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New York Times (4/11/2010)

"Stocks Are Back. So Are the Books."
by Paul B. Brown

Here are three ways to know that things are improving in the stock market:

• The personal finance magazines stop running articles about why you should invest in gold, natural resources and other alternative investments and return to writing about how average couples you have never heard of are making a fortune in the market.

• You are no longer petrified to look at the value of your personal and retirement holdings online—and you actually open the paper statements when they arrive in the mail.

• The nation’s publishers bring out a new crop of investing books, as they have started to do recently.

Among the new books, at least two are intriguing.

The first, by a couple of Yale professors, calls for investors —especially young ones—to borrow or go into debt to buy stocks, to have a longer investing timeline.

The second, by the best-selling author Phil Town, says it is virtually impossible to become wealthy by buying mutual funds, so you should concentrate your investment efforts on finding the best individual stocks.

We’ll deal with Mr. Town’s book, which doesn’t break a lot of new ground, in a moment. But let’s begin with “Lifecycle Investing” (Basic Books, $24.95), by the Yale professors Ian Ayres and Barry Nalebuff.

Mr. Ayres teaches at the law school and Mr. Nalebuff at the business school—and they begin with what they say is a fundamental, but overlooked, premise: You need to widen your investment time horizon to minimize risk.

“In its simplest form, diversification across time is an intuitive idea that’s a lot like asset diversification,” they write. “Just as it would be a mistake to invest all your savings in a single stock, it would be reckless to concentrate all your exposure to the stock market in a single year. You’re much safer spreading your stock investments across decades.”

So far, so good. And, as the authors point out, most people fail to spread out that exposure—simply because, as young investors, they didn’t have much money to invest. Their solution, which they concede is radical is to “use leverage to buy stocks when you are young.”

More specifically, they suggest buying stocks with 50 percent down, either by buying on margin—that is, taking a loan from a stockbroker—or buying stock index futures. The authors say extensive back-testing shows that this idea works. They add that “while it may seem paradoxical, exposing yourself to more market risk by leveraging stocks early on actually reduces overall investment risk” and that “you could increase your expected retirement savings by 50 percent.”

When the authors proposed a truncated version of their argument in Forbes magazine in 2005, they acknowledged receiving what they describe as “hate mail.” And it’s easy to see why their view would draw some criticism: the idea of going into debt to buy stocks may strike just about everyone as inherently risky.

If you buy a stock on margin, your stockbroker could require you to put up more cash—cash you may not have—if the stock tanks. That’s what a margin call is all about. The broker wants to guarantee that your loan to him is repaid. And if you buy futures, you could lose money if the price of the underlying investment doesn’t react as much as you expect.

And the concern only increases when you say that it’s young investors—people who are less likely to have stock-market experience—who should commit to this strategy.

Still, the underlying premise that you should diversify across time will strike most people as sound. And the authors are correct in saying that most investors in their 20s and 30s don’t have a lot of money to put in the stock market. Unless they are lucky enough to have a rich uncle or a trust fund, the only way to increase their exposure is through leverage. The authors say that sticking to their rule of putting at least 50 percent down limits the potential downside.

It will be intriguing to see whether their idea catches on.

To read the full article on the New York Times website, click here.


Time.com (4/16/2010)

"Why Young People Should Buy Stocks on Margin"
by Barbara Kiviat

We have 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 and the strategy they lay out in their new book Lifecycle Investing.

You are advocating that people in their 20s and early 30s take all 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 underinvest 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 toward 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 of 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 overreaction. A little leverage is a good idea. Too much leverage is bad, but no leverage is also a problem.
Ayres: The antileverage 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.

To read this interview on the Time website, click here.


Lifecycle Investing
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