I don’t know what to say. Maybe I will sell all my stocks again and buy guns, cigarettes, and booze.
We 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.
You are advocating that people in their 20s and early 30s take all of 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 under-invest 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.
How much more does this net a person?
Nalebuff: If you put all of the weight on reducing risk, then it won’t improve your return. However, if you want to keep the same risk as you currently have and apply it towards more return, then we find that retirement portfolios end up being about 60% bigger. It’s substantial. Of course, that’s based on the historical performance on equity markets — but the reduction of risk is not based on that, because whatever the markets do on average they’re going to do with our approach or another.
How do you know how much to lever?
Ayres: That’s a good question. If 2-to-1 is great, why not go to 3-to-1 or 4-to-1? The answer is, the cost of levering becomes too expensive. One of the great pieces of news in this book is that it’s really cheap to borrow money to take levered positions in stock at a 2-to-1 rate. But if you go beyond 3-to-1, it gets prohibitively expensive to borrow money. The benefits of diversification are lost when the cost of borrowing becomes too great.
How much does it cost?
Ayres: Over the past 138 years, the wholesale lending rate for margin loans was just 0.34 percentage points above the T-bill rate. Don’t do it from Vanguard or Fidelity — they don’t have competitive margin rates. But if you shop around places like Interactive Brokers, you can basically borrow very close to the T-bill rate, if you stay at a 2-to-1 basis.
Nalebuff: It’s also possible to do this via long-term options. Ideally, this idea will catch on and there will be funds that do it for you. Today there are a few, like the Ultra Bull fund from ProFunds.
Who isn’t this strategy for?
Nalebuff: If you have any credit card debt. Stocks don’t outperform the interest rate you pay on credit cards.
Ayres: Or if it’s likely that your future income will be very correlated with the stock market — maybe you’re on commission in the housing industry. That might be something that pushes you away from this being right for you. We have a chapter that lays out six different reasons why this isn’t for everyone.
You can’t buy on margin in a 401(k). Is it worth giving up the tax shelter and company match to do this in another sort of account?
Nalebuff: Absolutely not. We want to be 2-to-1. If a company match is going to give you the 1 right away, then you get 2-to-1 risk-free. That beats having to borrow for it. Even 50% matching is a better deal.
Is this how you have your money invested?
Ayres: Yes. I just turned 51, so I’m not in the stage of 2-to-1 leverage, but I have a margin position. I’m doing it in a way a 51-year-old should. It’s prudent to ramp down your exposure to the stock market over time. I’m not up at 200%. I’m at about 120%.
Do you have your kids’ college savings levered at 2-to-1?
Ayres: Part of the disciplined approach is you just do this with retirement savings. You don’t do this with money you need to spend before retirement.
You got hate mail when you first floated this idea in an article. What do you think the reaction is going to be now that you’ve written an entire book?
Nalebuff: I have no doubt that we will be held up as a prime example of what not to do. It’s a typical over-reaction. A little leverage is a good idea. Too much leverage is bad — but no leverage is also a problem.
Ayres: The anti-leverage impulse is so strong. I was taught in high school that leverage caused the Great Depression and that only speculators buy stock on margin. We have to overcome this psychology. We don’t demonize leveraged purchases of education and leveraged purchases of homes. We’re trying to open people’s minds to the idea that to buy stock on margin in a disciplined way to reduce and control risk is prudent and the way of the future.