Lifecycle Investing is a controversial strategy about using leverage to diversify across time. It’s a bold strategy, Cotton, let’s see how it turns out.
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The premise of Lifecycle Investing
Surprisingly, this isn’t a proposal that’s too dissimilar to a more traditional risk approach.
The idea is that, over a lifetime, you’re rarely ever invested in equities to the amount you want, so you should take more exposure to equities early on in your investing career and only reduce to your target share portfolio allocation near the end.
Traditionally, people do this by having a mix of 80-100% equities to 0-20% of government bonds in their investments when they’re young. As you get older, you would rebalance to have more bonds and fewer equities, eventually retiring at around a 60-40 or 50-50 mix.
The problem is that while you’re diversifying well with your assets, you’re not actually achieving this over time. When you’re only in the first 10 years of investing, you only have a piddly amount of actual money exposed to the market. Later on, you have (hopefully!) hundreds of thousands – maybe millions – exposed.
You also have things that are bond-like. More on that below.
Ayres and Nalebuff therefore propose using leverage early on to try and even the score, and their figures suggest that this actually decreases risk.
The Lifecycle Investing portfolio
The Lifecycle Investing method of diversifying across time is to start by using 2:1 leverage. Instead of rebalancing the equities:bonds ratio of a portfolio, they suggest starting by decreasing the leverage over time.
They wanted to balance the need to add leverage with the risk of leverage, so they propose starting with 200% exposure to equities, through buying options at 50% – using all your money and borrowing the same amount.
It’s important to consider that Ayres and Nalebuff only recommend this with a 30-40 year timeline. They’re open that it won’t work for shorter investing careers.
There’s a formula that they use to work out what your equities ratio should be at any time, but it starts in two small parts.
1. The present value of your lifetime savings
The idea is that you work out how much you’re likely to save over your (work) career. Ever. You plan it against reasonable inflation and promotion prospects for your industry.
I thought that this was an odd thing to predict, but nevertheless it’s a thing that you can sort-of estimate.
For example: if you’re a finance graduate just starting an investment banking job, you can safely assume that you’re going to earn a couple of million over a lifetime. If you’re in a structured career, like being a doctor, you can probably estimate the amount you’re likely to earn and save as you go through your career.
I’m not sure how possible this is for a lot of people. Fortunately, it’s just a rough estimate.
2. Your “Samuelson Share” – an indicator of target balance at retirement
This is the proportion of your lifetime savings that you’d invest into different assets if you got all of your savings in cash today.
Right now.
A quick note about asset allocation
To make things simple, Ayres and Nalebuff consider all investments in shares, real estate and commodities as “stocks” and all income assets – including things like the state pension – as “bonds”.
Being an American book, they say “social security” instead of state pension, but you get the idea.
This means that defined benefits pensions – like government pensions, military pensions, teacher pensions and so on – would fall into the same bucket as bonds. In my case, my public sector pension would count as bonds.
Years of exposure
Using the Samuelson share and the present value of your lifetime savings, the Lifecycle Investing method is to then break it down into dollar years of exposure in those assets.
I’m not going to go too much into this, partly because it’s a vague concept and partly because Ayres and Nalebuff then promptly abandon the complexity of working this exact figure out to go with rough estimates and promote a certain risk-reward profile. It’s not explained that well and then it gets dropped.
The core concept is that if you start by investing in a 60:40 portfolio, you end up having exposed a ton of your money to the various bonds earlier, because you haven’t factored in things like social security that comes later in life.
Why would you consider Lifecycle Investing?
Leverage sounds scary – and is – but the book shows that in any long-term period throughout the history of the (US) stock and bond markets this method will lead to more predictable results than either a) investing at a constant 60:40 split or b) decreasing the portion of equities and increasing the portion of bonds with age.
Their figures show that although the maximum amount that investors could accumulate over any historical period is smaller, the minimum amount is a lot higher and the median distribution (i.e. the statistically most likely average) is higher.
Mathematically, their plan checks out.
The best results seem to come from a 200% equity allocation that reduces to 83% at the point of retirement. That means leverage at 2:1 in just equities from the start, ending up with no leverage and a bit over 4/5ths of your pot being in equities at the end.
Why not more leverage?
If you use more leverage, you gain more volatility. A slight drop might completely wipe you out before you have the chance to add more money in to keep the debt at the agreed minimum percentage. This means that you’d miss out on any recovery, as you would have been put at a loss before the gain.
Ayres and Nalebuff compromise at 2:1, just in case a 30% market drop happens in your investing career. That way you won’t be totally wiped out (although you will have lost 20% of your input capital) and can top-up money and continue. It’s also a lot cheaper to get leverage at 2:1 than a higher ratio, and the cost of the debt will eat into your portfolio.
Doesn’t leverage cost you money?
Yes, it does. However, Ayres and Nalebuff worked out options as coming in a t less than 2% annual interest equivalent. I haven’t confirmed these figures, but that would make its impact on your investments pretty insignificant in a good year. A 7% rise in the stock markets would give you 14% growth, and even a 2% reduction down to 12% is pretty reasonable.
Note that the Lifecycle Investing approach is to buy options. You can also buy shares on margin (i.e. with a loan) or using a leveraged fund (such as this one by Xtrackers that’s 2x leverage of the S&P 500). However, you can get margin calls if your leverage ratio drops too low when you buy shares on margin (literally a phone call demanding that you pay in more cash or get liquidated), and leveraged ETFs rebalance daily, consolidating any damage from temporary market dips.
Criticisms of Lifecycle Investing
Mathematically, this all seems to stack up nicely. You actually reduce the risk of not having enough capital at retirement by raising the lowest predictable amount of capital you’d have at retirement. Yes, this is based on historical data, but the data is tested against a generation whose portfolio suffered through the Great Depression and World War One. That’s pretty robust testing.
The problem is that you need to sleep at night.
I’ll review it separately, but Morgan Housel’s criticism of this strategy in The Psychology of Money is that most people won’t rest easy at 2x leverage when recession hits. Sometimes stock markets can slide for a couple of years or flatline for a decade, which isn’t going to be comfortable. Debt is like a weight on the mind.
In the book, Ayres and Nalebuff also talk about one of their strongest critics. This is a person whom the authors clearly respect, but whose response is simply that investing 60:40 all but guarantees that capital will be there from your portfolio when you want it. This is pretty much the same idea as Morgan Housel’s.
My thoughts on Lifecycle Investing
I’m not employing this strategy directly, due to the Boat Plan. If I’m planning to live on my investments within a decade, the risks that come with a 200% exposure to equities simply aren’t worth the limited gains that I could make in that time.
I will probably look at leverage again. It might be that I could consider a counterbalanced portfolio where 1.5x leverage would result in likely gains each year. This is something that the YouTubers Money Unshackled have been doing. I’m still undecided about this though, as I take quite a lot of risk with my heavy tilt towards cryptocurrencies that I’m hoping to rebalance towards the back end of the year.
A good takeaway that’s applicable to anyone is the characterisation of bond and bond-like investments.
My public sector pension kicks in at around age 65 and gives me around £8k per year, inflation-linked. Assuming that the UK Government is still a thing in 35 years, that’s a pretty chunky contribution. If I need £20k in retirement (which is probably about right for us!) then I’m already 40% weighted in bonds.
This has changed my pension portfolio and I’m now going pretty much 80% equities and 20% real estate in my workplace pension, with 100% equities in my SIPP.
Final thoughts
Lifecycle investing with leverage is a bold strategy. Mathematically, it makes sense. However, given that it assumes a long investing career, I’m not sure it’s too relevant for most financial independence campaigners and it’s not something I plan to execute in the same way any time soon.
