Many thanks to an anonymous commenter on my last blog for pointing me to a very provocative piece of research from Ian Ayres and Barry Nalebuff, entitled "Life-Cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk". They advance the argument for actions like that of Clare College, borrowing money to invest in the stock market, and say that nearly all young people should do likewise:
People should be holding much more stock when young. In fact, their
allocation should be more than 100% in stocks. In their early working years, people
should invest on a leveraged basis in a diversified portfolio of stocks. Over time, they
should decrease their leverage and ultimately become unleveraged as they come closer to
retirement. The lifetime impact of the misallocation is large. The expected gain from this
improved asset allocation relative to traditional life-cycle investments would lead to 90%
higher retirement wealth. This would allow people to retire nearly six years earlier or to
retire at the same age (65) and yet maintain their standard of living through age 112
rather than age 85.
The argument is very clever, and I’d advise the trustees of Clare College to read it, because it quite clearly doesn’t apply to them:
The insight behind our prescription comes from the central lesson in finance: the
value of diversification. Investors use mutual funds to diversify over stocks and over
geographies. What is missing is diversification over time. The problem for most investors
is that they have too much invested late in their life and not enough early on…
Young people invest only a fraction of their
current savings, not their discounted lifetime savings. For someone in their 30’s,
investing even 100% of current savings is still likely to be less than 10% of their lifetime
savings or less than 1/6th of what the person should be holding in equities if, as is typical,
their risk aversion would have led them to invest at least 60% of their lifetime savings in
In the Samuelson framework, all of a person’s wealth for both consumption and
saving was assumed to come at the beginning of the person’s life. Of course that isn’t the
situation for a typical worker who starts with almost no savings. Thus, the advice to
invest 60% of the present value of future savings in stocks would imply an investment
well more than what would be currently available.
This leads to our simple advice: buy stocks using leverage when young.
Most people save money slowly, over time, and they generally both earn more and save more the older they get. In that context, it makes sense that early-career retirement savings carry an extremely high risk profile, since they are so small compared to total lifetime savings, but at the same time can potentially punch well above their weight, thanks to the magic of compounding. If the use of leverage wipes them out, that’s bad, but not disastrous, since there are many more savings to come over the rest of one’s life. But if returns are positive, and magnified by leverage, that can work wonders for one’s total wealth.
How to do this? One way is the Clare College strategy: simply borrow the money. An easier and possibly smarter strategy is to buy deeply in-the-money index call options:
For example, a two-year call option with a strike price of 50 on an index at 100
will cost something close to 50. Thus for $50, the investor can buy exposure to $100 of
the index return. We show below that the implied cost of such 2:1 leverage is quite low
(about 50 basis points above the yield on a one-year Treasury note), which makes the
strategy practical in current markets.
Alternatively, one can invest in a mutual fund which essentially employs the same strategy: conveniently, one exists, and is called UltraBull, and is designed to double the return on the S&P 500. (There are other, even more aggressive leveraged funds: Direxion has the S&P 500 Bull 2.5x Fund, which has exactly as much leverage as you think it does.)
On the other hand, as John Waggoner notes, the UltraBull fund is up only 8.8% over the past five years, while the S&P 500 is up 18.6%. (Or at least those were the figures a couple of months ago, when Waggoner wrote his column.) Those fees can really hurt you.
Ayres and Nalebuff don’t actually recommend buying the UltraBull fund; instead they recommend buying deep-in-the-money LEAP call options. My problem with that strategy is that it’s a bit too active for my liking: you need to know what you’re doing, keep track of expiry dates, pick the right options, and so on. There might well also be big problems with capital gains taxes. But in principle, I do think that this paper has uncovered something quite important – not for entities like Clare College, who can’t expect to save much more in future than they do at present, but rather for young savers in their 20s and 30s who don’t expect to touch their savings until retirement.