The Lifecycle Investor
Many people who are at or near retirement age wish they could have a second chance at saving after the down market of the last few years. The plight of these investors highlights the problem with conventional retirement investment strategies: an investor's lifetime of savings can be left over-exposed to risk as they approach the end of their working years.
"The first lesson in finance is diversification, diversification, diversification," says Barry Nalebuff. "We understand that you should diversify across stocks, which is why you buy a stock index, go domestic and international, and diversify across asset classes. But what most people miss is diversification across time."
In The Lifecycle Investor: A New, Safe, and Audacious Way to Improve the Performance of Your Retirement Portfolio, Ian Ayres and Nalebuff propose an investment strategy that does a better job spreading out the exposure to equities over the years of a personís working life. By investing more when young and less when old, investors can hold their lifetime exposure to the stock market constant while assuming more risk early when any losses will be smaller in absolute terms and can be recouped.
The challenge with spreading investments better across time is that most young people invest little because they donít have much money. Says Nalebuff, "Stocks for the long run is a great idea, but most people donít have a long run left when they have money to buy stock. And when they have the long run, they donít have money to buy stocks." To solve this dilemma, Ayres and Nalebuff propose that young people use leverage to buy stocks. By buying stocks on margin, they can increase their exposure to equities to more than 100% ó Ayres and Nalebuff propose 200% ó pay down the debt as they age, and then ramp down over time to 50% equities at the beginning of retirement.
The lifecycle strategy considers oneís entire portfolio of assets, not just liquid assets. "For young people, almost all of your assets are still in the form of your human capital and for most people thatís like a bond. If you have $50,000 in the market, and you decide to put $40,000 in stocks and $10,000 in bonds, you might think youíre 80% in stocks. But you have another $500,000 in bonds in the form of your human capital, which is slowly being converted to financial capital. Taking human capital into account, really, you have $550,000 of assets, only $40,000 of which are in stocks, so you are more like 7% in stocks."
Ayres and Nalebuff outline practical ways to implement their strategy. An easy first step is to be 100% allocated in equities until age 45. While less than 200%, it is a move in the right direction that everyone can take through an index fund.
"The ideal solution is that companies like TIAA-CREF and Fidelity would create a new type of target date fund, one that starts at 200% and comes down to 50% at retirement age. The challenge is that in order for these funds to avoid legal liability they would need to satisfy the prudent investor rule and itís not clear today whether ERISA and other regulators conclude that investing with leverage when youíre young is prudent." Ayres and Nalebuff have filed a provisional patent on their approach to retirement savings.
To test how their lifecycle strategy of 200% equities winding down to 50% at retirement would perform compared to more conventional strategies, Ayres and Nalebuff ran simulations using historical data. They followed 96 cohorts of investors, beginning with those who started working in 1871 through those who started in 1966 and retired in 2009 at age 67.
"Not only was the average return 50% higher and the minimum return higher, but each and every cohort ended up doing better under our proposed strategy," says Nalebuff. The 200/50 strategy also reduced risk by more than 20%.
Older investors can benefit from the lifecycle strategy. "If you wait until your 60, we donít have a lot to suggest. But if you are 45, we can still raise your minimum return by 16% and your average return by 40%. Even if you are 55, your average return can go up by 17%." However, they caution that the strategy isnít for everyone, including anyone with credit card debt, or who has less than $4,000 to invest, or is with a company that offers matching contributions to their 401(k) plan. For those working on Wall Street, their human capital is already correlated with the market and so no more exposure is required.
Ayres and Nalebuff are not under the impression that everyone will immediately take on their strategy. "We would consider it to be a great victory if people would meet us at 100% equity as a starting point. We could change the allocation rules used by target date funds and then create some pressure. Once thatís viewed as prudent, the obvious question is why are we stopping at 100%?"
The move from defined benefit to defined contribution retirement plans has put the onus of saving for retirement onto more and more individual investors. "The paradox of the lifecycle investing approach is that taking on more risk when young can lower your lifetime risk and thereby help you safely achieve your goals," says Nalebuff.
Barry Nalebuff is the Milton Steinbach Professor of Management at the Yale School of Management. His co-author Ian Ayres is the William K. Townsend Professor of Law at Yale Law School. For more information about The Lifecycle Investor, visit lifecycleinvestor.net.