Conversations with E21: Zvi Bodie on How to Make Sense of Markets in the Time of Coronavirus

Zvi Bodie is an expert on financial economics and retirement. He is a professor emeritus of finance at Boston University. 

He holds a PhD from the Massachusetts Institute of Technology and has served on the finance faculty at the Harvard Business School and MIT's Sloan School of Management. His textbook, Investments, coauthored by Alex Kane and Alan Marcus is the market leader and is used in the certification programs of the CFA Institute and the Society of Actuaries. In 2007 the Retirement Income Industry Association gave him their Lifetime Achievement Award for applied research.

How can people find security in these uncertain times?

We need to remember the principles of the risk management process, which is a systematic attempt to analyze and deal with risk and the unknown. The process can be broken down into five steps:

• Risk identification
• Risk assessment
• Selection of risk-management techniques
• Implementation
• Review

Risk identification is figuring out the risks you face. Sometimes it is not obvious because the biggest risks aren’t the ones you see coming. If you go to work every day, you may underestimate your risk of disability. Today, people are suddenly dealing with big, unforeseen risks—risks in markets, their health, and job loss—because they never anticipated the government shutting down the economy.

After you identify the risk, you can assess it. This involves measuring risk [all the different things that might happen and how probable they are], usually with data. What makes the current situation so difficult is that it is hard to assess. There are many unknowns, including how long this will last or even your odds of getting sick.

Once you identify and assess risk, you can decide how to best manage it. You can avoid risk, try to prevent it [an example is eating well or exercising to maintain your health], or decide to just bear it and hope for the best. But sometimes these options are not possible or are very expensive—like they are today. In that case, you can transform or transfer risk. This includes 4 basic strategies:

• Diversifying: owning lots of different risky assets so you aren’t taking any undue risk.
• Hedging: taking less risk and giving up upside; an example is buying I savings bonds (inflation-linked bonds that protect investor purchasing power) to offset the risk of stocks.
• Insuring: where you pay someone else to pay you if something bad happens, but you keep the upside in good times; an example is a put option on the stock market, a contract that ensures you can sell stocks at a prespecified price.
• Saving for emergencies: keeping an emergency fund of liquid savings for the unexpected.

Even now, you can buy insurance or hedge, though it can be expensive because put options are more expensive than normal (see chart below) and interest rates are very low.

After you decide on the best strategy, you implement it. Sometimes you need to shop around for the best price. Then you need to review it regularly because risk management is a dynamic process. You need to monitor how your strategy does as risk evolves, to check if it is still the right one.

We are seeing what seems like unprecedented volatility in markets. Will investing in stocks be riskier going forward?

Very few people I talk to know what tail risk means. Tail risk is an extreme and rare event. If risk is a probability distribution representing all the things that might happen and how probable they are, a tail risk is in the tails, extreme and improbable. This is a tail risk that was always there—the world is not riskier because it happened. This risk always existed.

Going forward, to get some clarity, take a look at the volatility index (VIX) term structure. The VIX is derived from the price of a put on the S&P 500. That price is based on how volatile people expect the market to be during the length of the put contract. The VIX tells you that volatility number, or how much risk markets anticipate in the future on the S&P 500. The VIX term structure is the volatility for different put contracts of different durations. It is normally sloped upward [because the future is riskier and unknown]. But now it’s going down. That means longer contracts assume less volatility—or risk—in the future.

This shows not only that markers expect to return to less risk, but also that you can still buy insurance. You can still buy a one-month put, but it is very expensive. Right now, that implied volatility is 60– 65%. Not too long ago, before the crisis, it was just 10–15%.

You’ve been warning about market risk for years. Can you relate to all the epidemiologists who have been warning about viral pandemic risks and were ignored too?

Yes, absolutely. Take Frank Snowden on the history of epidemics: this [pandemic] is one in a long chain. There’s a lot that we can learn from looking at history.

People often don’t realize the risk of stocks in the long run. Risk does not go away the longer you invest. People are often given financial advice that if you invest in stocks for many years, there is less risk because good times even out bad ones. But there is no such thing as a free lunch. If risk goes away if you invest for many years, so does your risk premium.

There is a paradox that misleads people—a heuristic—which is the probability of loss as a measure of risk. In this case, it is easy to show that the longer you invest, the smaller the probability of shortfall—which suggests stocks are safer in the long run. But that’s not the only thing that’s changing. The other thing is extreme loss; the tail is getting longer and longer on downside. You now have the possibility of 20 years of losing money in the market.

Now is a great reminder that tail risk is very real. Suppose you had invested in a target date fund 20 years ago and now you are ready to retire with 50% of the fund invested in stocks. You would be a very unhappy camper. For anyone who thinks the market has to bounce back soon, there is the example of Japan. In the 1980s, Japan was the second largest economy in the world, and many experts were predicting it would overtake the US by the end of the century. The Nikkei 225 peaked in 1989 at 38,951; hit a low point 20 years later in 2009 at 7,909; and, in 2020, it is at 23,828. Thus, after 31 years, it is down 39% from its peak.  This could happen in the US or any other country.

Does that mean now is not a good buying opportunity?

No, if you have the tolerance for risk, you would rather buy when it’s cheap than when it’s expensive. I am invested in stocks, but protect the downside with insurance.

You said we should use this time to build our human capital, what does that mean and how can people do that?

If you can take a personal sabbatical, you should take advantage of free sources on the Internet. My friend Bob Lerman, who is a labor economist specializing in apprenticeships, has written about how to use this time to build new skills. I just worked through Frank Snowden’s undergraduate history lectures to learn about major pandemics. Online courses from top scholars can be very good—there’s access to great free lecturers. This is a potential silver lining.

What principles of personal finance should this crisis reinforce?

Be prepared for the unknown unknowns.

The idea is to have an emergency fund. You never know what will happen. The last few months makes this perfectly clear. So many risks come out of left field. It is uncertainty, and when you have uncertainty you must assume the worst can be really bad and look for the safest thing. Build a cushion, as much as you can afford to save. I would invest the emergency fund in Series I savings bonds in which one can invest up to $10,000 per year. They are tax deferred and offer a certain, inflation-linked return. They are irresistible.

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