Thursday, March 15, 2012

Lifecycle Investing – a Leveraged Strategy

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.

Objections

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.

Conclusion

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.

13 comments:

  1. I think the whole concept is bunk, but laying that aside for a moment...

    There's also an error in the math I think. If you start at zero savings and end up at $200k, and your savings grow linearly (which they won't, but bear with me), then your average savings over your life is $100k, so you should be maintaining $50k stocks on average.

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  2. @Patrick: I began reading the book expecting to find that it was bunk, but it isn't. The objections I expected to have were thoroughly addressed by the authors. I still have serious concerns as I said in the article, but I'm not sure that they are fatal.

    I don't think they have made any math errors. If we start with the premise that your future savings are certain to happen and their present value is $200,000, then you are already holding a $200,000 bond. Then it makes sense to invest half of it in stocks right from the beginning. Your reasoning is what would happen with the typical advice to invest 50/50 what you have currently saved at any given time.

    The problem with their scheme rests on the degree of volatility in your estimate of future savings. If this volatility is low, then lifecycle investing makes perfect sense. I just don't think that this volatility is low.

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  3. Those are good points. After reading the book a few months ago I've been trying to find what could be wrong with it. #1 is a big one for personal reasons, #3 not as much but a lot of people could have a bad outcome.

    #2 is an interesting point. Increased debts don't help when you're in trouble, but if the investments you bought with them have kept up with the cost of borrowing then you're no worse off. You could even come out ahead at the right times.

    And if you spend 10-15 years building up in the 2:1 leverage phase, there's a chance that a good portion of the debt is tied to older investments that have had time to grow.

    It might make sense to try a more restrained version for safety. But if nothing goes wrong with that, people would generally keep pushing further until something does go wrong.

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  4. @Value Indexer: I think #2 is mainly a problem if you lose your job (and severance runs out) after the market has crashed. So, anyone losing their job in late 2008 and not finding work for a year would be spending depressed holdings and leverage would make it far worse.

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  5. True. On the other hand if you're already facing a major loss when everything goes wrong at once, then maybe being pushed a bit further to bankruptcy isn't an issue. You would basically be following the strategy that banks use, complete with government rescue.

    If the term of your loans is shorter than your planned holding period for your investments then you are acting like a bank. I guess the foundation of the strategy is just applying an old business model.

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  6. @Value Indexer: Good one :-) Forget about the sissy 2:1 leverage. Go for 100:1. Then it's either huge wealth or bankruptcy (and then try again). You just have to find someone willing to lend you a lot of money cheap.

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  7. I read somewhere that someone buying a house with a mortgage is already using leverage to build networth and in a sense indulging in lifecycle investing, if buying a house and using a paid-up house to fund retirement can be considered investing.

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  8. @Be'en: Mortgaging a house is sort of like lifecycle investing, but there are important differences. For one, housing is not as good an investment as stocks. There have been periods where this wasn't true, but over the long run housing hasn't performed nearly as well. A house also costs a lot of money for upkeep. And you can't pull full value from this "investment" unless you're willing to move and rent. So, there are similarities to lifesycle investing, but also some big differences.

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  9. I had forgotten about this book. Interesting concept but you point out some valid caveats.

    I don't know if he took inspiration from this book, but a 24-year-old by the name of Kevin Stone is following a leveraged approach (and blogs about it at
    freedomthirtyfiveblog.com). Whether through good fortune or design, he's doing great so far, having started his leveraged approach just after the financial meltdown and participating in the stock market rally since.

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  10. @Larry: The book has a cautionary tale about a young person who read the authors' early work, but chose to use more than 2:1 leverage. This young person got crushed by dropping stock prices and was left with painfully large debts.

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  11. @Michael: ok thanks for explaining the reasoning, but I still don't buy it.

    If you want to presume that your future savings are certain, then what you have (your future savings potential) is worth $200k cash. Cash really isn't very bond-like. Cash has no internal rate of return, and its value doesn't fluctuate with interest rates.

    If you take away the assumption of zero risk, then your $200k looks less like cash and more like, well, something else. Whether that something-else resembles bonds depends on its sensitivity to economic factors like inflation and interest rates. I don't see any particular reason to think a typical person's risk profile would match bonds any better than any other asset class. In particular, it's completely undiversified: it depends on the saving ability of a single individual.

    Anyway I hope I'm not wasting your time with bogus arguments that are dealt with in the book.

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  12. @Patrick: I think the idea is that your future savings are like a sequence of bonds of different durations and the $200k is intended to be the present value of all the bonds.

    In any case, the crucial concern is how safe such a sequence of bonds really is. From the point of view of a government employee or university professor, future savings might seem quite certain.

    The authors partially address the criticism that future savings aren't certain by saying that they don't advocate full stock exposure right away anyway. They say to limit yourself to 2:1 leverage initially. Over time, the idea is that your savings picture will be more clear and you'll be in a better position to decide when you've likely saved one-quarter of the amount you'll be able to save in a lifetime. (The 1/4 figure comes from a desire for 50/50 stock/bonds allocation and 2:1 leverage.) At this point you start to deleverage.

    Their reasoning works reasonably well until you consider the possibility that you'll be forced to dip into your savings well before retirement due to some sort of bad luck.

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  13. Guys dumb enough to do it!April 20, 2012 at 12:13 AM

    I find the strategy fascinating. I appreciate the concerns expressed by clearly intelligent people. I have been using the strategy and implementing the leverage through the value-averaging concept described by Edleson in a margin account. Over the past 18 months or so as I look back, the indications to buy have been at market lows and I figure it will take some time possibly years to get close to 2:1 leverage. This clearly is not a strategy for all and I think it is critical to have other funds available to cover emergencies. I have a hard time not considering borrowing to buy stock when I borrowed quite heavily to buy a house.

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