Scratch the surface of any financial crisis in recent memory and there is almost certainly a common factor at play as traders place their bets to maximize their upside, only to be exposed to severe losses on the downside — excessive leverage. The presence of leverage at the scene of most major market calamities has given it a dangerous reputation.

However, new research argues that greater leverage is just what individual investors need if they want to maximize their retirement savings and minimize risk.

“The typical decision of how to invest retirement savings is fundamentally flawed,” says a recent report from two Yale University professors, Ian Ayres, a professor at the Yale Law School, and Barry Nalebuff, from the Yale School of Management.

In a working paper published by the U.S. National Bureau of Economic Research in June, Ayres and Nalebuff theorize that although investors have learned the value of diversification across asset classes and geography, they haven’t recognized the importance of diversifying across different time periods. “The problem for most investors is that they have too much invested late in their lives and not enough early on,” they assert in their paper.

The reason is clear enough: most people start with little to no savings when they are young. So, they are constrained in the amount they can invest at the start of their working lives.

If an investor already had his or her full future retirement savings in hand at age 21, when he or she began working, it would be easy enough to adopt an asset-allocation strategy that maximizes return potential, given his or her risk tolerance. But because most people aren’t in that situation, it’s generally recommended that investors adopt greater equity allocations when they are young, moving to a more conservative mix over time; various investment funds have been created that automate that process.

The research of Ayres and Nalebuff, however, found that even these higher initial equity allocations are far too low. Although investors may put up to 100% of their small initial savings into stocks in an effort to build their nest eggs more quickly in relation to the discounted present value of their expected lifetime savings, their stock allocation is probably still too low. As a result, the paper concludes that these investors should leverage their portfolios while they are young.

The report acknowledges that this advice is controversial: “We recognize that our recommendation to begin with a leveraged position goes against conventional advice.” However, the authors argue, it rationally follows from the theory that investors should adopt a constant asset mix to reflect their risk tolerance.

More important, this argument was proven in the data. The advice was back-tested against actual U.S. market returns from 1871 to 2007, and assumes 44 years of investing as people enter the workforce at age 21 and retire at age 65. Using the study’s leveraged life-cycle model — employing leverage at an early age and gradually de-leveraging — the professors found that investors can achieve higher returns with less risk.

“The point of this paper is to overturn the standard orthodoxy that counsels against buying stock on margin,” Ayres and Nalebuff say in the report. “Most people (including ourselves) misinvested their retirement portfolios when young. The cost of this mistake is not small. Our estimates suggest that if people had followed this advice, historically they would have retired with portfolios worth 21% more on average when compared with [investing 100% in stocks] and 93% more when compared to the life-cycle strategy.”

Moreover, the increased returns also have less risk. “For all risk preferences, the results are better,” the paper explains. “This suggests a simple rule that will lead to better outcomes: whatever savings young people have, they should leverage them up.”

Historically, equities have returned about 9% and the cost of margin was 5%; this equity premium of 4% served as the source of additional returns in the study’s model. Admittedly, this premium may not persist in the future, but the study found that even if it is halved, investors would still benefit by leveraging up early on. Moreover, the authors also tested their hypothesis against historical returns in Britain and Japan and subjected it to a vast array of simulations to see how the strategy would perform with significantly different annual return distributions.

@page_break@For the most part, the strategy produced superior results. “This paper shows that it is possible for people to retire with substantially larger and safer retirement accumulations, and they can do this without having to save more,” the authors conclude. “All they have to do is invest using leverage while young.”

If that sounds too good to be true, consider that this is essentially the same promise offered by conventional diversification theories: a portfolio that’s diversified by asset class will deliver better risk-adjusted returns by lowering volatility and limiting the overall portfolio’s downside, thereby ensuring that future gains are made upon the highest possible initial value.

Critics of time diversification have argued that risk actually increases with time, as the value of the portfolio grows. The difference proposed in the Yale paper is that investors are being counselled to expose the discounted future value of their portfolio — not just the current value — to this diversity of annual returns, thereby smoothing the size of their bets in each year.

The report asserts that finding uncorrelated returns — the trick to diversification — is accomplished more easily over time than it is between asset classes: “Indeed, temporal diversification is more important because returns across different years tend to be less correlated than returns across different stocks within any given year. If only one type of diversification were possible, diversification across time lowers risk more than across stocks.”

Whether this theory is enough to overcome the apprehension many investors feel about borrowing to invest is another matter. And the paper does admit that utilizing leverage exposes investors to the risk that they could lose all their savings: “That risk is related to the extent of leverage. If portfolios were leveraged 20:1, as we do with real estate, this risk would be significant.”

However, Ayres and Nalebuff counsel that the maximum leverage investors should employ is 2:1 and that this should be used only in the early saving years. “Thus, investors only face the risk of wiping out their current investments when they are still young and will have a chance to rebuild,” the paper says. “Present savings might be extinguished, but the present value of future savings will never be.”

The professors’ recommended investment strategy follows three phases: “The worker begins by investing 200% of current savings in stock until a target level of investment is achieved. In the second phase, the worker maintains the target level of equity investment while de-leveraging the portfolio, and then maintains that target level as an unleveraged position in the third and final phase.”

Actual returns will determine when investors can start de-leveraging their portfolios. The research found that the median age at which investors could begin reducing leverage is 33 and the median age for moving to an unleveraged portfolio is slightly younger than 51.

Looking back at the historical data, the research found that if investors had followed this strategy, those entering the labour force in 1931 would have been hit hardest, losing 86.5% of their first year of savings in a year in which the S&P 500 composite index lost almost 40%. However, if they stuck with the strategy, by the time they retired, they would have done substantially better than investors who simply invested 100% in stocks throughout their working lives.

The strategy does, however, mean that investors are likely to experience some large losses in a given month. “Leveraged strategies expose workers to a much larger probability of incurring a substantial negative monthly return sometime during their working lives,” Ayres and Nalebuff note in the paper. Based on historical monthly returns, about 25% of investors would have suffered a drop greater than 40% in at least one month.

“However, that exposure to a risk of a substantial monthly loss,” the paper says, “does not mean exposure to a risk of substantial loss to accumulated retirement savings.”

Nevertheless, it is possible to conjure up scenarios in which the leveraging strategy does not outperform the conventional approach. The professors ran 10,000 simulations, re-placing actual annual returns at random — meaning that a given year’s return was put back into the return universe after it was picked and, therefore, could occur more than once. In this case, the leveraging strategy is no longer unassailably superior. “The reason is that with a large enough sample, some workers will draw the 1931 returns 44 years in a row,” Ayres’ and Nalebuff’s paper explains. “If nature draws depression many times in an investor’s life, unleveraged strategies will do better.”

(Of course, an investor that lives through 44 years of consecutive Depression-era returns probably has bigger problems on his or her hands than whether their retirement savings are on track.)

Still, the past year in the financial markets should be enough to warn investors that just because market events haven’t happened in the past doesn’t mean they won’t in the future. That could feed an intuitive reluctance to employ leverage.

“Despite compelling theory and empiricism, many people have a strong psychological aversion to mortgaging their retirement savings,” the report notes. “While families are encouraged to buy a house on margin, they are discouraged and often prohibited from buying equities on margin. We are taught to think of [leveraged] investments as having the goal of short-term speculation instead of long-term diversification. As a result, most people have too little diversification across time and too little exposure to the market when young. Based on historical data, the cost of these mistakes is substantial.”

Indeed, compared with conventional life-cycle strategies — starting with 90% exposure to stocks and reducing that to 50% over time — Ayres and Nalebuff have estimated that, based on past returns, adherents to their strategy would have been able to finance an additional 27 years of retirement, or to retire five-and-a-half years earlier, and still have enough money to last them through to age 85 — almost double the historical retirement consumption.

Although the study’s results are compelling, most investors have a hard enough time diversifying across asset classes, often timing their trades poorly and demonstrating little sensitivity to the underlying cost of products such as mutual funds. So, it’s hard to imagine them rigorously applying a long-term leveraging strategy to their portfolios. IE