Lifecycle Investing: The Ultimate Strategy for Younger People – An Example

I often get asked about Lifecycle Investing and how to implement it. 

If you’re under 40 and saving to achieve financial independence, this might be the most powerful strategy you’ll ever learn.

Lifecycle Investing has proven itself consistently over the last 150 years, increasing portfolios at retirement by an average of 63%. 

It has worked 100% of the time, and its success lies in addressing one of your biggest financial risks: “Last Decade Risk.”

However, it’s not for everyone. 

This strategy often involves borrowing to invest and maintaining a high equity allocation during certain phases of your life. 

Think of it as a concept rather than something to execute literally. Understanding it can completely transform how you manage your money.

Get your Financial Plan first. 

Lifecycle Investing involves thinking through the best way for you to do it over the next few decades. Creating your Financial Plan is an interactive process to help you think through all your various life options.

To understand Lifecycle Investing, first you need to understand what is wrong with the conventional method of “bit-by-bit” saving. An example is the best way to understand it.

In my latest video, podcast and blog post, you’ll learn:

• What is Lifecycle Investing?
• Why has it increased portfolios 100% of the time over the last 150 years by an average of 63%?
• What is “Last Decade Risk”?
• How does a bad decade just before retirement impact your savings?
• What’s wrong with conventional “bit-by-bit” saving?
• Why do returns before age 45 have so little impact on your life?
• How does Lifecycle Investing finance your retirement like a mortgage finances your home?
• What does it mean to diversify across time?
• What’s an example of Lifecycle Investing compared to traditional saving?
• How do you adapt your asset allocation for Lifecycle Investing?
• How can you implement it?
• How can it work for those who want maximum growth?
• Why is a financial plan crucial before starting Lifecycle Investing?

What is “Last Decade Risk”?

Young people today are mainly saving for their future like their parents did – a bit every year, such as making an annual RRSP or TFSA contribution. 

This “bit-by-bit” saving causes a big risk called “Last Decade Risk”.

The vast majority of the investments most people own during their working years are in the last 10-15 years before retirement.

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	Ending 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%
		100%

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 82% were only owned after age 50!

What happens if the last decade before retirement is a bad decade for his investments?

Since 2000-2009 was the second worst decade 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, note in this table that if Robert’s first decade is a bad decade, he ends up with only 15% less at age 65. However, if his last decade is a bad decade, he retires with 52% less.

Robert loses more than half his retirement income from one bad decade with no growth!

For younger people today, this means you are betting your retirement on your investment returns in one future decade, probably the decade from 2050-2060.

Is it smart to bet your retirement on getting a good return in that one future decade just before you retire?

How do you avoid “Last Decade Risk”?

Lifecycle Investing – Diversifying across time

The solution to “last decade risk” is a groundbreaking strategy 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 insightful.

First, let’s understand “diversifying across time”. Here are the stock market holdings of 2 brothers at 2 points in their lives:

	Peter	Paul
Age 30	$   100,000	$200,000
Age 60	$1,000,000	$900,000
Average	$   500,000	$500,000

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 with different types of investments. Why not also diversify across time?

An Example of Lifecycle Investing – Conventional Conner vs. Lifecycle Liam

Conner & Liam are good friends. They are both age 25 with good jobs earning $175,000/year, have $100,000 in investments that are 100% equities, and plan to retire at age 65 on $130,000/year before tax in today’s dollars. $130,000/year before tax gives them $100,000/year after tax to spend through their retirement rising by inflation. $130,000/year today is $425,000/year at age 65 with 3% inflation, so they will both need about $8 million at age 65 to live the life they want.

Conventional Conner does it the conventional bit-by-bit method of contributing $2,000/month to his RRSP. With an 8%/year long-term return, he can get to $8 million in 40 years.

Lifecycle Liam looks for a large investment loan so that he has a larger portfolio while he is young. He pledges the $100,000 for a 3:1 No Margin Call investment loan of $300,000 at 5%. His payment is only $1,250/month and is tax-deductible, the same as Conventional Conner’s RRSP contributions. At age 65, he sells $300,000 investments to pay off the loan.

What is the result? Lifecycle Liam is clearly better off in many ways:

• He only needs to use $1,250/month to retire the way he wants, while Conventional Conner needs $2,000/month. Both are tax-deductible.
• Lifecycle Liam would have a larger portfolio in 100% of the 40-year periods in the last 110 years.
•  If the last decade before they retire is a bad decade for the stock market, Conventional Conner would end up with a lot less than the $8 million goal. His retirement income would be about half, while Lifecycle Liam would be affected far less.
• If Lifecycle Liam contributes the $750/month extra to his RRSP so he uses the same cash flow as his friend, he can retire 5 years earlier at age 60 with the same lifestyle. Or he can retire with a higher income of $175,000/year before tax, the same as his income now, giving him $25,000/year extra after tax to spend for life.

Does Lifecycle Investing make sense?

If Robert told you that he plans to invest very little in the stock market for 30 years, and then invest heavily in the stock market for just the last 10 years before retiring, would you think that is smart? That would give him a high Last Decade Risk.

A better question is – does traditional “bit-by-bit” investing 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 essentially financing your retirement the same way we finance our homes. Most people would think nothing of taking a large mortgage to buy a $1 million home. 

If you live in that home for 40 years, you have $1 million invested in real estate every year. Why not finance your retirement the same way?

This is the Lifecycle Investing concept – borrow a large amount early and slowly pay it off in order to have the same amount invested every year.

Think of it as buying your retirement nest egg with one large investment at age 25, instead of buying it “bit-by-bit”.

This study proves that if done right as part of a long-term strategy, borrowing to invest can actually reduce your retirement risk by diversifying across time.

Asset allocation with Lifecycle Investing

With Lifecycle Investing, you allocate your investments between stocks and bonds based on the total you will invest during your lifetime. This is called “dollar years”. If you are going to invest $10,000 every year for 40 years, then you have $400,000 “dollar years”.²

You can think of the $10,000 you plan to invest in each future year 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 75% in stocks and 25% in bonds. Instead of investing the $10,000 based on 75/25, with Lifecycle Investing you would add up the total investments you will invest over the next 40 years ($400,000) and invest 75% of that figure, or $300,000, 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 $300,000 invested.²

Once you reach $300,000 in stocks, you slowly pay down your investment loan. Once it is paid off, then you start investing in bonds, until you reach your desired asset allocation of 75% stocks and 25% bonds.

The actual formula calls for a very high amount of leverage in year 1. Since the Yale professors are math geeks and not investors, they are not aware of all the methods of borrowing to invest and advocate only 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

Essentially, you borrow in your first decade of investing and invest 100% in stocks. You slowly pay off the leverage by your early 50s. Then you start adding bonds, moving to your desired mix by retirement.

In practice, this process leads to 3 periods through your working life:

1.      High leverage period – Leverage 3:1 (or more) and invest 100% in stocks – no bonds. If you have $10,000 to invest, borrow an additional $10,000 to $30,000 (minimum) to invest each year. The maximum would be to borrow in year 1 the full $290,000 (for 75/25 allocation) or $390,000 (for a 100% equity allocation) to get you to $400,000 in stocks. This period lasts until your stock market investments at cost reach your target percentage of your lifetime amount invested (e.g. 75% of $400,000 = $300,000). Typically, this period is the first 10 years of your investing life.

2.      Reducing leverage period – Pay off your investment loan slowly and maintain 100% in stocks. Typically eliminate leverage over 20 years by early 50s.

3.      No leverage period – Start introducing bonds moving to your desired allocation (e.g. 75% stocks/25% bonds) by the time you retire.

Does Lifecycle Investing work?

The study proved Lifecycle investing would have increased retirement income 100% of the time for anyone retiring in the last 96 years.¹

Lifecycle investing can be applied to either invest the same average amount as traditional “bit-by-bit” investing with less risk, or to have the same risk with more invested.

Here are the actual results for people that retired between 1914 and 2009 investing a constant percent of their income for 45 years¹ comparing 2 common conventional methods:

Retirement Investments	110-Age Rule	Fixed 75% Equities	Lifecycle Investing
Worst case scenario	$290,310	$308,726	$387,172
Average result	$646,575	$748,839	$1,223,105
Best case scenario	$1,026,903	$1,252,684	$2,177,424
Gain from Lifecycle Investing	89%	63%

You may be wondering – is this just better because they invested more in stocks? 

The answer is no. The Lifecycle Investing strategy has the same average investment in the stock market as the “Fixed 75% Equities” strategy.

The results are consistently better because you have more invested earlier. This is the benefit of diversifying across time.

I 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. Even with a huge crash at the beginning or end of your working life, Lifecycle Investing always came out ahead over a 40-year period.

You can do Lifecycle Investing fully, or just apply the concepts of investing more while you are younger to diversify across time. Either way, this strategy can make a huge difference in helping you become financially independent.

How do you implement Lifecycle Investing?

It is best to think of it as a concept. The Yale study showed that, when you are under age 50, the amount of money you have invested is far more important than your rate of return.

Options to implement Lifecycle Investing:

1. No leverage: Focus your energy on financial planning concepts like how to save & invest more. Find creative ways to invest larger amounts in equities while you are young.

2. Investment loan: Take one large loan or a series of small loans when you are young, based on the amount you are comfortable with and what you can qualify for. The most common types of investment loans are 3:1 loans. Most banks will only take mutual funds or seg funds as collateral, not ETFs or individual stocks. Make sure your loans are No Margin Call loans. One margin call in the next 40 years could wipe out your entire strategy.

3. Home equity: Once you own a home, you can use a secured credit line to borrow to invest. Lifecycle Investing annually from your home equity might work similarly to the Smith Manoeuvre strategy, and could be combined with investment loans.

Just to be clear, borrowing to invest is a risky strategy and is not for everyone. If you cannot stomach the ups and downs of the market, may make the “Big Mistake” (selling or investing more conservatively after a crash), or if you chase performance, then borrowing to invest is probably not the right strategy for you.

Borrowing to invest should always be a long-term strategy to increase your odds of success. I would suggest a minimum of 20 years.

If borrowing to invest is too risky for you, the Lifecycle concept is still very practical. Invest larger amounts in equities while you are young to diversify across time.

How can you adapt Lifecycle Investing if you are a maximum growth person?

If Lifecycle Liam is a maximum growth person, there are many things he can do to build his wealth faster, so he can be financially independent sooner or retire more comfortably.

These ideas are not for everyone, but they give you an idea of some of the possible enhancements:

• As his investments grow, he could pledge the growth for larger 3:1 investments loans to get an even larger portfolio working for him.
• If he buys a home, he could also do the Smith Manoeuvre or the Rempel Maximum strategies, integrating them with his Lifecycle Investing strategy.
• When he retires, he can keep his investment loan, so that he does not need to sell investments to pay it off. He could just pay interest through his retirement, giving him a continued tax deduction all his life.

Having the right plan & strategy beats investment returns

If you want to implement Lifecycle Investing, it is best to create a Financial Plan first, to decide how to do it over your life. Don’t do it without a plan.

There are many ways to do it. The right strategy for you might be large, small or no leverage. How will this fit in with the rest of your finances? It is far more effective to do it as part of your Financial Plan.

Your reason for doing it helps you stay focused. Do you want to do it to be financially independent sooner, to retire more comfortably, or just to have more freedom in your life?

Lifecycle investing is worth discussing, because it points out the huge “last decade risk” with traditional “bit-by-bit” investing and shows that the right leverage strategy over many years can reduce retirement risk by diversifying across time.

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 concept here shows that having a plan and using the right strategy is far more important than rate of return.

Most people will have 80% of the investments they will own during their working life after age 50. The rate of return you make before age 50 is not that important because it is on a relatively small amount of money. 3

For example, note that Robert owned only 2% of his investments from age 25-34 and 11% from 25-44. The rate of return he makes before age 45 or 50 makes little difference. Finding ways to get more money invested sooner is far more significant.

It is difficult for many investment-focused people to believe that the most critical issues for their future are having a comprehensive Financial Plan and using the right strategies. The concepts of Lifecycle Investing provide a useful example of the importance of having a Financial Plan.

Ed

REFERENCES

1 “Lifecycle Investing”, Ian Ayres & Barry Nalebuff, 2009

2 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.

3 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 you make after age 50 wipes out 4%/year of the return you make for the first 25 years from age 25-50, since you will own 80% of their investments after age 50.