Using Leverage (While Young) to Beat the Market Over the Long Term
Posted in Individual Investing
June 2, 2008
Should long-term investors view their retirement portfolios more like houses than savings plans? In other words, should they start out with considerable leverage and draw the leverage down over time? In their May 2008 paper entitled “Life-Cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk”, Ian Ayres and Barry Nalebuff investigate the effects of gradually phased-out leverage on long-term (for retirement) equity investment. Using annual return data for U.S. stocks and bonds and margin interest rate estimates for the period 1871-2007, they conclude that:
- Since 1871, the annualized 9.1% return on stocks has offered a 4.1% premium to the typical 5% cost of margin, thereby making leverage a way to beat the market on average.
- Both historical data and Monte Carlo simulations demonstrate that a phased strategy that starts with buying stock on margin when young generally outperforms both conventional life cycle allocation strategies and a constant 100% stock allocation strategy. (See the chart below.)
- The expected retirement wealth from a phased leverage strategy is 90% (19%) higher than that generated by a typical life-cycle strategy (100% stock strategy), allowing investors to retire almost six years earlier or extend retirement by 27 years.
- The increased returns have less risk. Even with the risk of wiping out current investments when young and leveraged, the minimum return at retirement for initially leveraged strategies is substantially higher than the minimum return for traditional life cycle allocation strategies.
- Explicit margin interest rates may be prohibitively high for small investors, but there are two reasonably priced alternatives:
- Leveraged diversified funds offer a recent implied margin interest rate of about 5%.
- Deep-in-the-money, long-range call options on stock indexes offer a recent implied margin interest rate of about 4%, less than 1% over the 10-year Treasury note yield.
- Even with the future equity risk premium at half its historical level (or with a higher margin interest rate), there is still a gain from employing leverage while young.
- The initially leveraged strategy also outperforms using UK and Japanese stocks.
The following chart, taken from the paper, depicts the final wealth accumulated over a 44-year investing lifetime for three annually rebalanced strategies:
- Invest all liquid savings in stocks with 2:1 leverage, and reduce this leverage whenever stock investments exceed a target of 88% of discounted lifetime savings (88% Target Strategy). If unleveraged stock investments exceed this target percentage, rebalance by shifting excess funds into government bonds.
- Invest 100% of liquid savings in stocks (100% Stock Strategy).
- Invest 90% of liquid savings in stocks at age 21, and reduce this percentage linearly to 50% by age 65 (90/50 Strategy), with the non-stock balance in government bonds.
The chart shows that the 100% Stock strategy generally beats the 90/50 Strategy, and that the 88% Target Strategy (early leverage) generally beats both of the more conventional approaches.
In summary, diversifying stock investments over time by using leverage when young is very likely to generate greater wealth at retirement than either 100% constant allocation to stocks or traditional unleveraged stock/bond allocation algorithms.
