“The point is simple: if diversification across asset classes is so good, why not also seek greater diversification across time periods?” – Ian Ayres
Last Decade Risk
There is a big risk in the way most people save for retirement. The big risk is that the vast majority of the investments most people own during their working years are in the last few years before retirement. We call it “Last Decade Risk”.
Since the 2000-2009 was the second worst decade ever for the stock market, there are many stories of people who saved and invested consistently for 40 years and yet found that one bad decade in investing just before retirement left them far short of the retirement they want.
For example, let’s look at Robert. He invests $10,000/year in his RRSP starting at age 25 and increases that by inflation every year as he gets more RRSP room, like many Canadians do. With an average 8% return, here is how his investments grow:
Age Investments % of Total
25-34 $ 176,000 2%
35-44 $ 617,000 9%
45-54 $1,649,000 25%
55-64 $3,988,000 64%
Here is the scary part – 64% of all the investments that Robert owned over 40 years (age 25-65) were owned in just 10 (after age 55) – and 80% were only owned after age 50!
Just to be clear, “last decade risk”, is not necessarily the end of the world, since statistics show that most Canadians will have another 25+ years of retirement ahead of them to make up for it. But having a lot less than you need in the year you start retirement can still be a huge worry.
How do you avoid “Last Decade Risk”?
Lifecycle Investing – Diversifying across time
The solution to “last decade risk” is the subject of a groundbreaking book by 2 Yale professors, called “Lifecycle Investing”.1 They advocate borrowing to invest when you are young and paying it off in your 50s. They show how this actually reduces risk by “diversifying across time”.
The book is quite technical and obviously written by 2 math geeks. But their concepts are very practical.
First, let’s understand “diversifying across time”. Here are the stock market holdings of 2 brothers at 2 points in their lives:
Age 30 $ 100,000 $200,000
Age 60 $1,000,000 $900,000
Note that they have the same exposure to the stock market during their lives, but Paul is more diversified across time. His “last decade risk” is lower.
The concept of “Lifecycle Investing” is that Paul could do this by borrowing $100,000 to invest at age 30 and allocating $100,000 of his stock market investments to bonds at age 60.
Most people are comfortable with the benefits of diversifying by different types of investments. Why not also diversify across time?
Does Lifecycle Investing make sense?
A better question is – does the traditional method of investing really make sense when it usually means having 10-30 times more money in the stock market at age 60 than at age 30?
Lifecycle investing is what we tend to do with our homes. Most people would think nothing of putting $25,000 down on a $500,000 home. The advantage here is that if you live in that home for 20 years, you have $500,000 invested in real estate each year. This is the lifecycle investing concept – borrow a large amount early and slowly pay it off in order to have the same amount of investments every year.
Just to be clear, borrowing to invest is a risky strategy and is not for everyone. If you cannot stomach the ups and downs, may sell or invest less after a crash, or if you chase performance, then borrowing to invest probably is not the right strategy for you.
However, this study proves that if done right as part of a long term strategy, borrowing to invest can actually reduce your retirement risk. If you define risk as the ups and downs of your investments, then borrowing to invest in the early years is obviously more risky than not borrowing. However, if you define risk as the risk of not having the retirement you want, then the risk over your lifetime can be lower with lifecycle investing.
Asset allocation with Lifecycle Investing
The solution of “Lifecycle Investing” is to allocate your investments between stocks and bonds based on the total you will invest during your lifetime. This is called “dollar years”.1 If you are going to invest $10,000 every year for 40 years, then you have $400,000 “dollar years”.
You can think of the $10,000 you plan to invest in each of the future years as a bond when you are determining how much to invest into stocks vs. bonds.
For example, let’s say that you want to invest 70% in stocks and 30% in bonds. Instead of investing the $10,000 based on 70/30, with lifecycle investing you would add up the total investments you will have over the next 40 years ($400,000) and invest 70% of that figure, or $280,000, in stocks.
Since you only have $10,000 in year 1, you would borrow the maximum you are comfortable with each year and invest 100% in equities until you reach $280,000.2
The actual formula3 calls for a very high amount of leverage in period 1. Since the Yale professors are math geeks and not investors, they are not aware of all the methods of borrowing to invest and therefore only advocate 2:1 leverage. The concept is to borrow what you are comfortable with and what you can qualify for in the early years.
Stages of life with Lifecycle Investing
In practice, this process leads to 3 periods through your working life:
- High leverage period – Leverage 2:1 (or more) and invest 100% in stocks – no bonds. If you have $10,000 invested, borrow an additional $10,000 (or more) to invest each year. Typically this period is the first 10 years of your investing life. This period lasts until your stock market investments reach your target percentage of your lifetime investments (e.g. 70% of $400,000 = $280,000).
- Reducing leverage period – Reduce leverage portion slowly and maintain 100% in stocks. Typically eliminate leverage by early 50s.
- No leverage period – Start introducing bonds moving to your desired allocation (e.g. 70% stocks/30% bonds) by the time you retire.
Does lifecycle investing work?
The study results proved that it resulted in a better retirement for people born every single year since 1848! Lifecycle investing would have improved the retirement 100% of the time for anyone retiring in the last 96 years.1
Lifecycle investing can be applied to either provide the same returns as traditional investing with less risk, or to have the same risk but a higher return.
In the book, each strategy is named by the percent in stocks in year 1 and the percent at retirement. For example:
- Traditional investing: 75/75 means a constant 75% in stocks.
- Lifecycle strategy: 200/50 means borrowing so you can invest double the cash you have in year 1 (200% in stocks) and then moving down to 50% stocks/50% bonds by retirement.
Here are the results of lifecycle investing strategies vs. a 75/75 traditional portfolio:
200/50 – Same returns as 75/75 with 21% lower risk. Same average investment in stocks as 75/75.
200/61 – Same risk as 75/75 with 18% more investments at retirement.
200/83 – Same worst-case scenario as 75/75 with average 63% more investments at retirement.
Here are the actual results for people that retired between 1914 and 2009 investing a constant percent of their income for 45 years1:
Retirement Investments 75/75 200/50 200/61 200/83
Worst case scenario $ 167,000 $ 291,000 $ 299,000 $ 167,000
Average result $ 749,000 $ 749,000 $ 881,000 $1,220,000
Best case scenario $1,330,000 $1,210,000 $1,460,000 $2,280,000
% Chance of beating 75/75 99% 100% 100%
You may be wondering – is this just better because they invested more in stocks? The answer is no. The 200/50 strategy has the same average investment in the stock market as the 75/75 strategy. This is why the average result is the same. The range between the highest and lowest returns is narrower, though, because of the reduced risk from diversifying across time.
I actually was surprised that the results were better 100% of the time. Remember, this includes people that had the Great Depression of the 1930s either at the beginning or the end of their working life.
Lifecycle Investing vs. Smith Manoeuvre
This strategy is different than the Smith Manoeuvre, which involves borrowing to invest slowly as you pay off your mortgage. The Smith Manoeuvre often involves maintaining the investment credit line through retirement (since this provides a higher retirement income if done right), while Lifecycle Investing suggests paying it off before retirement.
These are 2 of many possible strategies that can all be valid options to the traditional approach of just slowly investing your hard-earned dollars every year.
Having the right plan & strategy trumps investment returns
Lifecycle investing is worth discussing, because it points out the huge “last decade risk” with traditional investing and shows that the right leverage strategy over many years can sometimes reduce risk.
Most investors in their 30s and 40s believe that the most important part of their future retirement is the rate of return they get on their investments. This often leads them to ignore financial planning and just focus on investments. The concepts here show that having a plan and using the right strategy is far more important than rate of return.
In fact, most people will have 80% of the investments they will own during their working life after age 50. The rate of return you have before age 50 is not that important because it is on a relatively small amount of money.4
For example, the 200/83 strategy only has a moderate $10,000/year of leverage, but still produced a 63% higher retirement income and produced a higher retirement income 100% of the time.
It is difficult for many investment-focused people to believe us when we tell them that the most critical issues for their future are having a comprehensive plan and using the right strategies. The concepts of Lifecycle Investing provide a useful example of the importance of having the correct focus.
The traditional way of investing money each year creates a big “last decade risk” because 80% of your investments over your working life are usually after age 50. If your last decade is a bad decade (like the last decade), it probably means your rate of return for your entire working life is low. One bad decade can put you far below your retirement goal.
Lifecycle investing reduces “last decade risk” by diversifying across time. Essentially, you borrow in your first decade of investing and invest 100% in stocks. Then you slowly pay off the leverage by your early 50s, when you start adding bonds, moving to your desired mix by retirement.
The study by 2 Yale professors proved lifecycle investing for your entire working life provided a better retirement 99-100% of the time. This is a practical example of how having a plan and using the right strategies are the most critical issues in having the future that you want.
Read my post or watch my whiteboard video summary here:
1 “Lifecycle Investing”, Ian Ayres & Barry Nalebuff, 2009
2 They have scenarios ending at retirement and scenarios including pensions during your retirement years.
3 The actual formula would involve calculating your “dollar years” every year as the sum of your investments today plus all the amounts you plan to invest in the future.
4 Many people become more conservative and allocate more to bonds in the last 10-15 years before retirement. This probably means a lower rate of return. Every 1%/year lower return they make after age 50 wipes out 4%/year of the return they made for the first 25 years from age 25-50, since they will own 80% of their investments after age 50.
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