Two academics from Yale have a splendid new idea for the youth of today: borrow as much cash as you can, and invest it in the stock market. If that sounds strange, this will sound even stranger: it appears to be a way of reducing investment risks. So why might this not be crazy advice?
Imagine a baby-boomer and her son. She started buying US stocks in 1970 and sold in 2000. She would have felt sick during the terrible 1974 bear market but, looking back from 2000 (and especially from stock market nadirs 2003 or 2008), her timing would have been superb. She filled her boots with shares at rock-bottom prices in the late 70s and early 80s, and sold at the top.
Now imagine how her son feels. He started buying shares in 1995 and felt pretty clever by 1999. he could hardly imagine what a bear market looked like. But now, in 2010, he realises that he has spent many of the last 15 years buying shares at prices that now seem frothy.
Both individuals took the standard investment advice: they didn't put all their eggs in one basket, instead investing in a broad portfolio of stocks. They gradually dripped their money into the market, and both had the aim of shifting out of the stock market and into safe assets as retirement approached. Yet the mother's investments did brilliantly and the son's are stinkers. The only difference is what we could call 'generational risk'.
The conventional investment wisdom is to start off fully invested in shares — which are risky but often produce high returns — and then gradually shift to safe investments such as bonds. But following this advice exposes you to generational risk, because when
you are young the portfolio you've sunk entirely into the stock market is tiny. You own very few of the shares you eventually plan to own. In middle age you're totally exposed to the market and, towards retirement, under-exposed again. No wonder the year you're born makes such a difference to your stock market returns.
Hence the scheme hatched by the Yale professors, Ian Ayres and Barry Nalebuff: borrow to invest in shares while young, then hold that portfolio steady while gradually paying back the loan, rather than piling lots of extra cash into the stock market in middle age.
This is exactly how people buy houses: they borrow money, buy a small house, and gradually trade up to a bigger one, only paying off their mortgages late in life. Ayres and Nalebuff are proposing the same pattern in funding retirement.
Ayres and Nalebuff have crunched the numbers, looking at the 94 cohorts of investors who retired between 1913 and 2004. For every single cohort, the early-leverage strategy beat the conventional wisdom. I can't quite bring myself to tell younger readers to mortgage their retirements immediately... but generations of past investors would have prospered by doing so.
Tim Harford's new book,
Dear Undercover Economist, is now out in paperback
BUY IT HERE Dear Undercover Economist: The Very Best Letters from the "Dear Economist" Column
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