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moneysense.ca, 19/04/10
What Young Investors Should Do
In a paper titled Life Cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk (paper available here), Yale University economists Ian Ayres and Barry Nalebuff recommend that young investors should employ leverage to increase their exposure to stocks to 200% of their capital.
Our recommended investment strategy is simple to follow. An investor who targets a single percentage or a single present dollar value follows three phases of investment. 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 deleveraging the portfolio and then maintains that target level as an unleveraged position in the third and final phase.
The expected gains from such leveraged savings are striking. With increased longevity, people need to save more for their retirement. The expected gains in retirement accumulations relative to the traditional 90/50 life-cycle strategy would allow someone to finance an extra 27 years of retirement (well past age 100) or to retire at age 59.5 and still finance retirement through age 85. Or, to the extent that current savings are inadequate to maintain pre-retirement standards of living, this can boost retirement consumption by 90%.
At first glance, it sounds like a crazy idea but the economists explain the problem the strategy is designed to address in this interview with TIME magazine:
Another way of saying it is, we believe in stocks for the long run, but most people, when they have lots of stocks, don’t have the long run, and when they have the long run, don’t have lots of stocks. People seriously underinvest in the market for the first 25 years of their working life.
In my opinion, the strategy sounds fine in theory but is likely to run into problems in practice. The typical response of a young investor who purchased stocks on 2:1 margin and experienced a 50% stock market decline (and got wiped out) would be to abandon stocks altogether. It would be a rare investor who sticks to the strategy in the face of such a decline.
moneysense.ca, 19/04/10
I use margin in my investment account and 2:1 ETF’s (HXU for Canada) in my RRSP. The results speak for themselves: my Canadian models have beat the market by 25% per year and my US models have beat the market by 39% per year. However, in my opinion it would be foolhardy to take on this strategy without a market timer.
This style of investing is definitely not for everybody because the swings in portfolio value can be difficult mentally. Richard Dennis (Turtle Traders) said he could publish his trading rules in the newspaper and not worry about masses of investors moving in and out of the same stocks at the same time because most investors would have trouble sticking to the rules. It takes a certain kind of investor to follow a strategy of leverage and market timing.
This is the first time I posted since CC joined forces with MoneySense. The right column overlaps the text box that I type in to submit a comment and I can’t see the words that are at the right edge of the text box. Am I the only one to have this issue?
Fred
If somebody had done this strategy 5 years ago, they’d have been wiped out. Is starting from scratch again a good long term strategy?
While I’m young (28) and use leverage (only about 25% of my portfolio), I only did it after the crash and I plan to end it in about 2-3 years. I’ll repeat if and when another crash happens.
The more I read comments like this one, the more I think we’re all wrong by treating the question of investment allocation (including leverage) separately from investor behavior. Many of the rules of thumb (whether this rather more provocative one or more mundane ones) implicitly presuppose a certain form of investor behavior and optimize on its basis, when in reality investors behave quite differently. That’s the explanation why most retail investors appear to have lost money in the market over the long term, or close to it (too much switching), why many investors haven’t fully made up their losses since 2008 (myself included – as the market tanked I didn’t panic, but in retrospect I became somewhere between more lazy and more scared and did not fully execute on my regular buying strategy), why even investors for whom a leveraged investment strategy might make a ton of sense have trouble executing on it.
I look forward to investment advice that will interview me as to how I would behave in different market conditions, not to triangulate on my mythical “risk tolerance”, but to actually run the model of market behavior and figure out what is genuinely the best strategy for my little pea brain to execute on.
Hmm. Maybe part of the reason we younger investors don’t have a lot of money in stocks is because we don’t have the money that older generations do! We’ve got families to raise and homes to (try to) buy.
For me, at least, it doesn’t make sense to take a lot of risk right now. It seems like these “rules of thumb” are for rich people!
I understand the logic behind young using leverage but don’t they already have enough leverage (and risk) with real estate? Most people buy real estate using a 3-1 leverage ratio or more which involves large amounts of borrowed $$.
I would think that is enough risk.
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@Beth, @Four Pillars
I think you’re right. I also think the authors of the study are likely right – or at least, I can see any one of us easily writing a compelling and logically valid argument wherein under certain reasonable long term market assumptions, and certain behaviour assumptions, a young person with good financial habits, nerves of steel, a stable job, but little cash should leverage into the stock market (either not buying real estate at all — too much concentration risk too early — or leveraging into real estate and quickly into stocks via a Smith-type manoeuvre). But stress testing those market and behavior assumptions will be tricky….
@Fred: Good point about investors having trouble sticking to a plan. I am able to see the bug with Firefox. I’ll try and track it down.
@Christopher: I don’t think it is. I personally know investors who were wiped out by the tech. crash (because they were mostly invested in tech stocks) and stayed out of the market for years thereafter.
@Houska: I think the behavioural traps are underestimated by most researchers. Investors have trouble assessing their own risk objectively. One comment by Milevsky comes to mind: “When markets are up, investors figure they are risk tolerant and when markets are down, they become risk averse”.
@Beth: I’m fairly risk tolerant but I don’t think this strategy is for me either. If I want more risk, the first place I’ll look is dialling back on the bond portion.
@Mike: The authors contention is that young people buy homes with far more leverage, so they should at least consider a 2:1 margin to invest in stocks. I’m not sure though. For a variety of reasons, buying a home ain’t the same as buying stocks.
The idea that some fixed amount of leverage makes sense for all investors of a given age is silly. For someone earning $100k/year with $5k in savings, 5:1 leverage is mostly harmless. For someone earning $40k/year with $100k saved, 2:1 leverage is nuts.
The markets need less leverage, not more. There is enough leverage-induced volatility as it is.
Leverage always reminds me of the concept of cooking a receipe at twice as high a temperature so it will cook twice as fast! The only real benefit I can guarantee is that the clown who sold you the concept will make twice the commission on the securities plus a commission on the loan. He/she will refund neither when you file for bankruptcy.
As to Fred, congratulations, you are the best money manager in the world and your stated results “per year” far exceed what that Warren Buffet guy earns for his investors! I don’t suppose they are audited results are they?
sois mike:
I have been discussing my market timers on my blog since March, 2008 and those who follow me can attest to the performance of the models. Over a year ago, I put my US leveraged ETF model “QLD and PSQ” on Collective2.com. Vendors of trading systems on Collective2 are ranked using a proprietary scoring system. My vendor score is 995 out of 1000.
For those unfamiliar with Collective2, according to the site stats which are updated each trading day, over $100 million is traded each day based on investors auto-trading off the systems which are available on Collective2.
Unfortunately, Collective2 isn’t set up for Canadian securites so I have to use an ETF (EWC) with 2X leverage to simulate my HXU models. It isn’t perfect but it is the only option available on Collective2.
Fred
sois mike:
As for the Warren Buffett remark, my QLD and PSQ model which is on Collective2 and therefore independently moniored is up 35.7% versus a gain of 31.6% for Berkshire (BRK-A) since April 12, 2009 when I joined Collective2.
From the time I started blogging about my US leveraged models in March, 2008, my worst performing QLD model is up 98.4% while Berkshire (BRK-A) is down 11.8%.
I will reiterate what I said in my first post – the use of market timing and leveraged ETF’s requires a set of character traits that are rare. To give you an example, when I checked on the markets today, HXU was down over 4%. That can be a shock to most investors including myself. I have learned to tame my emotions but it has taken years to get to a point where I can be relaxed when facing such a large intraday loss.
Fred
Yahoo has been giving incorrect percentage changes on stocks today. In my last message I stated that HXU was down 4% at one point today as reported by Yahoo Finance when in fact it was down “only” 2%. Yahoo had the quotes correct but the percent change was incorrect.
Fred
Frankly, I also think that young people would be better suited to use their maturity earlier in their lives, and leverage on that, while de-leveraging it later in life when they’re not going to need it so much anyway.
CC: you miss the more practical issue. Two Yale professors are telling their students, some of whom have to borrow more than $20,000 a year in educational expenses, to leverage their lives rather than pay down their debt. Advice only a tenured professor with a defined pension plans could give with all seriousness.
Leverage is something I’ve used for the past two years. I too believe that since the majority use leverage with home purchases, there isn’t much of a difference here. It’s just a question of being able to stomach “this type of leverage”. With a house, your leverage is tangible (you live in it). With stocks, you have numbers on a screen.
The principles are the same, you can buy an overpriced house with leverage or an overpriced stock. In each case, it’s probably best to understand value before making a commitment.
[...] Canadian Capitalist discusses an idea in What Young Investors Should Do which entails a lot of leverage, which scares the living crap out of me, but still an interesting [...]
I was considering using leverage, but after thinking about it a bit I’m not so sure.
Consider the case when you have a cash portion in addition to your stock portion that you balance at a fixed allocation. This is kinda liking being leveraged at less than 1 to 1. In this normal situation when stock prices drop you become unbalanced and buy more stock to rebalance. When stocks go up you becomes unbalanced and sell stocks to rebalance. Notice the nice automatic buy low, sell high framework this sets up.
But when you use leveraging rebalancing works the opposite way. When stocks drop you become overleveraged and sell to rebalance. When stocks rise you become underleveraged and buy more stock. This automatic sell low, buy high idea doesn’t seem like sound advice to me.
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Leverage is definitely not for the faint of heart, that said, it can be a great way to increase your wealth in an envionrment where people are fearful. That fearful environment was in 2008 and 2009, today people are more confident and as we’ve seen the market has appreciated quite substantially.
I use to leverage my investment portfolio, but just stick with the basics at this point. However, when it comes to my real estate portfolio leverage has and always be my friend. Using other people’s money to purchase quality real estate at very reasonable prices sounds like a no brainer to me.
I would suggest that the key to gaining wealth is to save money and paydown debt. For many with families the saving will be a challenge in the early years but putting a little aside with an RRSP,TFSA, and having it build up over the years is the way to go. The boom bust approach of the gambler tends to falter when the bottom drops out and the panic sets in. My biggest caution is to avoid fees and to avoid panic. I also avoid strategies that appear to have ridiculous results compared to the works best long term investors, which tend to be pension managers. For those who are outperforming by ridiculously high amounts…..all the best and I hope it works out for you over the long term.