Category: Risk Management
Bodie, PBS notes, is “perhaps country’s foremost expert on pension finance”
The NewsHour blog “The Rundown” features insight on little-known safer investing strategies by the School of Management’s Zvi Bodie, “perhaps the country’s foremost expert on pension finance.” Bodie is Boston University’s Norman and Adele Barron Professor of Management in finance and author, most recently, of the books Risk Less and Prosper and Essentials of Investing, 9th Edition.
In his latest NewsHour post, titled “The One Safe Investment and Why You Never Hear About It,” Bodie writes,
…I recommend that for people concerned about preserving the purchasing power of their savings, an investment program should start with the purchase of US Treasury Series I Savings Bonds, of which you can purchase up to $10,000 per year per person….I Bonds provide the ultimate in long-run liquid financial security to residents of the U.S. An investor in these bonds cannot lose any money or any purchasing power for up to 30 years, despite either inflation or deflation. They provide a return at least equal to the rate of inflation and, often, have paid a “premium” of interest above and beyond inflation.
At the moment, because of historically low interest rates, that premium is zero, but it is reset every six months. If, in September (or the following March or a year from September, etc.), new I Bonds do offer a premium, you can sell the current ones and use the money to buy the new ones.
Read the full post, see all the comments it has inspired, and watch a related video on “The Rundown” blog.
Palazzo, B. (2012). Cash holdings, risk, and expected returns. Journal of Financial Economics, 104(1), 162–185.
A recent paper by Boston University School of Management’s Berardino Palazzo, an assistant professor of finance, approaches the relationship between an organization’s savings and its vulnerability from a unique angle. His article, “Cash Holdings, Risk, and Expected Returns,” explores the link between a firm’s cash holdings and the broader, systematic risks it faces, rather than focusing narrowly on the relationship between cash holdings and the firm’s specific cash flow volatility, as previous finance studies have done. This study was recently published in the Journal of Financial Economics.
Palazzo follows a recent strand of financial accounting literature to derive a proxy for a firm’s exposure to systematic risk. His findings illustrate how such systematic risk affects firms’ optimal cash holding policies.
The Riskier the Firm, The Higher Its Savings
Palazzo points out that previous studies ignore the overwhelming likelihood that investors are risk-averse. Instead, his paper rests on the assumption that investors are not risk-neutral. “[R]iskier firms,” he writes, “have the highest hedging needs because they are more likely to experience a cash flow shortfall in those states in which they need external financing the most.” Thus, the riskier the firm, the higher its optimal savings are.
Using a data-set of US public companies, Palazzo finds:
- Changes in cash holdings from one period to the next are positively related to beginning–of–period expected equity returns; firms with a higher expected equity return will experience a larger increase in their cash balance.
- Using market size and current profitability as measures, or proxies, firms with higher expected profitability have a larger sensitivity of cash holdings to expected equity returns.
- When using a book-to-market ratio, this correlation is weaker—not a surprise, Palazzo notes, given that the book-to-market ratio is a catch-all proxy for many variables besides future profitability.
- The higher the correlation between cash flows and an aggregate shock—in other words, the riskier the firm—the more the firm hoards cash as a hedge against the risk of a future cash flow shortfall, meaning the higher the savings.
- High cash firms have more growth opportunities but lower current profitability and, as a consequence, they are less exposed to a variety of risks. However, such firms earn a larger and significant risk–adjusted return compared to firms with a low cash–to–asset ratio.
In the February edition of American Banker magazine, Boston University’s Mark Williams authored the commentary piece “Reduce Taxpayer Risk: Roll Back FDIC Limits.” Williams is an executive-in-residence and master lecturer at the School of Management, an expert on risk management, former Federal Reserve examiner, and author of the book Uncontrolled Risk: The Lessons of Lehman Brothers.
Reduce Taxpayer Risk: Roll Back FDIC Limits
FDIC insurance is more than just a sticker affixed to a bank door, it is a gold-plated guarantee that the government will step in and make depositors whole. Bank customers accept that they will earn a quarter of a percent or less on their deposits because they understand that their money is protected. And banks large and small benefit from this access to a cheap and dependable source of funding.
When it began, FDIC insurance provided depositors with only modest protection. The initial coverage limit in 1934 was $2,500, or less than $45,000 in today’s dollars. Six months later, the limit was raised to $5,000 (still less than $86,000 adjusted for inflation) and the risk-sharing arrangement between banks, depositors and the government was forever changed. As long as depositors stayed within set limits, they assumed zero risk. But if the dollar size of bank failures exceeded the fees collected from the banks, then the government, and taxpayers, would become the ultimate financial backstop.
In recent years, FDIC insurance has experienced mission creep. Having grown at over twice the rate of inflation, it now provides more than modest protection.
Few Americans have the means to keep deposits of $250,000 and benefit from this protection. Instead, the larger limits have tilted the risk-sharing in favor of wealthier depositors and banks themselves.
Read Williams’ full piece on American Banker.
When a spontaneous acceleration problem led Toyota to recall eight million cars globally and suspend sales of several models in November 2009 and January 2010, the blue-chip corporation faced a momentous challenge. To make matters worse, in February 2010, Toyota suffered another blow when reports surfaced of faulty brakes on the Prius hybrid. The defects have since battered the company’s reputation, resulting in huge losses and sinking consumer confidence.
There are two schools of conventional marketing wisdom on what companies should do in the event of such crises:
- Some experts argue that companies should spend more money and build brand loyalty before any crisis occurs, providing a buffer to declining profits following a crisis.
- Others argue that a portion of advertising budgets should be set aside in case a crisis does occur.
Boston University School of Management’s Shuba Srinivasan, Associate Professor and Dean’s Research Fellow, Marketing, (with co-authors Olivier Rubel and Prasad Naik), in the paper “Optimal Advertising When Envisioning a Product-Harm Crisis,” addresses how companies and their marketing managers can prepare for a potential product harm crisis. The paper, forthcoming in Marketing Science, demonstrates that there is an optimal course of action for incorporating risk into the allocation of marketing resources.
“Marketing managers are better served by spending less on brand loyalty up front and maintaining a reserve for a post-crisis period.”
Using empirical data from the automobile industry, the authors develop a dynamic model of sales growth that assumes a crisis will occur at random times in the future. Their findings complement theoretical models recommending the best advertising budget decisions that incorporate crisis planning. Using the 2000 Ford Explorer rollover problem as an example, they show that Ford’s baseline sales dropped 65 percent immediately following the crisis, which cost the company $3.5 billion. Advertising spend before the crisis was less effective in maintaining sales afterwards, when profits sank.
“Advertising spending after a crisis is more effective in building brand interest than before a crisis.”
The study’s implications suggest that marketing managers and their companies are better served by spending less on building brand loyalty up front and maintaining a reserve for advertising during a post-crisis period. Further, advertising spending after a crisis is more effective in building brand interest than before a crisis.
Overall, product crises are rare, but when they happen they can be devastating to a firm’s brand equity. Managers are well served by setting money aside from their marketing budgets to be available following a potential product crisis event as insurance against the possible damage to long-term brand equity.
More about the paper “Optimal Advertising When Envisioning a Product-Harm Crisis”
Marking Milestone with Day of Panels, Presentations, and Networking
Scott Stewart on the graduation of the 10th MSIM class.
Watch faculty director Scott Stewart speak at the graduation of the 10th MSIM class.
On June 19, 2010, Boston University’s groundbreaking MS in Investment Management (MSIM) Program celebrated its 10th anniversary with a day-long conference devoted to today’s markets, drawing a group of almost 100 senior investment professionals and School of Management alumni.
“BU invented MSIM. Our approach provides advanced training in the theory and application of investment techniques and is now a model for high-level investment education.”
-Scott Stewart, Faculty Director, MSIM Program; Board Member, Boston Security Analysts Society
Among the milestones recognized was MSIM’s status as the first graduate program in the nation to be named a CFA Program Partner, providing students with unique preparation and the background necessary for the CFA® exams.
The conference included:
- A keynote presentation on “The Present and Future of Fixed Income: From Investment Grade to Emerging Market Debt,” by Bill Nemerever, CFA, Co-Manager of Global Fixed Income at GMO.In his talk, Nemerever, whose firm GMO manages more than $100 billion, provided a survey of fixed income management over the past 40 years, as well as insights into the current sovereign debt crisis. He noted that monetary unity without political unity has led to the Greek financial crisis, urging that we should be most concerned not necessarily by Greece’s problems, but by the risks it can spread.
- MSIM Advisory Board “Mini-Case” discussions on institutional, private wealth, and hedge fund management.
- Research presentations on manager selection techniques, optimal asset allocation amongst alternative investments, and key determinants of successful education in investment management.
- A review of the topic “The Business Environment for Boston’s Financial Services Industry” with Jim Klocke, Executive Vice President of the Greater Boston Chamber of Commerce.
- MSIM alumni career panels on fixed income, equities, and alternatives investing.
- Networking activities.
Thank you to FactSet for sponsoring this event!
Learn more about the MSIM program in the podcast Benefits and Features of Our MS in Investment Management Program.
Inspired by the MSIM Program curriculum at BU School of Management
Designed to be First Comprehensive Textbook for Advanced Portfolio Management Courses
Boston University School of Management’s Scott Stewart, research associate professor in the Finance Department and faculty director of the MSIM Program, has co-authored a new textbook on investment strategy called Running Money: Professional Portfolio Management. The work delves into asset allocation, security selection, and the investment business at large.
“This work is written by experienced money managers who, for 10 years, have been teaching the very course that inspired the book.”
Running Money, by developing advanced portfolio management tools and illustrating their practice, exposes students to what they need to “run money” professionally. This new first edition text is ideal particularly for an elective course in Portfolio Management, providing advanced instruction in setting broad asset mixes, managing individual asset class portfolios, and making effective investment business decisions.
The work is published by McGraw Hill, and two chapters have been adopted for use by the CFA Institute in its continuing education program.
Boston University School of Management’s Kathy Kram offers insight into President Obama’s reactions to the BP oil spill in a recent interview with BU Today, Boston University’s online news source. Kram, an Everett V. Lord Distinguished Faculty Scholar and Professor of Organizational Behavior, discusses the intersections of temperament, leadership, and public image, saying,
“Obama has a temperament that is grounded in getting all the facts and thinking decisions through rationally. Temperament is basically nothing more than a set of preferences for how one wants to be in the world.
–Professor Kathy Kram
“In Obama’s case, the negative response is, where is his anger? Why isn’t he acting faster? Those responses are coming from people who might have different temperaments themselves or would have wanted a leader to act differently than Obama did. But I take the position that it’s really not a matter of right or wrong temperament. It’s what do you have to work with and whether it works for you most of the time.
“I would want him to be aware of the downside of not expressing his emotions — i.e., losing the support of some of the public. Then he would have to figure out if there’s a way for him to do that without seeming inauthentic or ineffective. There’s a danger of doing something that’s not really you; you come across as inauthentic and you lose credibility, too.”
Read more, in the article “Is Obama Angry Enough?,” by Leslie Friday, BU Today, July 7, 2010
This series of ten videos features School of Management Professor Zvi Bodie discussing crucial topics in personal finance. From the hidden risks in your 401k to the age you should retire, Professor Bodie covers much of the ground in his book Worry Free Investing.
- The Conventional Wisdom is Wrong (above)
- You’re on Your Own
- Set Realistic Goals
- The Safest Investment is T.I.P.S.
- BU Will Be the First to Offer It
- I Love the Stock Market
- Don’t Trust Anyone
- Stay in the Labor Force
- I Hate Losing
- Three Crucial Tips
- Zvi Bodie discusses the "Hurricane on Wall Street: Managing Large-Scale Financial Crises"
With co-author Richard Fullmer, Bodie responds to SEC’s new education Web site
World-renowned investment scholar Zvi Bodie, the Norman and Adele Barron Professor of Management at Boston University, has published an article in Investment News reiterating his long-held theory that investors need to better understand risk. Along with co-author Richard K. Fullmer, Bodie writes,
A few months ago, the Securities and Exchange Commission unveiled Investor.gov, a website devoted exclusively to investor education.
A press release quoted SEC Chairman Mary Schapiro as saying, “Investing information is available from thousands of online resources — some good, some not so good. Through Investor.gov, we are adding our own online voice to provide investors with unbiased and factual investing information.”
This effort is to be applauded. With the burden of funding retirement rapidly moving from institutions to individuals, investor education is needed now more than ever.
It is the presence of two key adjectives in Ms. Schapiro’s statement that makes this initiative so momentous: “unbiased” and “factual.” These aren’t words to throw about lightly.
Having spent the bulk of our careers studying financial economics in an effort to differentiate between fact and fiction, we were inspired by these words to reflect on the principles that should govern any program of investor education. Without question, the first guiding principle must be the doctrine of “primum non nocere”: First, do no harm.
Strictly speaking, unbiased and factual information is that which is 1) fairly presented without selective omission, and 2) supported by science and empirical evidence.
Guidance that violates the first part of this definition falls into the “not so good” category (to quote Ms. Schapiro). Guidance that violates the second part is just plain wrong….
The following are four examples of misleading statements found repeatedly on investor education sites:
- The risk of investing in risky assets decreases with the length of the holding period, and therefore, stocks are safer in the long run. Financial economists have long shown this to be a fallacy. That this may not be immediately intuitive is no excuse. Risky assets remain risky, no matter how long one holds them. Time doesn’t diversify risk.
- Stocks are effective as a hedge against inflation. The truth is that stock returns are largely uncorrelated with inflation. The safest and most effective hedges against inflation are inflation-indexed bonds backed by the federal government. Of course, the expected return on these bonds is relatively low — a trade-off for their safety.
- This tool computes the “probability of success” for your financial plan and should guide your investment decision making. This is a dangerous half-truth that confuses the science of probability measurement with the science of risk measurement. The probability of anything is never a complete measure of its risk. Risk measurement is concerned not only with the probability of events but also with the consequences of those events. Using the probability of success as a risk measure can mislead investors into using an overly aggressive investment portfolio, because the severity of the downside goes unaccounted for.
- Retirees need a significant allocation to stocks in the retirement years to provide growth in order to offset inflation and address longevity risk (the risk of outliving the portfolio). This is true only in the absurd. It is analogous to saying that those unable to pay back a debt “need” to visit a casino to “address” the risk of defaulting. The better advice is not to get oneself into such a predicament in the first place. The suggestion that people need to place their financial futures at risk is irresponsible. Risk taking is a choice, not a requirement.
Notably, each of these items errs on the side of excessive risk taking.
Is it merely coincidental that many investors have suffered unexpectedly large losses in their retirement accounts, just when they could scarcely afford to bear these losses, or did the guidance they received make it inevitable?
By no means are we saying that investors should shun stocks or other risky investments.
We are just saying that investors (and practitioners) need to understand the true nature of the risks involved in investing and financial planning. Only then can wise decisions take place.
The central thesis of investor education shouldn’t be based on the principle of taking risk first and worrying about the consequences later. Rather, it should be based on the principle of safety first.
Start by educating consumers on what is possible with minimal risk taking, such as with a diversified portfolio of guaranteed, inflation-protected income annuities. Then proceed to discuss the risk/reward trade-off of other investment alternatives — and be sure to use a scientifically sound risk measure that accounts holistically for both its probability and its severity.
From the article “Investors need to know the true nature of risk,” by Richard K. Fullmer and Zvi Bodie, Investment News, February 7, 2010.
On Tuesday, December 8, 2009, world-renowned retirement-investment expert Zvi Bodie, the Norman and Adele Barron Professor of Management at Boston University, gave a public lecture at the National University of Singapore.
Watch the video of his talk, The Next Generation of Life-Cycle Investment Products, here.