With traditional diversification, people spread money around different types of investments to reduce risk. This approach misses out on an important opportunity: “diversify” how you invest over time.
Most people start out with a small amount of money, because that’s all they can afford, and increase it as their earnings grow. But investing so much later in life unnecessarily puts people at greater risk as they near retirement. They end up with far greater exposure to stock-market risk in their 50s and 60s than in their 20s and 30s, even if they are buying diversified mutual funds.
We propose a different approach: people should borrow money to make their initial investment bigger, so that they can invest close to the same amount every year over their lifetime. Instead of $1 for the first, $2 for the next, and $3 for the third, consider investing $2 in a row for three decades.
The total amount they invest remains the same—$2 of average market exposure—but when it’s a constant amount, instead of increasing, the market exposure is larger than before ($2 vs. $1) and then later is smaller than otherwise. Life ($2 vs. $3).
stable dollar
Both options—investing $2 each decade instead of $1, $2 and $3—provide the same expected return, as they both have $6 of accumulated market risk over time. But the risks associated with the two strategies are different: our time-diversified path produces less variation in returns than increasing investments.
When investment risk changes over time, market fluctuations are not balanced as well. With 2/2/2, an up in the first decade balances with a down in the third, and vice versa. But with 1/2/3, the first decade is dominated by an up third, a down, and in the first decade a down is also dominated by an up third. As a result, the 1/2/3 investment pattern leads to large swings in lifetime accumulation. The 1/2/3 strategy has little reliance on the stock returns of the first decade and too much reliance on the third decade. By comparison, the 2/2/2 approach is more evenly spread and thus better diversified.
People may think they can’t follow a 2/2/2 type of strategy because they didn’t save enough when they were young: they can’t invest $2 because they only have $1. But this is not true. Using leverage — that is, borrowing money to buy stocks — people can use $1 of capital to borrow another $1 and thus get $2 in their first decade in the market.
sound risky? Consider that young people do the same thing with housing when they borrow money to buy a home they’ve lived in for decades—and the leverage there often involves borrowing $9 for every $1 of equity. We offer to borrow only $1 for every $1 invested. Limiting ourselves to 2:1 leverage means that we don’t reach a perfectly equal market over time, but move us closer to that ideal.
history lessons
Using an initial 200% allocation — and gradually reducing the allocation of shares over time, to 83% at retirement age — is a winning strategy. In a 2010 book, we found that this “leveraged life cycle” approach produced better retirement accumulation for each group that retired from 1914 to 2009. We now have returns a dozen years after publication where we can evaluate how the strategy has actually worked in practice. Leveraged life-cycle returns have continued to provide superior retirement accruals for each group until mid-2022.
The average investor using our method – assuming they invested 4% of their annual income, which increased to $100,000 in their last year of work during their career – accumulated $1,255,000, compared to a traditional goal- Tithi fund investment, starting with 90% of the stocks, was going down. Up 50%, only produced $675,000, and a continued 75% strategy led to $774,000.
Of course, these higher returns are partly due to greater stock exposure, not the diversified benefits of a leveraged life-cycle strategy. To focus solely on the diversification benefits, we compared retirement accumulation to a less-aggressive life-cycle strategy, which again starts with 200% in stocks, but drops to 50% at retirement. Is. We compared this to a consistent 75% savings in stocks and 25% in bonds. We chose this particular 75% allocation because it produces a similar average accumulation ($774,000) across retiring groups. Therefore, there will be no difference in strategies as one has more lifetime exposure to a stock, which on average tends to outperform.
Comparing these two strategies shows that the leveraged life-cycle strategy reduces the standard deviation of retirement accumulation by 19% in retiree groups. Our more time-diversified, leveraged strategy generates higher returns for groups that experienced the worst stock returns (10 percent accumulation increases 10.9% relative to a sustained 75% strategy) and stayed through the best stock returns. diminishing returns for peers (the 90th-percentile accumulation also decreases by 10.9% relative to the constant 75% strategy).
Producing similar average returns with less risk is evidence of how a leveraged life-cycle strategy can diversify market risk. Of course, ramping up stocks to 50% instead of 83% at the time of retirement leads to less market risk and therefore lower average returns. The investor can choose: the same return as a continuous 75% exposure strategy with less risk, or the same risk but with a higher expected return. Time diversification makes either possible.
avoid trouble
Our strategy works in theory and practice. But there are potential objections that can set people off.
For one, people may say that investing on margin is expensive. But competitive margin loans are cheaper than home mortgages (though you may need to consider an online brokerage).
The second objection is that leverage is risky. But when you are more equitably exposed to market risk throughout, you have less risk. Using leverage to go from 1/2/3 to 2/4/6 would combine risk and market risk. But the strategy of 2/2/2 is not.
When the market falls, investors who have been around 1/2/3 of the way to retirement are in trouble. If the shares fall 25% in their last decade of investment, they will lose 25% of their $3 investment — while a 2/2/2 investor will lose only 25% of the $2. This is a 50% higher loss on a $3 investment.
One objection that has some merit is that our approach requires discipline. Some people can’t bring themselves to borrow money to buy stocks or get out of a downturn in the market for the first time. We want target-date funds to make things easier for investors by automating the process, borrowing at a lower cost, and automatically adjusting the portfolio. People could put money in every month and forget about it.
Meanwhile, young investors can go 100% equities. It’s not 200%, but it’s a step in the right direction and doesn’t require the psychological or logistical burden of borrowing to buy. And even though this advice for readers in the 50s and 60s may be a bit late, this is advice to pass on to the next generation. They don’t need to repeat our mistakes.