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 \u2014 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.
\u201cThe typical decision of how to invest retirement savings is fundamentally flawed,\u201d 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\u2019t recognized the importance of diversifying across different time periods. \u201cThe problem for most investors is that they have too much invested late in their lives and not enough early on,\u201d 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\u2019t in that situation, it\u2019s 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: \u201cWe recognize that our recommendation to begin with a leveraged position goes against conventional advice.\u201d 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\u2019s leveraged life-cycle model \u2014 employing leverage at an early age and gradually de-leveraging \u2014 the professors found that investors can achieve higher returns with less risk.
\u201cThe point of this paper is to overturn the standard orthodoxy that counsels against buying stock on margin,\u201d Ayres and Nalebuff say in the report. \u201cMost 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.\u201d
Moreover, the increased returns also have less risk. \u201cFor all risk preferences, the results are better,\u201d the paper explains. \u201cThis suggests a simple rule that will lead to better outcomes: whatever savings young people have, they should leverage them up.\u201d
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\u2019s 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. \u201cThis 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,\u201d the authors conclude. \u201cAll they have to do is invest using leverage while young.\u201d
If that sounds too good to be true, consider that this is essentially the same promise offered by conventional diversification theories: a portfolio that\u2019s diversified by asset class will deliver better risk-adjusted returns by lowering volatility and limiting the overall portfolio\u2019s 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 \u2014 not just the current value \u2014 to this diversity of annual returns, thereby smoothing the size of their bets in each year.
The report asserts that finding uncorrelated returns \u2014 the trick to diversification \u2014 is accomplished more easily over time than it is between asset classes: \u201cIndeed, 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.\u201d
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: \u201cThat 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.\u201d
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. \u201cThus, investors only face the risk of wiping out their current investments when they are still young and will have a chance to rebuild,\u201d the paper says. \u201cPresent savings might be extinguished, but the present value of future savings will never be.\u201d
The professors\u2019 recommended investment strategy follows three phases: \u201cThe 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.\u201d
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. \u201cLeveraged strategies expose workers to a much larger probability of incurring a substantial negative monthly return sometime during their working lives,\u201d 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.
\u201cHowever, that exposure to a risk of a substantial monthly loss,\u201d the paper says, \u201cdoes not mean exposure to a risk of substantial loss to accumulated retirement savings.\u201d
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 \u2014 meaning that a given year\u2019s 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. \u201cThe reason is that with a large enough sample, some workers will draw the 1931 returns 44 years in a row,\u201d Ayres\u2019 and Nalebuff\u2019s paper explains. \u201cIf nature draws depression many times in an investor\u2019s life, unleveraged strategies will do better.\u201d
(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\u2019t happened in the past doesn\u2019t mean they won\u2019t in the future. That could feed an intuitive reluctance to employ leverage.
\u201cDespite compelling theory and empiricism, many people have a strong psychological aversion to mortgaging their retirement savings,\u201d the report notes. \u201cWhile 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.\u201d
Indeed, compared with conventional life-cycle strategies \u2014 starting with 90% exposure to stocks and reducing that to 50% over time \u2014 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 \u2014 almost double the historical retirement consumption.
Although the study\u2019s 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\u2019s hard to imagine them rigorously applying a long-term leveraging strategy to their portfolios.\tIE<\/b>
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