightened stewardship.”  If the public – individual investors – are able to benefit from such help, they will be less resentful and less inclined to believe that financial capitalism is being dominated by a “power elite.”

Bodie, on the other hand, and co-author  Rachelle Taqqu,  have from the beginning structured Risk Less and Prosper  around the discussions of a group of four men and women, composites, presumably, who meet periodically with a financial adviser, hoping to improve their investment performance. These individual investors are at center stage throughout. Bodie and Taqqu write,

Something has gone terribly wrong with the way we think about personal investing. Trustworthy investment advice for individuals is hard to find. Much of what goes for advice is filled with misleading promotions masquerading as education, and the result has been pervasive misinformation. Investors are not aware of how much risk they are bearing. Two stock market collapses in seven years have made these failings all too clear.

Their book is full of practical advice.  But there is no doubt about their basic target.  It is the mutual fund industry, with its 8,000 funds, and what they call “the credo of stocks-for-the-long-term” – the idea that a properly diversified portfolio of stocks somehow magically diminishes risk to the vanishing point.  (What if you retire and need money at a time when the market is down?  You can run through your savings pretty quickly in that event – see this column by Joe Nocera of The New York Times for a personal account.)

Instead, Bodie and Taqqu argue for relatively heavy dependence on US Treasury Inflation Protected Securities, or TIPS, and similar I-bonds, arranged in maturity “ladders” to produce substantially risk-free income as they mature.  I spend too little time in the market for wealth management to fully appreciate the difference between what they say is the conventional approach to managing several different portfolios, which they compare to assembling a computer system from components, and the goal-based method that they recommend.

But I am pretty sure they are right when they tout the advantages of fee-only compensation of personal financial planners and members of the Financial Planning Association as a means of cutting down on conflicts of interests, as opposed to advisers who charge a fee for service (commissions) and who are often paid by a third party (as brokers) to sell particular products.  (There is no discussion of index funds or TRIPS in Shiller, and Social Security shows up under “entitlements” rather than “safety nets.”)

Which system will win out?   The financial technostructure, as represented by the current array of firms on Wall Street?  Or a system that places less stress on personal responsibility for risk management, in the form of relatively simply financial products that require less (though still some) expensive financial advice?  Shiller notes that gross value added by financial corporate business has grown from 2.3 percent of GDP in 1948 to 9.1 percent in 2010 (not counting insurance!). Who is to say, he asks, whether that is too little or too much?  Perhaps the trend is inevitable, required by the advancing economy.

Then again, maybe not – or at least not that much Reading Shiller, I was reminded of another excellent theorist of the good society, John Kenneth Galbraith.  His 1967 book, The New Industrial State, Galbraith summed up a certain view of the power elite that was prevalent in those days. The industrial system, Galbraith argued, was a relatively autonomous, relatively beneficent alliance among giant corporations, and the executives who ran them – managers and planners, scientists and engineers – often at the expense of consumers, shareholders, would-be entrepreneurs and even bankers.  Galbraith was mildly critical of the apparatus he described, while Shiller is at pains to defend financial capitalism. But the memorable thing about The New Industrial State was the extent to which it failed to anticipate the broad turn towards deregulation of various sorts that was just ahead.

Shiller may be making a similar mistake. I understand the advantages of the banks and other huge financial corporations:  long-range planning techniques, slick advertising campaigns, vast sums for political lobbying. The recently enacted JOBS Act authorized hedge fund advertising for the first time, after all.

Myself, I have more confidence in consumer sovereignty, and the capacity of innovators and policy entrepreneurs to undercut the mutual fund industry’s claims to deliver superior performance.  No matter how old you are, pay attention. Keep your eye on Vanguard, those personal financial planners, and proponents, including Bodie, of the so-called “next generation” of retirement plans.

4 responses to “On Financial Peace of Mind”

  1. No matter how old you are, pay attention. Keep your eye on Vanguard, those personal financial planners, and exponents, including Bodie, of the so-called the “next generation” of retirement plans.

    Where’s the obligatory reference to Twain’s investing advice:

    Behold the fool saith, “Put not all thine eggs in the one basket” — which is but a manner of saying, “Scatter your money and your attention;” but the wise man saith, “Put all your eggs in the one basket and WATCH THAT BASKET.”

    The Tragedy of Pudd’nhead Wilson

  2. I have a formula for the Financial Peace of Mind you discuss in your letter: Read Barrons and as many good free financial blogs as possible; Use Vanguard or some other low cost supplier of index funds; work at least until age 72; and, know what the purpose of your investing is all about. Mike Whitney

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