Inflation Hedge - Fama/French/Repetto

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Robert T
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Inflation Hedge - Fama/French/Repetto

Post by Robert T » Thu Jan 28, 2010 12:41 am

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May be of interest - views from Fama, French and Repetto on TIPS.

From Ken French: http://www.dimensional.com/famafrench/2 ... hedge.html
KRF: As Gene says, TIPS are a great inflation hedge, particularly if you buy a bond that matches your investment horizon. For example, suppose you plan to spend a lot of money in ten years and you buy a ten-year TIPS with a promised real annual yield of 2%. The face value of the TIPS is adjusted every six months for the level of inflation over the last half year, so your dollar payoff grows with inflation. As a result, if we ignore the effect of taxes and uncertainty about the rate at which you will be able to reinvest your semi-annual interest payments, your average annual real return over the next ten years is sure to be 2%. Thus, regardless of what happens to inflation, you know exactly how much real spending power you will have in ten years.
From Eduardo Repetto: http://www.dfaus.com/pdf/DC_Services_DC_Focus_1q08.pdf
TIPS are the natural hedge against inflation risk and should be used as the lowrisk asset.
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Post by chicagobear » Thu Jan 28, 2010 8:40 am

"...if we ignore the effect of taxes..."

My problem with TIPS.

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TIPS are a great matching strategy asset

Post by bobcat2 » Thu Jan 28, 2010 9:16 am

Quote from French.
TIPS are a great inflation hedge, particularly if you buy a bond that matches your investment horizon.
Exactly right. TIPS should be the primary asset of your matching strategy for retirement. They become little more than another relatively safe bond if used as part of a diversification strategy for retirement. This simple but fundamental point seems to be difficult for many people to grasp.

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In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

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Post by dbr » Thu Jan 28, 2010 10:34 am

TIPS should be the low risk asset, which also means they will be the low return asset. Hopefully that is understood.

I don't think the concept of investment horizon is simple in any way, shape, or form, and that confuses many people.

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Post by ddb » Thu Jan 28, 2010 10:38 am

chicagobear wrote:"...if we ignore the effect of taxes..."

My problem with TIPS.
Is it a problem because you have insufficient tax-deferred space in which to hold TIPS?

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Re: TIPS are a great matching strategy asset

Post by Beagler » Thu Jan 28, 2010 10:52 am

bobcat2 wrote:TIPS should be the primary asset of your matching strategy for retirement.
Unless one has targeted goals (e.g., putting a certain grandchild through school), it seems difficult to precisely "match" retirement expenses. Generic things like "buy groceries for the year" don't seem to fall into a matching system, or do they? I'm eager to learn from others.
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Re: TIPS are a great matching strategy asset

Post by dbr » Thu Jan 28, 2010 10:57 am

Beagler wrote:
bobcat2 wrote:TIPS should be the primary asset of your matching strategy for retirement.
Unless one has targeted goals (e.g., putting a certain grandchild through school), it seems difficult to precisely "match" retirement expenses. Generic things like "buy groceries for the year" don't seem to fall into a matching system, or do they? I'm eager to learn from others.
This would be an example of the problem in understanding "horizon."

I don't mean that you, Beagler, have a problem, but rather that you raise a valid example of the discussion.

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Post by chicagobear » Thu Jan 28, 2010 12:00 pm

ddb wrote:
chicagobear wrote:"...if we ignore the effect of taxes..."

My problem with TIPS.
Is it a problem because you have insufficient tax-deferred space in which to hold TIPS?

- DDB
I have never understood why the inflation adjustment payment is taxable. That seems to be counter to the whole point of TIPS.

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Post by metalman » Thu Jan 28, 2010 12:10 pm

TIPS should be the primary asset of your matching strategy for retirement. They become little more than another relatively safe bond if used as part of a diversification strategy for retirement. This simple but fundamental point seems to be difficult for many people to grasp.
Which is precisely why TIPS are for those close to or in retirement, not accumulators - since TIPS yields are likely to suppressed by an inflation premium, accumulators will do better in the long term by tilting to nominal bonds.

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Post by dbr » Thu Jan 28, 2010 12:29 pm

chicagobear wrote:
ddb wrote:
chicagobear wrote:"...if we ignore the effect of taxes..."

My problem with TIPS.
Is it a problem because you have insufficient tax-deferred space in which to hold TIPS?

- DDB
I have never understood why the inflation adjustment payment is taxable. That seems to be counter to the whole point of TIPS.
It would seem that any inflation indexed income stream has the same problem including Social Security, inflation indexed annuities, and COLA'd pensions.

How much of the "unfair" tax burden under inflation is offset by the inflation indexed structure of the tax brackets?

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Post by bobcat2 » Thu Jan 28, 2010 5:10 pm

...it seems difficult to precisely "match" retirement expenses.
That's true. You can’t know how much you are going to spend annually years from now. But you can decide how much retirement income you want to be very safe and that safe retirement income is best met through matching like strategies using investments such as TIPS and real life annuities. That safe part of the portfolio should not be part of a portfolio diversification strategy that uses both risky and less risky assets, which periodically get rebalanced in some manner. Therefore, if you want very safe retirement income rely on matching strategies exclusively. If you want to have greater upside potential and are willing to live with the chance of a much lower retirement income stream, then rely solely on a diversification strategy to manage portfolio risk. Most of us will pick somewhere in between and manage risk by relying on matching strategies for part of the portfolio in order to establish a safe income floor, and a diversification strategy for the rest of the portfolio in order to give us upside potential above the floor.

Before retirement a big hunk of the portfolio could also go into TIPS via a matching type strategy. It makes sense if you plan on annuitizing a part of your portfolio at retirement, or early on in retirement, to have TIPS investments before retirement to safely fund the life annuity, or at least a large part of it. Again the investor would be using a type of matching strategy to control risk instead of a diversification strategy. It doesn’t make much sense to me to fund your future safe life annuity by investing primarily in risky assets before retirement in order to purchase the safest part of your retirement income at retirement.

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Re: TIPS are a great matching strategy asset

Post by grabiner » Thu Jan 28, 2010 9:56 pm

Beagler wrote:
bobcat2 wrote:TIPS should be the primary asset of your matching strategy for retirement.
Unless one has targeted goals (e.g., putting a certain grandchild through school), it seems difficult to precisely "match" retirement expenses. Generic things like "buy groceries for the year" don't seem to fall into a matching system, or do they? I'm eager to learn from others.
You can do reasonably well by matching expenses over a long time period. You can buy a portfolio of TIPS which will pay you the inflation-adjusted equivalent of $50,000 every year for the next 20 years; you won't have expenses of exactly $50,000 after inflation every year, but many things will even out.
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Post by CaveatEmptor » Fri Jan 29, 2010 1:27 am

I hold lots of TIPs but I don't buy the argument that they are risk-free, because the temptation to under-state inflation increases as a government's finances become shakier (and this crisis has not exactly improved our government's financial condition). I'd probably double my allocation to TIPs if the entity measuring the inflation rate was free of conflict-of-interest (i.e., does not stand to gain from the under-statement of inflation).

Argentina's TIPs have been a disaster for their long-term holders because the officially announced inflation numbers have become less than half of the real inflation (as measured by actually paid consumption prices). The table on the following web site shows the discrepancy between Argentina's official inflation and the one based on actually paid prices by consumers:

http://en.wikipedia.org/wiki/National_I ... _Argentina

When Argentine TIPs were re-priced by the marketplace to reflect the government's fibbing with the numbers, the holders of pre-2007 TIPs suffered severe capital losses.

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Post by dbr » Fri Jan 29, 2010 10:13 am

The comment that an asset is "the risk free asset" is only in context of modern portfolio theory analysis that is looking at return and volatility of returns to examine what kind of portfolio is "most efficient." In this case we would be considering the analysis in real rather than nominal terms and nominating TIPS as the anchor for the bottom of the curve. At least that would be my understanding of that statement.

Nobody would pretend that volatility of returns encompasses all of the risks that pertain to financial well-being in this world -- or even that most of the important risks are encompassed.

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