Thursday, November 18, 2010

Recanting a Small Part of Lifecycle Investing

Ian Ayres

Crosspost from Freakonomics:

On page 9 of Lifecycle Investing, Barry Nalebuff and I write:

“[B]efore you invest in stocks, first pay off all your student loans and credit card debts.”

On reflection, we were only half right. You should pay off your high-interest-rate credit card loans before investing in stock. But in this post from our Forbes blog, Barry and I show why young investors need not pay off their student loans before investing in stock.

Our new result that you shouldn’t wait to pay off your student loans substantially expands the number of young investors who should start buying stock on margin. Most young college and professional school graduates have amassed significant student loans, and many more take on home mortgages. But Barry and I now believe that many of these savers would be wise to expose themselves to leveraged stock risk rather than merely use any savings to pay down existing debt. Our mistake was in thinking that the cost of investing in stock was the added interest that must be paid on the student loan. That is, the cost of investing in stock on an unlevered basis. But our Forbes post shows that the cost of investing on a leveraged basis can be much cheaper:

Imagine you are 26 years old and you owe $40,000 on student loans. You’ve managed to save $10,000. Should you use that money to pay off part of the loan balance or should you invest the money in the market?

If the student loan carries a 5.5% interest rate and you expect the stock market return to be 5%, this question seems like a no-brainer. You should use your savings to pay off the student loan and implicitly earn 5.5% on your money (by saving that amount in accrued interest) rather than invest the money in stock and just earn 5%. Indeed, by paying off part of your student loan, you areguaranteed a 5.5% return, whereas with a stock investment you’re taking the risk that your return might be much smaller.

But it turns out that there is a third option, another way to invest in stock that may be more attractive that either of the foregoing alternatives. You can use the $10,000 as collateral and invest $20,000 in stock by buying on margin at 2:1 leverage. Today, it is possible borrow (directly atInteractive Brokers or indirectly through ProShares UltaS&P500 or Barclay’s leveraged ETNs) at less than 1.7% interest. The market return only needs to exceed 3.6% [= (1.7 + 5.5)/2] in order to produce a better result than paying off your student loan. When you buy stock on margin, you incur two different kinds of cost. The opportunity cost of not paying down your student loan is 5.5% on first 10k and the margin interest cost on the 10k that you borrow is 1.7% (or less!) – so that the average or blended cost of investing on margin is 3.6%.

This is a case where the pushback we received from readers (for example, here and here and here) led us back to the drawing board. Thank you, Freakonomics nation, for pushing us to this new idea.

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