Dare to Diversify

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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?www.lifecycleinvesting.net 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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  1. R.M. 'Auros' Harman says:

    If everyone is doing that, isn’t there a risk of experiencing the “systemic margin call”? If lots of young people are leveraged up to invest in the market, and the market goes down steeply, you can have enough equity wiped out that folks start needing to liquidate, and that further depresses the market.

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  2. Brett says:

    “can pay big diversification benefits”

    Looks to me like “can” is the operative word here. Not to mention that big benefits typically come from big rewards.

    I’ll follow the next few posts, but being in my 20′s myself, I’m not convinced that I’ll end up being convinced.

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  3. Chappy8 says:

    OK, I’ll bite. How many of the 45 year scenarios end up with the young person having to take a loan against their 401k to make current payments on the borrowing they are doing against that value? Also, how does a young person borrow against a defined benefit plan? I don’t know how that is done.

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  4. Josh says:

    “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.”

    It’s my understanding that accounts designated as retirement accounts, my Roth IRA for example, cannot be leveraged. I would love to borrow more money to invest, especially on a day where the Dow was down over 200 points, but I just don’t think what you are suggesting is possible with some accounts.

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  5. Mike says:

    This all assumes that the historical stock gains will continue into the future.

    However, people are becoming much more educated these days about the stock market, and what it is they are actually buying. For example, when I buy shares in Google, I am essentially buying nothing. I don’t vote at shareholder meetings, they don’t pay dividends, etc. Mark Cuban has a few eye-opening posts on his blog about this. He calls stocks “baseball cards”. And truly, that’s what they are. I buy a piece of paper, hoping I can sell it to someone else down the line for more money. If the name on my “baseball card” does well, that typically does net me more money for it than I paid for it. But, solely because they too think they can then turn around and sell it for more later on.

    Look… if 0.5% of the population understood this in the 1950′s, maybe only 5% understands it right now. But that percentage is going up. And sooner or later, it’s going to hit a critical value at which, people decide that maybe it’s not a good idea to invest all their money in baseball cards, and they’ll put it in something more stable, more guaranteed, or at the very least, more USEFUL than a piece of paper with a name on it.

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  6. Bill McGonigle says:

    What are they investing in then? Most stock pickers don’t do better than the indexes and most of the indexes are down or flat over a very long period.

    Should they be using options to guard against big events? I did some margin’ed options investing at this age, and won some big, lost some big. Wound up paying for a cheap wedding and going home in the net. Meanwhile I was several sigmas out for a 23-year-old investor. Heh, I mean speculator.

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  7. Joe says:

    “It’s my understanding that accounts designated as retirement accounts, my Roth IRA for example, cannot be leveraged. I would love to borrow more money to invest, especially on a day where the Dow was down over 200 points, but I just don’t think what you are suggesting is possible with some accounts.”

    You might be able to trade options with your Roth IRA, though (as I can) which has the same effect as the leveraging he suggests. You could use your $5k to buy cheap in-the-money calls, which is riskier than just buying the underlying stock/index/ETF but as he suggests has benefits from a time diversification standpoint.

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  8. Ben says:

    You can lever stuff in an IRA as long as you don’t use margin loans. You could do it the cheapest with options or index futures, or use the 2x or 3x index ETF’s. There are not many people in their 20′s willing and able to do this, I would think.

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