Most investors understand that you should have more exposure to stocks when you’re young and gradually allocate more to bonds and cash as you approach retirement. In their new book, Lifecycle Investing, Ian Ayres and Barry Nalebuff point out there’s a problem with that strategy—and they offer a solution.
Ayres and Nalebuff believe in diversifying across asset classes and agree that index funds are the best way to do this. But they argue that we must also diversify across time, something almost no one does: “Even after accounting for inflation, a typical investor has twenty or even fifty times more invested in stocks in his early sixties than he had invested in his late twenties… It’s as if your twenties and thirties didn’t really exist.”
We do take advantage of “temporal diversification” when we buy a home. When you’re in your twenties, you might save $25,000 and use it as a 10% down payment on a house, which gives you $250,000 exposure to the real estate market using 10-to-1 leverage. As you pay down your mortgage, you gradually “deleverage” as you build up equity. But even if you trade up to a bigger house a couple of times, your lifetime exposure to the real estate market stays relatively stable over three or four decades. “Homeownership is one of the very few ways that people have been willing to diversify across time,” the authors say. “This is a huge, hidden benefit of buying a home.”
Now compare that with the way most people invest for retirement. Someone in her twenties might have just a few thousand dollars invested in stocks. After paying off her mortgage, she’ll have a lot more money to invest, but by that time she may be 50 years old, and the conventional wisdom says she should be in more conservative investments. That’s the crux of the problem Ayres and Nalebuff identify: you either have lots of time and little money to take advantage of the higher returns on stocks, or you have lots of money and little time to ride out the volatility of the equity market.
By now you may have figured out Ayres and Nalebuff’s strategy: borrow to invest in stocks when you’re young. They suggest investing 200% of your savings in stocks throughout your twenties and thirties — in other words, using 2-to-1 leverage. As with a mortgage, you gradually reduce the amount of leverage as you get older, but you keep your lifetime exposure to the stock market much more consistent over time.
The authors provide reams of backtesting to compare their strategy with traditional asset allocation models. (The most common is the rule of thumb that your stock allocation should be equal to 110 minus your age — for example, you should hold 70% in stocks age 40.) The leveraged strategy delivered much higher lifetime returns in every case, even for people who lived through the Depression or retired right after the market crash of 2008–09. If you’re comfortable with the math, you can download their original research paper to see the detailed results.
An ideal strategy—if you’re a computer
I have no doubt their numbers are accurate. But the problem with Ayres and Nalebuff’s strategy is not math, it’s human psychology. The book does discuss cases where the Lifecycle strategy would be inappropriate, and one of these is “if you would worry too much about losing money.” This is stated casually, almost as an afterthought, but it’s a fatal flaw. The strategy would work magnificently if you were in a coma and a computer were managing your portfolio. But it’s hard to imagine that more than a tiny percentage of non-comatose investors would have the stomach to carry it out.
Ayres and Nalebuff must never talk to investment advisors or they would know that just about everyone “worries too much about losing money.” Advisors repeatedly tell me that their biggest challenge is convincing their clients not to panic during market downturns. Even without leverage, most investors earn subpar returns because they can’t stick to a disciplined strategy. How would you have reacted if you’d had 200% of your savings in stocks during the 2008–09 crash? You would have been wiped out, and you probably would have been scared out of the market for a long time, maybe forever.
The other obstacle with the Lifecycle strategy is that it’s too complicated for most investors to implement on a practical level. I won’t get into the details, but it involves buying on margin or using index futures, which are derivatives that allow you get market exposure without actually buying shares in an index fund. Recommending that retail investors manage their life savings this way is like suggesting that homeowners should do their own electrical work. Some will be able to do it successfully, but most will eventually get a nasty shock and give up. And a few will burn their houses down.
Would the Smith Maneuver be an example of this style of investing?
I think another unrealistic aspect of this strategy has to do with cash flow. Unless you happen to be in a career where you can make good money in your 20s and 30s, most young people are financially strapped. If they’re saving at all, they’re probably saving to buy a house, and I would think many young people would be scared off by the cash flow challenge of having to meet mortgage payments, car payments, school loan payments, PLUS payments on a leveraged investment loan. Strategies like this have to be considered in context of all the other typical financial commitments and constraints faced by the target group.
I’m not sure I agree with the negativity around investor psychology, since we already do a bit of temporal diversification (% of my portfolio in bonds is equal to my age). So if there’s a better way, bring it on.
I’m just wondering if you’re being overly negative on a point that I don’t think is worthy of half the post.
Btw, awesome blog!
Pedro: The Smith Maneuver is a way you can leverage your exposure to stocks when you’re younger, though the technique is very different from what the authors describe in this book. One of the main goals of the SM is to make your mortgage tax-deductible, but this is not necessary in the US, where mortgage interest is already tax-deductible.
Brad: You’re right, although I should mention that buying index futures doesn’t require an investment loan and doesn’t require that much capital. They can be used to expose you to a lot of market risk without a lot of money up front.
@Farhan: I should clarify that holding a percentage in bonds equal to your age is the exact opposite of what the authors describe as temporal diversification. For example:
– You’re 20 years old and have $10,000 to invest. You invest 20% in bonds ($2,000) and 80% in stocks ($8,000).
– You keep contributing money every month, adjusting your stock-bond allocation every few years based on your age.
– By the time you’re ready to retire at age 65, your portfolio has grown to $600,000. You invest 35% in stocks, or $210,000.
In this example, you may be only 35% in stocks at age 65, but you have $210,000 of market exposure, compared with only $8,000 at age 20. That $8,000 had 45 years to compound, but your $210,000 benefits from a lot less time. You’d make a lot more money if you could get more exposure to equities early in your life.
Hope that makes sense.
I couldn’t agree with you more, Dan. This is yet another example of a sophisticated investment strategy that is completely inappropriate for the vast majority of retail investors.
Perhaps the investment strategy is inappropriate, but the concept isn’t one that I had thought about. The problem they outline is absolutely correct! Using CCP’s example in the comments, $8k vs $210k is a pretty big difference. Their solution may not be ideal, but one can always come up with different solutions that better fits their lifestyle and income.
I read a bit of the Ayers & Nalebuff paper after reading about it in MoneySense and I had the exact same objection. Yes, it sounds wonderful in theory but unlikely to work well in practice. It is hard enough seeing your savings fluctuate like a yo-yo in the stock market. I can’t imagine how hard it will be “losing” OPM in the stock market. Chances are our budding, young investor is likely to throw in the towel somewhere near the bottom of his first bear market.
I think that a lot of people get hung up on the leverage aspect of the book and as such easily dismiss it. The main take home message is the concept of diversifying your investments across time and how the present value of your lifetime of savings is akin to a bond. The example is that if you are young, if you expect that the PV of your lifetime savings is 500K, then your desired asset ratio between stocks and bonds should include this amount. Thus, if you only have 5K cash to invest, even investing all of that in equities gives you less than 1% exposure to the market. The authors suggest to alleviate that by using leverage (safely, up to 2:1) to work up your desired total amount invested (e.g. 60% of 505K) earlier in life. However, even without leverage, the advice is still sound and one could consider keeping 100% of their investments exposed to the market for much longer than conventionally thought given that they anticipate a lifetime of earnings.
On the topic of leverage, why is it that people have no problem lining up to buy illiquid assets in real estate at 10:1 or 20:1 leverage but balk at the idea of going out at 2:1 in the stock market with a tenth or a hundredth of the invested amount?
I purchased this book online (for less than two dollars! I LOVE Amazon’s used books!) a week or two ago and just got it in the mail today. Reading through it now. Seriously considering adopting this strategy.
One day I was pondering investments and thought “stupid people here take out huge mortgages on houses that require a lot of work and perform poorly as an investment, why do I not do the same with a nice portfolio?”…ran the numbers in a spread sheet (using data provided by CCP, of course) and it checked out. Searched further, discovered the book, stopped thinking and waited for it to arrive :-)
I think that Dan’s above comment about how “human psychology is the fatal flaw in this” holds just as true for the CCP strategy. There will always be people who cannot follow a couch potato method because they cannot mentally stay invested when the markets inevitably tank. Therefore I do not think this argument against temporal diversification holds any more water than those flimsy arguments with which various people attack the couch potato strategy.