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Lifecycle investing on steroids

Yesterday we noted that the buy-and-hold crowd was back.  With the bear market fading in our memories and calls for a fundamental revision of target date funds funds fading it seems appropriate that we now see calls for investors to take on even more risk in their retirement accounts.

Barbara Kiviat at Time.com interviews Yale professors Ian Ayres and Barry Nalebuff about their proposed retirement saving plan.  This plan seeks to take advantage of time diversification by leveraging a young person’s retirement portfolio (or stocks) and slowly deleveraging as retirement approaches.  They argue that this approach both increases terminal wealth and reduces risk.

In short, they argue that we all have been brainwashed into thinking that leverage is always a bad thing when it comes to the stock market.  They note that some safeguards would have to be put into place to protect investors.  We recommend you read the interview and the research paper* linked to below.

Not surprisingly this approach attracted negative attention in the blogosphere, including a post by Jason Goepfert at Sentiment’s Edge who writes:

Let me say this, though.  Suggesting that young people go full-tilt leveraged into stocks is not diversification.  Don’t let any academic tell you otherwise.

One could view this sort of approach as a target date or lifecycle fund on steroids.  With leverage providing a (potential) boost to returns.  The problem is that steroids (i.e. leverage) comes with a cost.  Outside of the explicit costs of leverage, i.e. margin rates, there is an additional level of education required.

John Keefe in the Financial Times notes the many problems with retirement plans, not least of which is the lack of understanding on the part of participants.  During the credit crisis many investors cried foul at the poor returns on their (non-leveraged) target date funds.  One could imagine the hue and cry that would have erupted if a leveraged approach had been commonplace back in 2008.

The point is not the way the Monte Carlo simulations work, but rather way our brains work.  Just as it was with buy-and-hold investors, it is unlikely that many would have continued with this  approach through what turned out to be a 50%+ (non-leveraged) downturn in the stock market (S&P 500).  As we noted in yesterday’s piece there are few things that harm a portfolio more than jumping from one strategy to another.

Our caveats with this strategy are too numerous to mention here.  One can think of ways that would help mitigate the risks from this sort of strategy including adding a valuation overlay or using a globally diversified multi-asset portfolio as opposed to an all-equity portfolio.  But these do not address the main issue – human psychology.

Suffice it say that like most backtests a leveraged approach to retirement investing underestimates the willingness of participants to withstand serious drawdowns.  In short, a levered-equity retirement strategy can be perfectly rational in theory and wholly unworkable in practice.

*The aforementioned research paper:

Ayres, Ian and Nalebuff, Barry J., Life-Cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk (May 27, 2008). Available at SSRN: http://ssrn.com/abstract=1139110

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