Lifecycle investing a new, safe, and audacious way to improve the performance of your retirement portfolio
Auteur: Ian Ayres, Barry Nalebuff
Ma note: 6/10
Mes highlights
Over the last 138 years, stocks have outper-formed bonds—not every year, but for every generation. On average, stocks have outperformed bonds by 5 percent.
Of course, low fees also mean low ad budgets. If you see a firm spending loads of money trying to convince you to invest with them, you should realize that it will be your money that’s paying for the ads.
A good way to measure risk is by the range of outcomes that you’ll see 95 percent of the time
The larger the volatility, the more important it is to di-versify
Even in your twenties, with $25,000 down, you can buy a $250,000 house or apart-ment. Although the bank “owns” your home, you still have full $250,000 exposure to the market
but all their housing risk is invested in a single property, a single housing stock if you will. It’s better to diversify across time and across assets
While people are comfortable investing in a home on a 10:1 leveraged basis, they have not been able to bring themselves to invest on even a 2:1 basis in stock.
If the key to buying real estate is location, location, location, the key to buying stocks is diversification, diversification, diversification
Buying stocks with leverage will ultimately reduce your invest-ment risk. INTRODUCTION 7
The gains from diversifying across time are even more important than the gains from diversifying across assets—for the simple reason that the returns in different years are less correlated than the re-turns in different stocks.
You won’t be able to invest with leverage (at least not at present), but the employer match is even better than leverage
LEAP is the acronym for Long-term Equity AnticiPation, which is a fancy way of saying a long-term stock option.
SPDR (pro-nounced Spider), a fund designed to mimic the performance of the S&P 500 index.
If he were to invest his current $5,000 savings 60 percent in stocks and 40 percent in bonds, then it would be as if he had $3,000 in stocks and $502,000 in bonds.
Total dollar years is the sum of dollars you have invested in stock each year.
Federal law limits the amount you can borrow— it can’t be more than you put up. So if you have $4,000 to invest, you can borrow another $4,000 from your stockbroker in order to buy $8,000 of stock. This is called buying stock on “margin.”
The advantage of the option is that there aren’t any margin calls. Whether the market goes up or down, you won’t be called on to put in more money. A second advantage is that call options allow you to double your exposure to the market at a very low cost.
The big step is to realize that (if you are like most people) your future salary is like a bond and therefore you are prob-ably much more heavily weighted in bonds than you realize
The second step is to discount that bond back to today. Because that money comes in the future, it isn’t quite as valuable as if you had it today.
The present value of a future dollar is always less than a dollar, but it isn’t zero—and your optimal investment today should take it into account.
The advantage of this approach is that the fund automatically does all the rebalancing for you. Each year it shifts more of your money from equities into bonds
under 19 basis points (a basis point is one-hundredth of a percent)
Phase one lasts until your portfolio grows to the point that 2:1 leverage gets you to the target allocation
Eventually, you will reach the target without using any leverage at all. This initiates phase three. You begin this phase at 100 percent stock, and as your assets grow, you reduce the exposure until you hit your target allocation.
Samuelson’s model crucially assumed that you had all your savings in cash at the beginning of your life
Because of this individual aspect, the tar-get allocation number will be different for each person
his Samuelson share is a rather conservative 40 percent. That means if he were given all of his life-time savings today in cash, he would invest just 40 percent in stock and the rest (60 percent) in government bonds.
In fact, the birthday rule provides a slightly larger total stock exposure than the lifecycle strategy that aims for a final stock allocation of 40 percent.*
One problem with increasing leverage is that it greatly increases the risk of a wipeout along the way.
interest rate on the money you borrow goes up.
It may seem at first that a 200/50 strategy is more aggressive than the 75/75 strategy. Overall, our diversifying lifecycle has more years where the stock allocation exceeds the constant 75 percent. However, the initial leveraged years are the years where the current savings are smallest. In fact, the two strategies are equally aggressive, and historically they produced identical average returns. When we hold savings constant (for a hypo-thetical person with a $100,000 salary at retirement) and apply the two in-vestment strategies to historic returns for ninety-six different lifetimes, we find that they both produce the same average retirement accumulation of $749,000.
Our advice is to use stock options to gain leverage
October 1987, when the stock market declined more than 12 percent in a single month.
The returns on the S&P 500 in 1929, 1930, and 1931 were −9.5 percent, −22.7 percent, and −44.2 percent
You can even kick the tires on the simulation (and customize it to reflect your situation) online at www.lifecycleinvesting.net.
if you are sufficiently pessimistic about future stock mar-ket returns, you should simply stop investing in stocks altogether.
Monte Carlo approach is that it can be re-peated again and again. Instead of limiting ourselves to 96 overlapping cohorts of historic investors, we analyzed how 10,000 different investors would do if they lived in a world where stock returns followed a wide range of possible distributions.
People bet real money when they bought, sold, or held stock yesterday at the market price. If there was a true consensus that stock prices would fall tomorrow, then everyone would sell today, and so prices would fall today instead.
A P/E ratio of 20 means that for every $20 of stock price companies had $1 in earnings
He could have replaced some of the bonds in his portfolio with stock (and even used leverage if need be) to start exposing his expected inheritance to the stock market be-fore his grandmother passed away.
FatWallet, where you apply for a bunch of credit card promotional offers and invest the balance transfer money into higher yielding savings accounts. I
MT started out at 400 percent and then increased his leverage as stocks fell. As stocks fall, our rebalancing strategy has you reduce your exposure; MT bought more. That meant his leverage became unbounded as his assets fell to zero
The reason to invest in stocks is that on average they outperform bonds. That’s true enough. But stocks don’t on average outperform the interest you have to pay on credit card debt. Stocks don’t return 14.67 percent tax-free
Along with credit card debt, there are five other situations that militate against investing with leverage.
- You have less than $4,000 to invest.
- Your employer matches contributions to a 401(k) plan.
- You need the money to pay for your kids’ college education.
- Your salary is correlated with the market.
- You would worry too much about losing money.
To get 2:1 leverage, you will want a call option with an exercise price of roughly half the market price. Recall that the options are on the SPDR index, which is designed to mimic the performance of the S&P 500 index at one-tenth the price.
Traditional brokers, including Fidelity and Vanguard, charge way too much for mar-gin loans to make them worthwhile. There are some great online options such as Interactive Brokers, but they require a minimum account size of $10,000
Once the market moves by more than 10 percent, it is time to sell and reduce your exposure. This rebalancing made a big difference in 2008. Although the market fell by 36.6 percent, our 2:1 leveraged portfolio only dropped by 64 percent, not 73.2 percent. The reason is that rebalancing required selling along the way down and that reduced losses as the market continued to drop.
relative risk aversion” or RRA for short
If you are willing to risk a third but not a half, then your risk parameter is somewhere between 1 and 2.)
How much you want to invest in the stock market turns not just on your risk tolerance but also on your expectation about the future risk and return of investing in the stock market.
RETURN” is measured by the expected equity premium—the amount by which stock returns are expected to exceed the return on gov-ernment bonds
RISK” is measured by volatility, the expected stan-dard deviation, of stock returns
the historical equity premium is 7.87 percent on stocks − 2.83 percent on boards = 5.04 percent.
If you go to websites like www.myrisktolerance.com, you will be asked a series of questions like the following: When you think of the word risk in a financial context, which of the following words comes to mind first?
8Thus the consumer pays $0.45 to avoid some-thing that has an expected cost of $55 × 0.477 percent = $0.26. The phone company charges a fee that is almost double what the repair costs, and many people seem willing to pay this high premium in order to avoid the risk.
If someone is sell-ing you the insurance, they expect to make money. Few insurance products operate with less than 30 percent overhead and profit margin. Thus you can expect to make at least 30 percent if you don’t buy the insurance.
Inflation-adjusted annuities offer a much better deal. In effect, they allow you to spend 5.3 percent of your assets for as many years as you need.
To maintain 2:1 leverage, ProFunds sells shares when prices fall and buys shares when prices rise. This hurts performance whenever prices bounce around, since ProFunds will be buying high and selling low. On the other hand, if prices move in one direction, then ProFunds’ rebalanc-ing will help performance
For example, if the SPDR had fallen from 75 down to 50, then Margie would have lost her entire remaining $500, while PF would only have lost $333 of his remaining $500.
when you are not con-strained by leverage, rebalancing re-quires you to buy additional stock when prices fall and sell when prices rise. However, when you are starting out and thus constrained by the max-imum 2:1 leverage, then rebalancing your portfolio leads you to sell shares when prices fall and buy when they rise.
Investing in short-term bonds is like having a variable-rate mort-gage, while investing in long-term bonds is akin to having a fixed-rate mortgage.
Let’s pretend for a moment that real interest rates are constant at 3 percent. If inflation is running at 2 percent, then short-term bonds will offer 5 percent. If inflation rises to 5 percent, then the short-term bond rate will go up to 8 percent. The advantage of short-term bonds is that they mature quickly and so can adjust to changes in inflation
Holding a long-term bond is like being on the other side of the equa-tion, except that you can’t refinance. If inflation goes up, the long-term bond you hold will shrink in value, and if inflation falls, your bond will appreciate.
Inflation Protected Securi-ties or TIPS
The advantage of TIPS is that they lock in a real interest rate. That’s why we think the majority of your money in bonds should be in TIPS