Friday, May 07, 2010

Dare to Diversify

Ian Ayres

Crosspost from Freakonomics:

Most people viscerally understand that it would be a horrible idea to invest in the stock market for just one year of their lives. If it turned out that the one year was 2008 (when the S&P index lost 37 percent), your retirement portfolio would be toast. It’s smarter and safer to spread your exposure to stock market volatility over a number of years.

But sadly, we don’t have very good theories of how to diversify risk across time. We understand how to diversify risk across assets, but we don’t have clear notions about optimal time diversification.

Barry Nalebuff and I are trying to change all this in a book published today. The book is called Lifecycle Investing: A New, Safe, and Audacious Way to Improve the Performance of Your Retirement Portfolio. You can read an excerpt here, and has downloadable data and calculators that will let you see our diversifying strategy in action.

In this YouTube clip, Slate editor Emily Bazelon helps us explain why diversifying risk is so audacious.

Most people do a very bad job of spreading investment risk across time. We often invest 40 or 50 times as much in the stock market in our 60s as we did in our 20s and early 30s. We know not to invest in the stock market for a single year. But many of us only take advantage of about a decade (or a decade and a half) of time diversification. A few thousand dollars in the stock market in your 20s doesn’t buy you much diversification if you have six or seven figures in the stock market in your 60s.

Our book shows that doing a better job of diversifying risk across time can reduce the volatility in your retirement portfolio by more than 20 percent. What’s more, investors can use this diversification tool to safely take on more risk. Holding risk constant, you can increase the expected return on your portfolio by 60 percent.

Of course, to more evenly expose yourself to the market, you have to buy more stock when you’re young. The problem is that most people haven’t saved much for retirement in their 20s and 30s. It would be nice to buy more stock when you’re starting off. But a reasonable initial reaction is that you can’t invest what you don’t have.

That’s just wrong. If you’ve saved $4,000 for retirement, you can borrow another $4,000 and invest $8,000 in stock index funds. The idea of mortgaging your retirement savings seems to go against everything we’ve been taught about prudence. But over the next few posts, I hope to convince you that modest amounts of leverage when you’re young can pay big diversification benefits.

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