The problem, he says, is that investment advisors are not taking a full measure of risk. The tenet typically used by advisors, and which is backed up by nearly a century's worth of data, is that stocks over the long run provide a better return than government bonds. Bodie doesn't argue this point, noting that from 1926 to 2000, the inflation-adjusted real rate return on stocks averaged 9.3% per year.
But there's more to this picture, Bodie states.
"The problem with that is the metric you are using for risk-the probability of a shortfall," he says. "Risk as we use it in the real world always has two dimensions. There's the probability of a bad thing happening. But the other dimension is the severity of a bad thing happening."
In other words, even though the risk of a stock shortfall declines as the investment horizon grows longer, the risk rises that a shortfall will be substantial. This is proven, Bodie states, by what it costs to protect a stock investment with a put option. For example, he says, insuring a $100,000 investment with a put option over a one-year period currently costs about $8,000. That same put option, however, would cost $40,000 if the time horizon were 25 years.
If stocks are safer the longer you hold them, Bodie says, a put option should be cheaper with a longer time horizon. But the cost of put options generally rise proportionally to the number of years going out, he says.
"As you go further out, the probability of a worst possible outcome" gets higher, he says.
Bodie doesn't claim to have discovered this principle. He notes that Paul Samuelson, a 1970 Nobel laureate in economics, spelled it out in mathematical detail in a paper published in 1969. It was a paper that also had an influence on Bodie, who was a doctoral student at MIT around the time of the paper's publication. In that paper, Samuelson noted that all the data on the long-term historical performance of the U.S. stock market was based on a sample of one.
In the early 1970s, in fact, Bodie decided to do his doctoral dissertation on ways to hedge against inflation. It was then that he began to embrace the value of inflation-protected bonds, as well as realize that practitioners weren't interested.
"What I discovered was that one of the obstacles to getting people to understand the value of inflation-protected bonds was this hellacious belief that stocks are safe in the long run," he says.
Ironically, one of Bodie's classmates at MIT at the time was Jeremy Siegel, the author of Stocks for the Long Run, which generally touts the long-term viability of stock investments based on historical data. Bodie and Siegel, it turns out, often run into each other's paths on the lecture circuit. Siegel pumps up the value of stocks in his talks, and at his Bodie wags his finger at stock devotees- as they did at the Financial Planning Association's convention in Philadelphia in early November.