A strategy for retirement saving that shatters conventional wisdom
Market Movers links to an intriguing paper from Ian Ayres and Barry Nalebuff, both from Yale, that recommends twenty-somethings plan for retirement by borrowing money to invest in the stock market. Leverage up to buy stocks? Yes. They write:
The typical decision of how to invest retirement savings is fundamentally flawed. The standard advice is to hold stocks roughly in proportion to 110 minus one’s age. Thus a twenty-year old might be 90-10 in stocks versus bonds, while a sixty-year old would be 50-50. This advice has been automated by life-cycle funds from Fidelity, Vanguard, and others that each year shift the portfolio from stocks into bonds. Our results demonstrate that the early asset allocation is far too conservative.
We find that people should be holding much more stock when young. In fact, their allocation should be more than 100% in stocks. In their early working years, people should invest on a leveraged basis in a diversified portfolio of stocks. Over time, they should decrease their leverage and ultimately become unleveraged as they come closer to retirement. The lifetime impact of the misallocation is large. The expected gain from this improved asset allocation relative to traditional life-cycle investments would lead to 90% higher retirement wealth. This would allow people to retire nearly six years earlier or to retire at the same age (65) and yet maintain their standard of living through age 112 rather than age 85.
This might sound like bad advice or impossible advice to commit to taking, especially for risk-averse investors, and neither us nor Ayres and Nalebuff know of any companies that allow their employees to buy stocks on margin through a 401(k) plan. But consider that people already perform a similar act when they take out a mortgage. Borrowing money to buy a home is normal. Borrowing money to buy stocks is crazy. Yes, you can live in a home, not in a stock portfolio, but Ayres and Nalebuff’s paper reveals the underlying, unspoken current that people think of leveraging as behavior associated with speculators or people with short-term goals. Ayres and Nalebuff’s intention is to have people think of leveraged stock investments as “long-term diversification” – more like houses (pre-housing boom houses, anyway).
And they’re not completely reckless. They recommend a maximum 2:1 leverage, which for most young savers is far less than the leverage they take on with a home that over the short-run can, like a stock, be a risky investment. Making calculations from market data since 1871 they estimate a worst case scenario from (surprise!) October 1929 when their strategy would have produced negative returns of 53% for young investors who were leveraged 2:1. And investors, they say, should be prepared for (surprise again!) serious fluctuations in their portfolio. Self-control problems, not the actual borrowing, would seem to be the biggest threat to good decisions.
There are some strategies for how to leverage (hint: you don’t just run out their and buy any stock; read the paper for specifics), which Market Movers isn’t fully sold on. From the Nudge blog’s purposes, the bigger question is whether companies should include an option for this strategy in a worker’s retirement package?