With an innocuous name like Lifecycle Investing, the premise is simple but its implications are anything but. The two Yale professors posit that, just as you would diversify your investment across different asset classes, you should also diversify across time.
A young investor invests very little in the stock market compared to when they’re old in terms of raw numbers. A typical investor has twenty or even fifty times more invested in stock in his late fifties or early sixties than he had invested in his late twenties.
So being invested in the stock market in your twenties doesn’t provide much diversification when you have so much more invested later on. From a time (temporal) diversification perspective, your stock market exposure in your twenties and thirties is almost non-existent.
Lifecycle Investing matches the risk profile of the birthday rule – where you invest 110 minus your age in stocks and the rest in bonds – but provides a 50 percent higher return on average. This strategy can also match the risk profile of the constant allocation (e.g. 75:25 constant) rule and provide a 60 percent higher average return.
But I don’t have any extra money to invest
To solve this problem, they offer a simple but radical and potentially hazardous idea:
“Use leverage to buy stocks when you’re young.“Yale professors and authors, Ian Ayres and Barry Nalebuff
For most, the word leverage rings alarm bells in our head. But is it anymore different than buying a house with a loan?
Most of us do not hesitate to take out a loan when buying a house with leverage of over 10:1 but shudder at the mere thought of buying stocks with leverage even at a 2:1 ratio.
People have been doing with housing, what they should be doing with regard to their retirement investments. You buy a home with borrowed money, and the loan declines as you pay off the loan. Housing investment is naturally diversified across time because it exposes you to the same investment in the housing market year after.
If people bought houses the way they bought stocks, they’d have to wait until they’d saved enough to pay cash for the whole house. They’d be lucky to buy a house before their fiftieth birthday. Instead they propose to make stock purchases a little bit more like buying a house.
How much leverage?
They suggest just buying stocks with a 50% leverage or 2:1 ratio when you’re young. Even a small amount of leverage when you’re young makes a huge difference because the effects get compounded over many years.
Their book, then lays out some step-by-step instructions for how to implement the lifecycle strategy. This includes what option contracts to purchase, how much you’ll pay in implied interest, and what bonds to buy. They also consider the alternative strategies of investing in leveraged mutual funds or buying stocks on margin.
They suggest buying stock options (unfortunately stock options are not available in Nepal yet) to leverage your stock market portfolio in a 2:1 ratio. Alternatively, margin loans (you can borrow up to 65% off your portfolio with Nepali banks) in a 2:1 ratio. Only use margin loans when you can get it at a low enough interest rate so as to be profitable.
Investing in the three phases of life
- In the first phase—which typically lasts for the first ten years
of your working life—retirement savings are leveraged at 2:1.
- In the second phase—which typically lasts until your mid-
fifties—investments are partially leveraged, more than 100% but less than 200%.
- In the final phase—which lasts until retirement—investments are fully unleveraged, and your portfolio includes corporate and government bonds along with stocks.
Spreading your investments better across time means investing more when you’re young. But there’s a good reason why you (and pretty much everyone else) don’t invest more then: You don’t have the money. That’s where leverage comes in. The main point of this book is to show that it’s prudent to make leveraged investments when you’re young.
“You can hold your lifetime exposure to the stock market constant and reduce risk by having more exposure when you’re young and less when you’re older.”
Is that much leverage worth it?
“If you are a young professional with future [earnings that] cannot be efficiently capitalized or borrowed on, to keep your equities at their proper fraction of true total wealth, you should early in life put a larger fraction of your liquid wealth in common stocks.”Paul Samuelson, 1970 Nobel Prize in economics
Lifecycle investing takes on the generally accepted prudent practice of putting most of your investment into stocks at a young age and gradually reducing your exposure to the stock market and into bonds or other fixed market instruments as you get older or closer to retirement. And audaciously takes it to its logical but counter-intuitive conclusion.
Whether you like this audacious counter-intuitive strategy or not, all investors need to know about lifecycle investing.
Perhaps the hardest part of this strategy is facing a wipeout in the early part of your cycle due to leverage and then having the heart to stick with it.
Personally for me, leverage is fine if I can find stocks with a high enough risk to reward ratio to justify it. Otherwise, I’m better off mentally if I’m not leveraged but according to their research my retirement nest egg will likely suffer.
I highly recommend reading the book.