Risk Less and Prosper

12/27/2011 02:30 pm ET | Updated Feb 26, 2012
  • Kent Smetters Professor of Business and Public Policy, Wharton School of the University of Pennsylvania

The new investor book, Risk Less and Prosper, by famed Boston University finance professor Zvi Bodie and leading financial advisor Rachelle Taqqu, is a good read for those of you who are skeptical of investing in today's stock market. But it is a must-read for those of you who actually think that you know what you are doing. Nobel prize winner Robert Merton wrote the book's forward.

Bodie and Taqqu challenge much of the conventional wisdom about investment advice. The biggest myth they explore is that stocks are less risky the longer that you hold them. While very few economists really ever believed this idea, it is widely practiced by financial advisors. That's unfortunate. In fact, recent research by my colleague Robert Stambaugh at Wharton and Lubos Pastor at Chicago demonstrates that the expected return to stocks is so uncertain that longer-horizon investors should maybe hold fewer stocks.

Besides challenging "what" to invest in, Bodie and Taqqu also challenge "how" to think about investing altogether. Most investment advice pitched by financial advisors is terribly naïve, even if supposedly based on "modern portfolio theory." In essence, most financial advisors construct investments based on a client's "risk tolerance" that is judged by asking them a series of hypothetical questions. Once created, this same portfolio is then applied across almost every potential goal of the client including, for example, a wedding next year, a house down payment, college, cars, vacations, and even retirement. This simpleton procedure is the basis of calculations by almost all popular software packages being used today by financial advisors.

Instead, Bodie and Taqqu argue for a more real goal-based approach. Each goal should be matched with its own appropriate investment. Basic living expenses during retirement should be financed by low-risk investments, for example, Treasury inflation protected securities held in tax deferred retirement accounts. Only less important goals should be financed by taking on more risk. Of course, the Bodie and Taqqu approach would require additional saving and sacrifice today since the expected returns to safe investments are lower than risky equities. But don't let appearances deceive you: the larger expected return to equities is simply a reward for taking on more risk. Any advisor who tells you otherwise is selling you fool's gold.

As a professor, I like Risk Less and Prosper because it forces academics to think more critically about the variety of different risks and priorities that exist in the real world. As an actual practitioner -- I closely advise Veritat Advisors -- the book is consistent with how we generally think about risk management. (Disclosure: Zvi Bodie serves on Veritat's board of advisors.) For you as the reader, this book will give you the confidence to start taking control of your financial life again by avoiding a lot of dumb risks and marketing pitches along the way.