A few weeks ago, I indulged my inner financial engineer and bought a small amount of the 30-year TIPS at the annual February auction.
When it matures on February 15, 2053, I’ll be 104 years old. The American Academy of Actuaries and Society of Actuaries’ Longevity Illustrator tells me that the odds of either me or my spouse reaching that age are about 3%.
From the perspective of short-term risk, this security is not for the faint of heart; several days during the past year saw daily price changes in the longest TIPS of 4%. Furthermore, in bad states of the world, TIPS are notoriously illiquid; had the 30-year bond been available in 2008, it would have suffered a peak-to-trough price fall of nearly a third, as the yield, as judged by the extant 20-year bond, would have peaked at about 3.3%. (And, while in retrospect, long TIPS were a mouth-watering opportunity, at that moment there were far better bargains in equities.)
It’s a near certainty that my brand spanking new bond will suffer similar gyrations on the way to its maturity, at which point it will have become riskless in terms of real consumption, which is all any rational investor should care about.
A TIPS is risky in the short term and riskless in the long run, which is precisely the opposite of, and complementary to, a T-bill, which is riskless in the short term but, because of reinvestment rate volatility, risky in the long run.
As Buffett famously said, “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
The key word in the above quote is “temperament.” Exactly where between our ears does it reside? In the nomenclature handed down to us by neuropsychologists Keith Stanovich and Richard West, it sits in our System 1 – anatomically, our limbic system, or in layman’s terms, our hundreds of millions of years old reptile brains. By contrast, our rational inner Spock resides in evolutionarily newer System 2, which in humans greatly enlarged over only the past few hundred-thousands of years.
Humans are ludicrously overconfident; we all know, for example, that 90% of drivers think they’re above average, which is a mathematical impossibility. In investing, this overconfidence manifests itself in the delusional belief that we can time markets and successfully pick securities. Those delusions are expensive enough, but even more dangerous and expensive is our overconfidence about our risk tolerance – that is, how well our System 2 controls our System 1 when the economic and financial excrement hits the ventilating system.
This neuroanatomic paradigm provides an excellent way to think about the roles of T-bills and TIPS in our portfolios.
Cash protects us from the depredations of our System 1. Crudely stated, investing is an operation that transfers wealth to those with a strategy and can execute it from those who do not or cannot. Nothing maintains one’s membership in the first group during the worst few percent of the time like a nice pile of T-bills. Even when their yields are derisory, which they were for a decade before 2022, their role as elixir of equanimity makes them arguably the highest returning asset in our portfolios by allowing us to sleep through the rough patches. There’s a reason, after all, why Warren Buffett keeps roughly a fifth of Berkshire’s assets in T-bills and cash equivalents.
As put by financial author Matthew Josephson,
[During a market panic] there are many casualties, cruel transfers of individual fortunes. Yet he who possesses even a modicum of unimpaired capital is as one who watches the sand run down in an hourglass, while fully aware that he may, at the given moment, turn the glass over and begin the process anew.
Or, as supposedly said by JP Morgan, a bear market is when stocks are returned to their rightful owners – those with the unimpaired capital. That’s how the rich, who by definition have oodles of it, get richer. And as the run on Silicon Valley Bank illustrated, nothing says “unimpaired” quite like a T-bill.
TIPS, on the other hand, epitomize System 2 rationality. When we invest, we defer consumption from our present to our future selves, and nothing secures that as well as TIPS laddered to match retirement spending. (Although because of their 30-year limit and absence of 2034–2039 maturities, they’re not perfect.)
Some argue that a single-premium immediate annuity (SPIA), by theoretically insuring against longevity in a way that a TIPS ladder doesn’t, also serves the retiree well. Trouble is, there aren’t any inflation-adjusted ones available. As put by one of Paul Samuelson’s most illustrious students, Zvi Bodie, buying a nominal annuity amounts to “betting that future inflation rates will be lower than the market consensus at the time the annuity is purchased … this sort of speculation is imprudent for retirees.” In other words, if long-term price rises significantly outstrip expectations, a SPIA’s supposed longevity insurance melts away in a blizzard of future funny money.
A bond fund manager recently related to me his difficulty in figuring out the role of TIPS in his portfolios. After fumbling for a reply, I realized that he was right: like Social Security, they don’t occupy a formal slot in most folks’ asset allocation. Rather, they’re an excellent, though still imperfect, supplement to Social Security. In the same way that most retirees don’t capitalize their monthly government checks into the bond component of their portfolios, TIPS should be kept mentally separate from the policy asset allocation as well.
To summarize, TIPS and T-bills are complementary assets. The former appeals to our System 2’s inner Spock, who first and foremost wants to secure our future consumption, while the latter assuages our System 1’s inner Daffy Duck, who wants us to bail at the worst possible time and violate Charlie Munger’s first rule of compounding, which is to never interrupt it.
The prudent retiree holds a goodly pile of both.
William J. Bernstein is a neurologist, co-founder of Efficient Frontier Advisors, an investment management firm, and has written several titles on finance and economic history. He has contributed to the peer-reviewed finance literature and has written for several national publications, including Money Magazine and The Wall Street Journal. He has produced several finance titles, and four volumes of history, The Birth of Plenty, A Splendid Exchange, Masters of the Word, and The Delusions of Crowds about, respectively, the economic growth inflection of the early 19th century, the history of world trade, the effects of access to technology on human relations and politics, and financial and religious mass manias. He was also the 2017 winner of the James R. Vertin Award from the CFA Institute.