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 by 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 stocl 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.