Lifecycle Investing: Good In Theory, Bad In Practice

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 |  About: SPDR S&P 500 Trust ETF (SPY)
by: Difu Wu

In Lifecycle Investing, authors Ian Ayres and Barry Nalebuff proposed that just as we should spread our investment risks by asset diversification, we should likewise diversify over time. They called this concept lifecycle investing: by attempting to attain, then maintaining, a constant allocation of the present value of our total lifetime investment in stocks, such as 83%. The ideal allocation to stocks depends on each individual investor's risk tolerance, but 83% is proposed by the author as near ideal given the risk and return of the stock market in the past compared to alternative assets. If the ideal allocation in stocks cannot be reached early on in an investor's life, the authors recommend using up to 2:1 leverage to bring the current allocation closer to ideal.

To illustrate how lifecycle investing can be put into practice, let us use the following example. Suppose an investor starts investing $10,000 annually at age 25, and continues to invest $10,000 annually, adjusted for inflation, for the next 40 years until retirement at age 65. The total present value of his investment is therefore $400,000. For an ideal constant lifetime stock allocation of 83%, the investor would aim for $332,000 invested in stocks today. At age 25, just starting to work, the investor most likely does not have nearly that much money to put into stock yet. With only $10,000 to invest, he would use 2:1 leverage to bring his effective exposure to stocks to $20,000.

Ayres and Nalebuff offered several strategies to leverage. The method they recommend the most is to buy a deep in the money call option with the longest expiration date (usually around two years) on the S&P 500, or an index ETF that tracks the S&P 500, such as SPY. Alternative ways to leverage include buying stocks on margin, buying S&P futures, and buying 2:1 leveraged ETFs.

Using the recommended call option method, the option would have a strike price approximately half the current price to give a 200% leverage. For example, if someone were to do this today (Sept. 10, 2012), he would look for the longest expiring option on SPY, which expires Dec. 20, 2014, or a little over two years. With SPY currently trading at 144.39 (one-tenth of the S&P 500), he would look for a call option with a strike price around half that, or $72. The closest one is the one with $70 strike price, trading at $74.13 bid, $74.82 ask. Alternatively, he may also consider the $75 strike price option, trading at $69.13 bid, $69.82 ask. The former would give a slightly lesser than 2:1 leverage, while the latter slightly greater than 2:1 leverage. If he opts for the former, he would pay 100 times the ask price (since each option represents 100 of the underlying security), plus a commission, say $10 per trade, for a total of $7492. Should the S&P go up 20% before this option expires, SPY would trade around $173.27. In reality, it would be less because the SPY would have paid out 2 years of dividends, which the option trader does not receive. The current yield is 1.87%, so subtracting twice that means SPY would trade around $166.79. With a strike price of $70, the investor would receive $9679, or $9669 after $10 commission, which is gain of $2177, or 29%, better than the index gain.

Lifecycle investing is sound in theory, as it addresses one of the biggest problems facing most investors: that we often have too little to invest when we are young to let compounding work over a long time frame. For the young investor, his earning potential may be viewed as a huge bond, calling for greater stock exposure for proper diversification. While most would stop at 100% stock allocation for the young aggressive investor, lifecycle investing boldly calls for a 200% stock allocation using leverage early on, until the ideal stock allocation can be reached via less leverage. Actually trying to put lifecycle investing into practice today is where it gets problematic, for the following reasons:

The call option method is a market timing strategy: The longest call option available expires in a little over two years, which is too short a time frame to invest in stocks. With a two-year time frame, nobody knows whether stocks would go up or down. If an investor used this strategy in 2009 or late 2008, he would have been well rewarded. However, if he used this strategy in 2006 or 2007, he would have been wiped out. A method that relies heavily on market timing and exposes an investor to the possibility of losing 100% of his investment is simply unsatisfactory. The alternative leveraging methods are even worse and involves much shorter time frame. Future contracts expires in months. Margin trading is the worst of all, as margin traders can get wiped out anytime the market falls 50% (or get a margin call whenever the market falls 33% if the broker requires maintaining 25% equity). With the stock market hitting new highs, now appears to be a particular risky time to use leverage in lifecycle investing.

Costs are too high: The use of leverage is not free, far from it. For the call option buyer, he incurs a large spread ($69 when he buys in the $70 strike price example above), commissions both ways, forfeiture of dividends, and capital gains tax at least every 2 years or so when the option expires and he must roll over to a new option. An investor who simply buys and holds SPY would incur none of these fees. In the example of the $70 strike price call option above, the option is worth $144.39 (current SPY price) - $70 (strike price) - $0.20 (commissions both ways) - $6.48 (foregone dividends) = $67.71. By paying the $74.82 ask price, the option buyer is incurring $711 interest on $7000 debt (the strike price times 100), which is about 5% annual interest rate. The alternative leveraging methods, such as margin trading, involves even higher costs.

With leverage, rebalancing means buying high and selling low: As equity falls while debt remains constant, leverage increases. As equity rises while debt remains constant, leverage decreases. Ayres and Nalebuff recommends rebalancing back to 2:1 leverage, especially with falling markets to reduce the risk of getting wiped out. Rebalancing a leveraged position means buying high and selling low. While it cannot be known whether the stock market will be higher or lower in two years, it is almost certain that it will fluctuate. The more often one buys high and sells low by rebalancing a leveraged position, the worse the actual result strays from tracking the underlying index over the long term, especially during volatile times. This point is nowhere made clearer than by leveraged ETFs, which rebalances daily. The SEC has issued a warning on leveraged and inverse ETFs, citing this real life example:

Between December 1, 2008, and April 30, 2009, a particular index gained 2 percent. However, a leveraged ETF seeking to deliver twice that index's daily return fell by 6 percent-and an inverse ETF seeking to deliver twice the inverse of the index's daily return fell by 25 percent.

Clearly, for all the reasons above, using call options or other leveraging methods to implement a lifecycle investing strategy is bad in practice. In an ideal world, lifecycle investing would work well if young investors could avail themselves to low interest borrowing to buy stocks, then repay the loan after 40 years (or at least amortize the loan over a similar long period of time). In the real world, however, personal loans are both high interest and limited in amount of funds a person can borrow. Low interest loans are only available for education, buying a house or car, or when collateral is involved to protect the creditor (some brokers do offer low interest margin rates, but the entire equity position can be liquidated when stocks fall so the broker is not exposed to any real risk of default).

Accepting the theory of lifecycle investing, but rejecting its practice, I propose the following for the more prudent young investors:

1. Pay off all debts with high interest rates first: An interest rate is too high if it exceeds the expected return on stocks after capital gains tax. For example, if someone is in the 25% tax bracket, and stocks normally return 10% a year, any debt charging more than 7.5% interest is too high. Paying off high interest debt guarantees an investor at least that much return, free of tax.

2. Keep debts with low interest rates. For example, debts for education and mortgage debts for housing are good debts with low interest rates. Delay paying them as long as possible, and amortize them over the longest time period possible, so you get more money now to invest in stock.

3. Contribute at least enough to your 401(k) to get the maximum dollar amount of company match each year: If your company matches up to 5% of your pay, make sure you contribute at least that much. This is free money.

4. Allocate 100 percent to stocks: Young investors with an investing time horizon measured in decades should have zero allocation in bonds, regardless of their risk tolerance. Over the long term, inflation risk is much greater than market risk, and stocks will almost certainly outperform bonds.

5. Borrow money from family and friends at low rates if possible, and invest in stocks: For example, your grandma might be happy to give you a million dollars for the equivalent of an annuity. If she could get the same rate from you as she would get from the commercial bank, she might just as well help you out, as long as you prove yourself to be credit worthy.

6. Rebalance: Within a 100% stock portfolio, an investor should have large cap US stocks (such as the S&P 500), small cap US stocks, and international stocks, allocating one-third to each, for instance. Whenever one of these asset classes underperforms relative to the others, the investor should rebalance to buy more of the underperforming asset, while selling some of the outperforming ones. This is buying low and selling high, which will contribute to better performance in the long run. International stocks have significantly underperformed relative to US stocks recently; rebalancing now will pay off as international stocks start to outperform again in the future.

7. Slightly favor small value stocks: Between 1927 and 2011, small value, large value, small growth, and large growth stocks have averaged 13.5%, 10.0%, 8.8%, and 9.0% annualized returns, respectively (see here). Small cap and value stocks are generally more risky and therefore demand a risk premium in the stock market. Higher risk premium means higher expected returns. Overweighting small value stocks is likely give a little extra leverage for better returns.

Conclusion

Increasing stock exposure early on in an investor's career is a worthy goal, but using leverage to accomplish this is foolhardy. Options, futures, margin trading, and leveraged ETFs are all unacceptable due to over-dependence on market timing, high costs, and loss of tracking accuracy due to leverage rebalancing. The prudent young investor would fare better instead by saving as much as possible, paying off all high interest debts while keeping or incurring low interest debts to invest in stocks, allocating 100% in stocks, rebalancing to buy low and sell high, and favoring assets with higher risk premium, such as small value stocks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.