p150 whynot 11/14.lo

10/21/05

3:56 PM

Page 150

Why Not? Ian Ayres & Barry Nalebuff

ONVENTIONAL WISDOM OFFERED TO RETIREMENT

Csavers is to start out at age 25 mostly in stocks, thenwind down to a bond-heavy portfolio at age 65. The
conventional advice is spelled out on page 104 in a
description of age-based retirement funds offered by
the big fund families.
This strategy, we think, is too tame. You should be more than
100% in equities when you are young. An exposure of 200% tostart would be a better idea. That’s right—if you are young, you
should be buying on margin. Pay down the debt as you age andthen ease off to a 50-50 stock-and-bond mix at the beginning ofyour retirement.
Margin buying? For retirement? It sounds terribly risky, but
it in fact reduces the risk that you will end up poor. And it leaves
you with much better diversification across time.
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’dhave less risk investing $200 in each of the three stocks. Indeed,spreading risk over stock is what leads people to buy broadbased index funds.
The same idea of equal investments applies equally to investments across time. If you have $100 invested in year one, $200
invested in year two, and $300 invested in year three, you havetoo 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 stayfully invested. You could get the same exposure to the market
with less risk by owning $200 worth of stock in each of the threeyears. You could do this by buying on 50% margin in the firstyear, paying off the debt with your year two savings, then goingto 33% cash or bonds in the third year.
Most investors have a lot less at risk in their retirement
accounts in their early working years than in later years. Inessence, they’re missing an opportunity to diversify acrosstime—they’re putting too large a bet on the return on stocks inlater years.
At first, it seems that this is just a fact of life. You can’t havean equal amount invested in all years, because in theearly years you can’t invest what you don’t have.
But this ignores the possibility of leverage. People150f o r b e s Í November 14, 2005

Retirement
savers are
missing an
opportunity todiversify acrosstime—they’reputting toolarge a bet on
the returnon stocks inlater years.

Ian Ayres and Barry Nalebuff are professors at Yale Law School andYale School of Management. The data are available for download at
ianayres.com.

\Mortgage Your
Retirement

invest what they don’t have all the time when it comes to realestate. A 5-to-1, 10-to-1, even 20-to-1 leverage is becoming thenorm. A person who buys a $600,000 house has a relatively flat
exposure to the real estate market. The exposure grows onlywith house price appreciation and not with increased savings.
The key is that your exposure to the real estate market is basedon the full value of the house, not just your down payment or
your current equity position.
Retirement accounts should take a lesson from home ownership. Retirement programs should allow people to take out retirement mortgages to buy more stock when they are young. Just as
home mortgages become less leveraged over time, so would theretirement investment mortgages. You can’t do this now, at least
without resorting to options and the like. But even allowing
retirement savings to start off with the allowable 2-to-1 leverageleads to much better and less risky retirement outcomes, but todate we know of no 401(k) or
self-direct IRA plan we know ofpermits margin buying.
To test how our theory
would work in practice, wetook historical stock-andbond-return data collected byRobert Shiller and added margin rate information. Following Shiller’s approach, we ran
simulations on the returns for
91 cohorts of workers, thoseretiring in 1913 through 2004.
We calculated the real investment return (the return aboveinflation) from an investment
strategy that began with a
2-to-1 leveraged investment instock 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 seemto 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 atretirement produced 29 cohorts with real returns that fell shortof 3%. Because of the longer investment in equities, the averagereal return for the leveraged strategy across the 91 cohorts wasmore 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 theadvantage 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?
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