We have just survived the worst debt-fueled binge since the Roaring '20s. Now two professors at Yale University are suggesting we introduce leverage into a new realm of our lives our retirement portfolios. TIME's Barbara Kiviat asked economists Ian Ayres and Barry Nalebuff to explain themselves and the strategy they lay out in their new book Lifecycle Investing.
You are advocating that people in their 20s and early 30s take all their retirement savings and buy stocks on margin. Can you explain why that's not as crazy as it sounds?
Ayres: It's not as crazy as it sounds because it helps people better diversify risk across time. It would be really crazy if you only invested in the stock market one year of your life, because that could be a really bad year. That could be 2008. People do have the right intuition that it's better to spread exposure to the stock market over time. The problem is, having just a few thousand dollars in the market in your 20s doesn't give you very much diversification across time when you have hundreds of thousands or millions of dollars in the stock market in your late 50s and 60s.
Nalebuff: 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.
But when you're 22 years old, you just don't have the cash.
Nalebuff: You don't have money, so the only way to have more exposure to the market is to employ a little leverage. It may be leverage, but it's not on a lot of money, and it's also not a lot of leverage. Unlike a house, which you might buy on 10-to-1 leverage or 20-to-1 leverage, here we're only talking about 2-to-1.
Do you have numbers to back up that this actually turns out better for people?
Ayres: Running the numbers on more than 130 years of stock data, we find that this reduces lifetime risk by about 20%, where risk is measured by standard deviation. Not only that, it beats traditional strategies in every historical 45-year span basically every working life. Secondly, it would have worked in other countries. We've looked at stock data from the Nikkei and the FTSE. Thirdly, it works in Monte Carlo simulations, where we make different assumptions that the market might be riskier, that the market might not be as beneficent as it has been in the past.
Nalebuff: It's not just good luck. Theory tells us that diversification reduces risk. You know you should buy mutual funds to have lots of different stocks, to not put all your eggs in one basket. Stocks are not perfectly correlated, and so you get lower risk by having a large basket. Well, returns across time are even less correlated than returns across stocks. So if you think of each year as a different asset, you would like to spread your investment out across multiple years. You expose the same amount of money to stocks, but you reduce risk because you spread that stock exposure more evenly across more years.
If you're using leverage, how can risk go down?
Nalebuff: The increased market exposure when young allows you to have less exposure later on. And while the total market exposure is the same, it's better spread out. Therefore, it has less risk.
Do people wind up with more money even for time periods like the Great Depression and our more recent financial turmoil?
Ayres: There is this beautiful chart that shows year by year how our strategy works against two traditional strategies investing every year of your life in 75% stocks and 25% bonds, and a target-date fund that ramps you down from 90% stock when you're young to 50% stock when you're old. The cohort that retires just after each crash still winds up with more money than in either of the traditional strategies.
Nalebuff: The place where we do the worst most recently is people retiring in the early 2000s. We had them investing less in their final years, so they missed some of the run-up. If you invest more when you're young and less when you're old, and there's a great run at the end, you won't get the same benefit of that.