In the book Lifecycle Investing, authors Ian Ayres and Barry Nalebuff propose an investing strategy for diversifying across time that involves all-stock investing with 2:1 leverage while you are young. Many readers would be tempted to quickly dismiss this idea as crazy, but the authors are not crazy and they do a good job of answering (almost) all objections.
Common advice is to think about all of your savings together as a single portfolio. Even if you have multiple accounts, your focus should be on having a sensible overall asset allocation; the allocation within any one account is less important. Ayres and Nalebuff take this a step further to say that you should take into account future savings as well.
So, if you are destined to save $200,000 over the course of your lifetime, and a 50/50 split between stocks and bonds suits you, then ideally you should have $100,000 worth of exposure to stocks and $100,000 exposure to bonds for your entire life. If we treat your future savings as a kind of bond, then your focus should be on maintaining $100,000 exposure to stocks.
The problem is that while you are young and have modest savings, you don’t even have $100,000 in savings. The authors’ answer to this is leverage. However, they recommend limiting the leverage to 2:1 using margin at a brokerage or using deep-in-the-money call options. The authors caution that the interest rate (or implied interest rate) must be low for this strategy to make sense.
By limiting leverage to 2:1, you wouldn’t be achieving $100,000 of exposure to stocks for your whole life, but it would be closer than any other commonly-advised investing strategy. With this approach, your investing life has 3 phases: (1) 2:1 leverage until stock exposure reaches the right level, (2) gradual deleveraging, but still owning no bonds until your portfolio holds more than you need exposed to stocks, and (3) holding a mix of stocks and bonds.
The authors perform many simulations comparing this strategy to more common strategies showing that the lifecycle approach has lower volatility and higher returns due to its superior diversification across time. This is true even when the asset allocations are adjusted so that both approaches have the same overall stock exposure.
The authors give some practical information about how to follow their advice using margin or stock options. They also show how to calculate the implied interest rate on borrowing when using stock options.
1. Future savings are more stock-like than the authors suggest.
Although the authors point out that if your income is heavily tied to the stock market then early leverage isn’t for you, they portray future savings for most people as more or less bond-like. It is easy for someone of baby boomer age to look back and think that their life’s path was more or less destined to happen. But this is just 20/20 hindsight. A 25-year old can’t know that he or she will have stable employment and be able to save money steadily.
Back in 1990, how many people predicted the demise of Nortel? Yet tens of thousands of people were thrown out of work. Only a tiny fraction quickly found new jobs at the same pay. A much more typical scenario was a 2-year search ending with a new job paying 75% of what Nortel paid.
The authors address this objection partially saying that while total lifetime savings may be uncertain when investors first start out, even conservative estimates mean that 2:1 leverage makes sense to start. As investors age, their lifetime saving picture becomes more clear and it becomes easier to decide when to move to the second and third investing phases. In my opinion, the future is more uncertain than the authors portray it to be.
2. Life events drive many people to spend some or all of their retirement savings before they reach retirement age.
This is the most serious objection. Continuing with the Nortel example, thousands lost their jobs at the same time that stock prices crashed. If these people had been lifecycle investing, their savings would have been decimated at the very time that they needed to withdraw some of it to live on. In effect, lifecycle investing would have forced them to sell almost all of their stocks when prices were lowest.
The authors could counter that lifecycle investing is not suitable for people in volatile careers. However, viewed through the eyes of people in their 20s, almost all future career paths are volatile, even if they don’t realize it. Few Nortel employees in the 1990s would have believed what was waiting for them.
3. People have proven that they cannot handle huge drops in their portfolios.
Most experts advise people to have some bonds in their portfolios to moderate big drops in stock prices. This may be bad for long-term returns, but it stops some people from panicking when stock markets crash.
I recognize that some investors are more able to handle volatility than others, but asking a young person to stay the course in lifecycle investing can be a tall order. Imagine that a young person struggles to save $20,000 and watches it drop to $8000 because of 2:1 leverage and a 30% drop in stock prices. How many people could remain rational in such circumstances? Far too many would sell everything and swear off stocks for life.
The authors’ contention that investors should include a time component in their thinking about diversification makes sense. However, I think Ayres and Nalebuff vastly understate uncertainty about the future. I’m not sure whether this objection is fatal to lifecycle investing. I’d like to see the authors include in their simulations the possibility of having negative savings due to job loss at the same time as the stock market crashes. Until they address this possibility adequately, I can’t recommend that young people follow their lifecycle investing plan.