A Mutual Fund For Time

It may be that almost all of have been missing an opportunity to better diversify our retirement investments across time. In our latest Forbes column, Barry Nalebuff and I show why leveraged stock investments when you're young can actually reduce risk.

It is obvious that you're not well diversified if you invest $100 in one stock,
$200 in another and $300 in a third. You'd have less risk investing $200 in each
of the three stocks. Indeed, spreading risk over stock is what leads people to
buy broad-based index funds.

The same idea of equal investments applies to investments across time. If you have $100 invested in year one, $200 invested in year two, and $300 invested in year three, you have too much exposure to year three and not enough to year one. This is what you get if you put $100 a year into savings and stay fully invested. You could get the same exposure to the market with less risk by owning $200 worth of stock in each of the three years. You could do this by buying on 50% margin in the first year, paying off the debt with your year two savings, then going to 33% cash or bonds in the third year.

That's right -- we should be striving to keep something like a constant real dollar amount invested in stock throughout our lives.

At first the idea of investing a lot in stocks when you're young seems impossible:

You can't have an equal amount invested in all years, because in the early years
you can't invest what you don't have.

But this ignores the possibility of leverage. People invest what they don't have all the time when it comes to real estate. A 5-to-1, 10-to-1, even 20-to-1 leverage is becoming the norm. A person who buys a $600,000 house has a relatively flat exposure to the real estate market. The exposure grows only with house price appreciation and not with increased savings. The key is that your exposure to the real estate market is based on the full value of the house, not just your down payment or your current equity position.

This is more than just a compelling theory. Barry and I have took historical stock-and-bond-return data collected by Robert Shiller and added margin rate information:

Following Shiller's approach, we ran simulations on the returns for 91 cohorts
of workers, those retiring in 1913 through 2004. We calculated the real
investment return (the return above inflation) from an investment strategy that
began with a 2-to-1 leveraged investment in stock at age 25 reducing to an
unleveraged 50% investment in stock at age 65. We found that none of the cohorts
ended up with less than a 2.5% real return on their investment (and only 2 of
the 91 cohorts fell below 3%). In contrast, what would seem to be a much more
conservative strategy of starting with an 85/15 stock/bond split at 25 falling
to a 15/85 stock/bond split at retirement produced 29 cohorts with real returns
that fell short of 3%. Because of the longer investment in equities, the average
real return for the leveraged strategy across the 91 cohorts was more than
double the conservative strategy.

In real estate the most important rule is location. For investments, it's diversification. Investors understand the value of diversifying across domestic stocks and many appreciate the advantage of including international stocks in their portfolio. The big missed opportunity is to do a better job diversifying over time, getting an early (and leveraged) start in stocks. We do this with houses, so why not stocks?

You can play around with an excel spread sheet simulating various strategies by clicking here.