- If you’re under 40, you should definitely read this.
- We’ll discuss a retirement investing strategy created by Yale academics.
- The common retirement investing strategy is terrible in any case.
Retiring early is something a lot of us would love to do.
There’s a way to do it that includes investing and leverage, but not the greedy kind of leverage where people bet the farm on a specific investment and lose everything.
Today, we’ll discuss an article written by Yale professors Ian Ayres and Barry J. Nalebuff, Life-cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk.
Ayres and Nalebuff analyzed data since 1871 and found that young investors would be much better off using a certain amount of leverage early in their investing years. Let’s discuss their findings and then look at investing with leverage in the current market environment.
Life-Cycle Investing & Leverage
The usual retirement investing strategy tells you to invest 110 minus your age in stocks and the rest in bonds. I agree with those who say that such a strategy is fundamentally flawed and will discuss the topic in another article because it’s extremely important. Nevertheless, let’s stick to what the professors found.
Their main thesis is that people should invest on a leveraged basis in a diversified portfolio of stocks in their early working years. Over time, they should decrease their leverage and ultimately become un-leveraged as they get closer to retirement. Applying such a strategy would lead to 90% more retirement wealth, would allow earlier retirement, and would maintain one’s living standard through age 112 instead of age 82.
As we all know, time in the market is what creates returns, be it through dividends, inflationary protection, or capital appreciation. Therefore, the more you invest in your early age, the higher your wealth will be later on. A normal investing strategy is usually well diversified across assets, but not across time as most of the investing happens at a later stage when salaries are higher. Thus 20 years go by and the small portfolio doesn’t really accumulate wealth. However, the biggest wealth creator is the first dollar you invest when you are young.
According to the professors, the best thing to do is to take leverage to buy stocks in order to take advantage of the value time brings. In a similar way that a young person buys a home. The problem is that it isn’t easy to invest in stocks with a mortgage (do it if possible) but what they advise is to use margin debt (borrowing from your broker) or buy in the money call options on the index.
It’s important to note here that leverage only makes sense if the expected return on stocks is greater than the implicit margin rate. Since 1871, stocks have returned 9.1% per year while the margin cost has been 5%. Thus, there was a premium of 4.1% which created the increased returns. If you’re interested in doing such a strategy, check your margin rates with your broker and expect a 4% return form the current stock market, not more. You can invest in stocks that offer higher returns.
The proposed maximum leverage is 2:1 as more could lead to a total loss in case of a huge market downturn. However, such a huge downturn hasn’t happened since 1871, not even in 1929. Also, it’s important to stress that only young investors that have the possibility to rebuild their portfolios should use margin, and only use it limitedly.
By applying the strategy and using margin, an investor would definitely do much better than with a common stock/bond allocation depending on age and slightly better than what a 100% allocation to stocks offers.
The average benefit over a stocks and bonds strategy is 90% more retirement wealth. However, those who retired from 1952 to 1974 would have had three times more money in their retirement account if they had invested using margin during the cheap markets of the 1930s and enjoyed the bull markets of the 1960s with much more wealth.
So, do you want to retire earlier? The current margin rate at Fidelity is at 4.25% which really doesn’t offer a benefit as stocks are expected to yield 4% over the long term. However, a prudent internationally diversified strategy can be created that leads to returns of at least 6% if not even more. Nevertheless, there will be stock market declines and if you want to retire earlier, you might really want to think about taking out a loan or investing on margin when the long-term stock market expected return is significantly higher than the margin interest rate. A good metric to assess that is to look at the CAPE ratio.
For stocks to yield above 5%, the CAPE ratio should be at least 20. Therefore, you either remain patient and wait for a better premium for stocks, or build a portfolio that allows you to reap higher returns in respect to the cost of the loan.
An important note here: financial authorities have not yet declared retirement investing by using margin as prudent, thus make sure to really dig deep into the strategy and see how it fits your retirement needs.