Home > Uncategorized > Lifecycle Investing Not Always Smooth (1/2)

Lifecycle Investing Not Always Smooth (1/2)

January 23, 2012 Leave a comment Go to comments

The recent book Lifecycle Investing has an interesting perspective. The message to borrow when you’re young and use a lower stock allocation when you’re older makes sense in a lot of ways. But given the many ways it can go wrong it’s worth looking at it closely before doing anything. I recently had the chance to read the book. There are a couple of details that might make it less attractive than it sounds at first.

Through many simulations the authors show that the strategy would have a near-perfect success rate in past scenarios and even artificial simulations. The simulations come in two forms. When compared to a conventional strategy with the same average outcome, the lifecycle approach brings the minimum and the maximum closer to the average so you aren’t exposed to chance as much. And when it is adjusted to have the same worst-case outcome, the lifecycle strategy has much higher average and best-case outcomes.

Volatility Costs

However there is one small detail that’s only mentioned in two sentences throughout the book. Although true lifecycle balancing might mean borrowing like a 2006 homebuyer, the authors recommend limiting leverage to 2 to 1. By borrowing as much as you invest you are 200% in stocks. This means that if the value of your investments falls your leverage increases and you have to sell a bit to bring it back into balance. Their recommendation is doing this every 1-3 months.

At one point they refer directly to leveraged ETFs that do this every day. They are forced to buy high and sell low. As a result those ETFs can lose money any time the market has enough volatility, whether it’s rising or falling overall. At another point in the book they point out that in 2008 the strategy would have a young investor selling on the way down and limiting their losses. But they don’t comment much on how this could limit long-term gains when the market rebounds. As of today, anyone who sold when the S&P 500 was below $1318 (between June 20 2008 and February 11 2011) and didn’t buy back since then has lost.

Could it actually help to sell on the way down? That may be the case temporarily, but most of us would be foolish to judge our investment results over one year. As the example above shows, selling in Fall 2008 seemed smart in 2009 but not 3 years later. When buying any investment you need to consider where it will be when you sell it and what you get paid along the way.

Overall their simulations still show a better result for past investors who would have followed this strategy throughout their lives, even during the Depression. But this may be something that increases the risk in the future depending on the sequence of monthly returns. And informed investors willing to take a chance might do better.

Don’t Focus On Tomorrow

The overall message of diversifying dollar-year exposure is good. If you have $100,000 invested for 10 years the returns are more predictable than if you have $1m invested for 1 year. But again the returns in any one year don’t matter as much as the end result. If you invested at the start of 1999 you would have a great year, but the long-term picture wasn’t so pretty.

That example is unfair because diversification means more of the bad and the good. The hope is that the good parts will be greater. Like dollar-cost averaging this strategy allows you to get more predictable returns than simply investing a large amount one day. For those who don’t want to do too much research this isn’t a bad way to go overall.

But since I believe my instincts are different from the average investor and I might profit from this, I look at ways to potentially do better. Instead of diversifying my dollar-years what I would really want to do is go further and buy more at the cheapest time relative to the final price I will be selling at. There is no grand strategy to do this since there are far too many unknowns but it does suggest small adjustments. A year ago when I considered the markets to be slightly over fair value I wasn’t giving up on stocks completely but I wouldn’t use a lot of leverage at that point.

Useful Tool If Used Well

This is getting long, so come back later this week for the second part with ideas on how to safely apply this. Even if you don’t follow the exact strategy it contains useful tools.

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