In this post, I would like to review a new book by Ian Ayres and Barry Nalebuff, entitled Lifecycle Investing: A New, Safe, and Audacious Way to Improve the Performance of Your Retirement Portfolio(May, 2010). Im rushing it off a bit since I have a water fight scheduled with my two boys in the backyard during this heat wave. If you see any errors, omissions or something is unclear, please do leave a comment at the end of the post and Ill fix it up. (Note: article was amended July 8.)
The authors, both Yale University professors, believe manypersons in their 20s or 30s should consider allocating up to 200% of their retirement savings to equities. In other words, they should leverage their savings — as can be arranged through margin debt in a brokerage account or by maintaining a rolling position in long-term options on a stock-market index.
Public reaction in the two months following publication of the book has generally been skeptical. Many people have a more conservative attitude to leverage after the financial meltdown of 2008. And going by the historical behaviour of most investors, there is arecognition, as the Canadian Couch Potato blognoted,that many investors may not have the emotional capacity to deal with the magnified volatility of leveraged investing.
Yet, a leveraged approach such as the authors are recommending does have its fan base in academia. The authors report their book was inspired by articles written by Nobel-laureate economist Paul Samuelson. Furthermore, Yale University professor Robert Shiller endorsed the book and gave it a top rating in a review on the Amazon.com website.
How do the authors justify leveraged investing? They believe that asset allocation for retirement savings should be determined with regard to a persons lifetime wealth, which includes the discounted value of the stream of income expected from a persons human capital (job skills, training). So if a young persons risk tolerance is for a 50/50 mix of stocks and bonds and the present value of their human capital is $950,000, they should put $450,000 of the latter into stocks — assuming they already have $50,000 of savings in stocks.
But no markets exist for converting human capital in this fashion, so the only thing that can be done is to leverage whatever savings are available to at least approach the 50/50 mix. This can be done through buying on margin in a brokerage account or buying long-term options called LEAPS on a market index. The leverage provided by these vehicles does not require applying for a loan and can be assumed if the person has a mortgage and student loans (but requires enough cash flow to also service the latter).
The authors recommend 2:1 leverage because it getsmore and more expensive to borrow at higher ratios. At 2:1 leverage, “the wholesale lending rate for margin loans was just 0.34% points [on average] above the T-bill rate” over the past century in the U.S. But shop around the authors recommend: some brokers get closer to the treasury-bill rate than others. For example, in the U.S., Interactive Brokers would be cheaper than Vanguard or Fidelity.
So, at 2:1 leverage, the young person with $50,000 in savings will effectively borrow another $50,000 and have $100,000 exposure to stocks (i.e. a 200% allocation of their financial assets to stocks). Over their lifetime they will bring that leverage down. In an example provided by the authors, they show it coming down to 50% of financial assets as retirement draws near.
The authors ran a series of backtests on historical data from the U.S. and other countries, as well as performed Monte Carlo simulations. They found noticeably lower risk and/or better returns for persons investing over their lifetime earnings period (45 years), compared to benchmarks using a fixed asset allocation (e.g. 75% for stocks) or the target-date approach of a declining allocation to stocks as age increases.
In their NBER paper(2008), the authors declare: “The expected retirement wealth is 90% higher compared to life-cycle funds and 19% higher compared to 100% stock investments. The expected gain would allow workers to retire almost six years earlier or extend their standard of living during retirement by 27 years.”
Ayres and Nalebuff claim their approach does a better job diversifying exposure to stock market risk across time. The increased market exposure when an investor is young allows them to have less exposure later on in their life. While the total market exposure is the same over their lifetime, its better spread out and thus has less risk.
As the authors state in their book, their approach is not for everybody. Its recommended only for a subset of the investing public. Reasons for not doing this at home include:
have credit card debt have less than $4,000 to invest need money to pay for your kids college education have a salary correlated with the market worry too much about losing money arent knowledgeable about margin debt or LEAPS
The latter condition perhaps requires more comment. Margin debt may give rise to margin calls and the possibility of loosing all ones money invested in the stock market (the authors factored this risk into their simulations). And if you choose to meet the margin call and the market continues downward, you could even loose more than your original capital invested. As for LEAPS, they can be complex. Of note, their prices are affected not just by the direction of the stock market, but other factors such as market volatility, interest ratesand the movement toward expiration date.
For investors who don’t feel confident using margin debt and LEAPS,there is an expectation that funds based on the Ayres and Nalebuff approach will emerge, at least in the U.S. They will take care of the details of trading LEAPS or using margin for investors — for a fee, of course.In fact, it seems the Profund family of funds in the U.S. already has funds like these, according to one of the authors.
Professor Shiller, as noted above endorses the Ayres and Nalebuff book but makes it clear, as do the authors, that it is not a suitable approach for every person, time and place. For one thing, to emphasize again, it should only be applied to savings set aside for retirement. Saving for a downpayment on a house, childrens education and other needs is a separate envelope that requires different approaches.
Shiller also cautions that the book could promote irresponsible investing among readers with gambling tendencies and/or inappropriate financial situations. Furthermore, he is not optimistic about starting the approach whenever the stock market is pricey. But, as a general, long-haul advice book, for savvy people who can judge their situation and not get themselves into a corner, the book is indeed valuable, Shiller concludes.
As for the risk a young persons retirement savings could be decimated by leverage, Shiller says: Most young people could survive an annihilation of their retirement savings; they still have plenty of time to rebuild it later and it may generally be a good bet to take just such a risk. This is the basic point that Ayres and Nalebuff make, and it is right.