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).
The authors, both Yale University professors, believe many persons 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 behavior of most investors, there is a recognition, as the Canadian Couch Potato blog noted, 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 person’s lifetime wealth, which includes the discounted value of the stream of income expected from a person’s human capital (job skills, training). So if a young person’s 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 would appear, this is more or less what’s available through margin debt and LEAPS. So, 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 also show in their example that setting asset allocations in this manner has expected returns comparable to a person who maintains a fixed allocation of 75% to stocks over their lifetime. The difference is that the latter approach has more risk since most of their stock exposure comes as the person approaches retirement and thus has less time to ride out the ups and downs of the stock market. Ayres and Nalebuff claim their approach does “a better job diversifying exposure to stock market risk across time.”
As the authors state in their book, this approach is not for everybody. It’s 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
• aren’t 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 losing all one’s 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 lose 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 and the movement toward expiration date.
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, children’s 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 where a young person’s 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.”