This is a follow up to Invest Time. I recommend reading that first.
In my initial post, I argued that most young adults should be 100% invested in stocks. Since then, I've chatted with several colleagues and subscribers who agreed that young adults being 100% in stocks isn't radical at all. I've decided to go even further and discuss why 200% in stocks isn't that radical either given the newsletter's audience. In today's notes, I'll try to summarize some parts of Ian Ayres & Barry J. Nalebuff's brilliant book - Lifecycle Investing, but I highly recommend reading it. This is one of those books with an expiration date for the reader depending on how much time they have left to invest.
Leverage & Wealth
Let's revisit this idea of diversifying across time (temporal diversification as the book calls it). The goal is for you to try to spread out your exposure to the market across several decades.
People make the mistake of putting 80 percent of their stock investments in just ten years. This can have disastrous consequences if those ten years happen to end badly. In fact, as we write this in the summer of 2009, the S&P stands at its 1997 level. People close to retirement who invested the bulk of their stock money in this lost decade will not have done well. You are better off spreading your stock investments across several decades.
But as a young adult, you probably don't have enough money to properly diversify your portfolio. Your portfolio can be 100% in stocks using just your own money, but you'll need to borrow the other half to get to 200%. Now most people stop listening, or reading in this case, whenever leverage comes into play. Borrowing money is sometimes scary, and investing borrowed money is a taboo for most. But this isn't Dave Ramsay's notes. Leverage plays a big part in building wealth, and borrowing can be beneficial or disastrous depending on how the money is borrowed and what it's used for.
Let's take a mortgage for example - people are fine with putting up to 20% down on a new property and borrowing the rest. What's unheard of is a real estate investor that pays cash for every single property they invest in. If you buy a $100k home with $10k down, you'll be levered 10:1. If that home's value increases by 10%, your equity also increases, but by 100%. The same goes for downturns - a 10% decrease in the scenario above wipes out all the equity you have in that property in the short term. This translates over to stocks, though we'll never be levered 10:1. You can still leverage your positions in stocks without borrowing anything if debt scares you, but everything has a cost. There's only one free lunch in investing.
The book suggests a 2:1 leverage for the first decade of your working life. After that, gradually lever down till your mid fifties. Finally, start to fully unlever while replacing portions of the portfolio with fixed income. As a young adult, you're probably in the first stage. You can leverage with margin, levered ETFs, or options. With margin, you're borrowing money from your brokerage, and they'll charge interest on the money till it's paid back in full. It is the easiest way to get closer to 2:1, but beware of margin calls.
Some levered ETFs, such as ProShares Ultra S&P500 (SSO), try to return 2x the daily performance of the S&P500 before fees and expenses. If you go this route, beware of decay & volatility. Simply put, if the index goes up 10% from 100 to 110, your levered etf position goes from 100 to 120. If the index then drops 9%, from 110 back down to 100, the levered position drops from 120 to 98.4. You end up with $2 less than you started with. I don't recommend levered ETFs due to the decay on top of their expense ratios.
Options, on the other hand, get a bad reputation. They can actually be used to lever your portfolio without directly borrowing money. Deep in the money LEAPs with a strike price roughly half of the index can be used to achieve 2:1 leverage. As of writing, SPY is trading at $333. You can get a Jan 21 2022 165 Call for $170. Remember that an option grants you the right to purchase 100 shares at the strike price. You're essentially paying a little more for this right. In our example, this option will cost $170 * 100 shares or $17,000, but it exposes you to about $34,000 worth of SPY returns. This is my preferred way of levering.
The lifecycle strategy recommends starting at 200% in stocks, and levering down to 83% stocks at retirement. Compared to more traditional strategies like 90/50 target date (90% stocks now, 50% stocks at retirement) and constant 75% stocks, the 200/83 lifecycle strategy performs extremely well from a return and risk perspective. The authors of the book ran 96 different historic simulations on a theoretical investor that was invested for 43 years starting from 1871 - 1914, 1872 - 1915, till 1966-2009. They found that you can dramatically increase your returns by taking slightly more risk.
With the 200/83 lifecycle strategy, you'll end up with about 90% more compared to the birthday rule, and 63% more wealth compared to the constant strategy. Even the downsides are better - 33% and 25% more respectively. The strategy's risk (the standard deviation) is higher at 37.05% compared to 26.09% and 33.36%. Another way to measure this risk is with the Sharpe Ratio; it's used to evaluate the risk adjusted performance of an investment. The birthday rule had a sharpe ratio of 2.12, constant had 1.84, and lifecycle had 2.06. In other words, the constant portfolio is riskier than the lifecycle strategy and doesn't have the returns to show for it. The lifecycle strategy is slightly riskier than the birthday rule, but its expected return is much higher!
You may have heard the quote that claims "diversification is the only free lunch" in investing; that still stands, but this is pretty close. By following the lifecycle strategy and reducing your stock exposure at retirement to 50 from 83, your outcome is better for almost no additional risk! Both the 200/50 and birthday rule end up with the same 26% standard deviation.
The increased exposure is what boosts your returns, while the better allocation across time is what keeps the
risk under control.
Your Sharpe ratio also comes out ahead at 2.34 vs 2.12. This is a big deal because it attributes the out performance to diversification as opposed to investing more money or taking additional risk.
Markets don't always go up. When they don't, levered portfolios get hit harder. With this strategy, a market drop is even riskier because it pushes our leverage over 2:1 as equities get hit. The strategy requires the investor to maintain 2:1 in that initial decade which means buying more as prices fall.
Of all the 96 back tested simulations, the 200/83 rule came out on top even during market downturns. Those entering retirement in a downturn aren't affected because they no longer have leverage, and the unlucky person in their 20s who just started may see a significant drop of a much smaller portfolio, which will recover over time.
This strategy is definitely not for everyone. Chapter 6 is one of the most important chapters as it cautions investors not to over do it.
- 2:1 is the recommended maximum.
- High interest debt should be dealt with before hand. Don't go chasing an 8% return while paying 20%+ on credit cards.
- If your employer matches on a 401k plan, take that money! You'll get market returns + a risk free contribution from your employer.
- Don't do this with your house's down payment or children's college money
- This isn't for people with jobs that are correlated with the market.
- This is absolutely not for those who can't take any risk. A good measure will be how often you check your brokerage app or refresh it when prices are in free fall. I recommend reevaluating your risk appetite if you won't get good sleep with during downturns.
- Most importantly, this isn't an investment advice. Everything you've read so far is for educational purposes only.
Thanks for reading today's notes. I love reading and learning about finance, and recently started writing about it. Feel free to send comments my way by replying directly to the newsletter or emailing me at newsletter -at- tolusnotes.com.
I've written one of these back to back for 4 weeks now. I'll be taking March off to read some more.
💻 You can run all these numbers yourself - download the dataset and simulations from the book's official website
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