Sunday, 1 July 2012

Book Review: Lifecycle Investing by Ian Ayres and Barry Nalebuff, Tanto Media Inc., 2010

(this book review was first published in the SBE's Business Economist, 14 Sept 2010)

The authors of Lifecycle Investing, Professors Ayres and Nalebuff of Yale University, believe that one of the greatest risks we all face is that of living too long and not being able to afford it. The subtitle of this book is ‘A new, safe and audacious way to improve the performance of your retirement portfolio,’ but they could also have called it ‘Time is your retirement money.’ From both historical data and Monte-Carlo simulations of their lifecycle investment model, the authors conclude that in addition to diversifying one’s retirement portfolio among assets, investors should also spread their market exposure throughout their working lives. They show empirically that people generally invest too little in the market when they’re young in comparison to when they’re older, finding that the typical investor is twenty or even fifty times more invested in equities in his or her early sixties in comparison with their late twenties (even after accounting for inflation).

The key message of the book is to use leverage to buy equities when one is young. They argue that investors have not traditionally appreciated the potential value of temporal diversification and that this is even more important than the gains from diversifying across assets as the returns in different years are less correlated than the returns in different stocks. “This book seeks to foster a second diversification revolution. Better diversification across time leads to reduced risk. And reduced risk allows for increased market exposure and higher returns."

The diversification benefits of leverage are possible whenever a person knows that he or she is going to have a substantial amount of savings in the future; for many people their total wealth is tied up in their human capital. The strategy comes down to two important figures: the present value of one’s lifetime savings (cash value of current savings plus the present value of future savings contributions) and what they call a person’s individual ‘Samuelson share’. Paul Samuelson showed that for a plausible type of risk preference, individuals would want to allocate a constant proportion in the stock market year after year, regardless of what happened to the value of stock. Ayles and Nalebuff come up with the following investment rule: every year of your working life your investment target is the product of your Samuelson share multiplied by the present value of your lifetime savings. The target allocation will be different for every person and is based on the return and risk associated with equities and how this compares to bond returns. The higher the return on equities and the lower the risk, the more one would want to allocate to stocks. The second component is one’s attitude toward risk; the more risk-averse one is, the less one would want to invest in stocks whatever their predicted return.

The authors compare their strategy – investing all liquid savings in equities with 2:1 leverage to achieve a Samuelson share of 83% early in working life, ramping down leverage until retirement – with two common strategies in use today:

• the target-date strategy: invest 90% of liquid savings in stocks at age 21 and reduce this proportion linearly to 50% by age 65;

• and a constant proportion invested in stocks strategy.

They perform simulations using stock market data back to 1871. In every case, no matter when one retires (even if right after the crashes of 1929 or 2008), their lifecycle strategy fared better. Much of the book is devoted to the mechanics of the investment strategy, simulations and results. They also compare lifecycle investing to buying a home, which is also a form of temporal diversification with borrowed money, the leverage declining as the loan is repaid. Thus with home ownership, one keeps a relatively constant exposure throughout the course of one’s life. The added advantage of lifecycle investing, they say, is that it allows diversification across time and across assets. Ideally young investors should borrow money to invest in a broad market basket of international stocks (probably through low cost mutual fund indexes and ETFs).

There is an entire chapter on contra-indications, warning that lifecycle investing is not appropriate in the following situations: if one has student or credit card debts, if one has less than $4,000 to invest, if one’s employer matches contributions to a retirement plan, if one needs the money to pay for children’s college education, if one’s salary is correlated with the market or if one would worry too much about losing money.

Perhaps the most compelling chapter is the last, ‘What if everyone did it,’ and here the authors take a tour of the history of investment strategies, subsequent legal rulings and changes in instruments. They say that under a modern view, an investment objective of preserving capital is not inconsistent with a disciplined, ramping-down approach of buying equities on margin when the client is investing for the long run. The authors appear to be totally committed to their approach; in fact they plan to be ‘in there pitching’ to the US Department of Labor for a regulation signalling that strategy is not per se imprudent or unsuitable. However, they also acknowledge that it may take some time to convince regulators.The authors provide a website for those with questions or who would like to input their own data for simulations. And though perhaps their promise of helping people see the world from a different vantage point in order to help them be ‘happier and wealthier’ is a bit much, the apparent hate mail that they received when they first presented their ideas might have been unfairly reactionary. Time will tell.

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