The Ultimate Strategy for Millennials – Lifecycle Investing

If you are under age 40 and saving to become financially independent, the ultimate strategy for you to understand is Lifecycle Investing.

It has worked 100% of the time in the last 150 years and increased portfolios at retirement by an average of 63%.

Results are so consistent because it reduces one of your biggest financial risks, “Last Decade Risk”.

Lifecycle Investing is not for everyone, but understanding the concept can change your entire approach to managing your money.

Prefer an overview? Like videos? Check out our whiteboard video, or read the full post below!

To understand Lifecyle Investing, first you need to understand what is wrong with the traditional method of “bit-by-bit” saving.

“Last Decade Risk”

Millennials 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:

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 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, note in the table below 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 Millennials, this means you are betting your retirement on your investment returns in one future decade, probably the decade from 2040-2050.

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 practical.

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

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?

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?

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 what we do with our homes. Most people would think nothing of putting $25,000 down on a $500,000 home. If you live in that home for 40 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 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 2:1 (or more) and invest 100% in stocks – no bonds. If you have $10,000 to invest, borrow an additional $10,000 (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 $30,000 (or $400,000) in stocks. This period lasts until your stock market investments 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 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:

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.

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 100% loans and 3:1 loans. Most banks will only take mutual funds or seg funds as collateral, not ETFs or individual stocks.
  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.

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 concept is still very practical. Invest larger amounts in equities while you are young to diversify across time.

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.

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 sometimes 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 have 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.

Summary

Lifecyle Investing is the ultimate strategy for Millennials who want to become financially independent to understand.

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.

It has worked 100% of the time in the last 150 years and increased portfolios at retirement by an average of 63%.

Results are so consistent because it reduces one of your biggest financial risks, “Last Decade Risk” by diversifying across time.

The traditional way of investing money “bit-by-bit” 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 2000-2009), you could lose more than half of your retirement income.

Lifecycle Investing is a practical example of how having a Financial Plan and using the right strategies are the most critical issues in having the future that you want.

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.

Ed

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.

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Ed has a unique understanding of how to be successful financially based on extensive real-life experience, having written nearly 1,000 comprehensive personal financial plans.

The “Planning with Ed” experience is about your life, not just money. Your Financial Plan is the GPS for your life.

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15 Comments

  1. Ed Rempel on April 17, 2022 at 11:24 AM

    Hi Mads,

    In general, the higher leverage, the more benefits for you over the long-term, as long as you can maintain it for the long-term.

    Leveraged ETFs don’t work, though. The math of them means you can end up losing money even over the long-term. Normal market fluctuations up-and-down result in leveraged ETFs declining. For example, if the market rises 1% on Monday and drops 1% on Tuesday to your starting point, leveraged ETF will show a 2-day loss. It’s a quirk of their math and having to reprice daily.

    Leveraged ETFs are short-term market timing vehicles and not effective for long-term investing.

    Ed



  2. Mads Hennelund on February 4, 2022 at 8:52 AM

    Hi again Ed,

    I appreciate your answer regarding the >2x leverage and agree that if you avoid margin call risk, the 2x max that the authors recommend can be exceeded. They do mention, however, that one reason for the 2x limit is costs of borrowing which tend to go up with the leverage amount. That is a valid point I think.

    One other thing that I really can seem to figure out is the samuelson share, i.e. risk preference. Because now at age 32, I allocate above 100% to equities and zero to bonds, accordingly with the lifecycle theory. But in order to find my equity target (100% , 82%, 75% or 65% of present savings + discounted future earnings) I sort of have to find out my future prefered samuelson share and set that now at age 32, where my risk preference is >100% equity. I think this part is quite difficult to figure out because your risk preference usually slide towards lower risk as you age. But if I set the preference to 100% now, which is where I’m at now, my target moves way into the future and the high leverage period will have to last for many many years.

    Hope you have some insight here to help me along with the target setting accoring to risk profile.
    best
    MAds



  3. Ed Rempel on January 20, 2022 at 11:52 PM

    Hi Alexander,

    The authors of the book are university professors. Good analysis, but clearly not very knowledgeable about investment or leverage investing options.

    Lifecycle Investing is targeted for younger people that usually don’t have a large portfolio and often have money tied up in their home. LEAPS are generallly 2:1, so it will take most people many years to reach their target investment amount.

    Using their secured credit line or the Smith Manoeuvre strategy or a 100% investment loan can mean a larger initial investment, without having to save 50% of the money yourself. Even a 3:1 investment loan gives you a 50% larger portfolio than a 2:1 LEAP.

    LEAPS have higher costs, since they are long-term options, so your return will be noticeably below the index long-term. I have not used them and am not clear exactly what happens with a 2:1 option if the market temporarily drops 50%. Does that mean the option loses 100%? They trade based on market bids, not double the index, except at maturity, so maybe it would drop only very close to zero.

    In short, the Smith Manoeuvre, secured credit lines and 100% or 3:1 investment loans are far more effective than LEAPS.

    Ed



  4. Ed Rempel on January 20, 2022 at 9:30 PM

    Hi Mads,

    In general, higher leverage works over the long-term, so combining leverage types can be helpful. We have clients that use their home equity and then pledge it for an investment loan to get a higher amount of leverage. It’s very effective. All low interest and no margin call.

    There is an issue with leveraged ETFs, though. They are not suitable as a long-term investment. Because of the math of how it works, you are likely to lose money over the long-term. If the market goes up 1% and then back down, the leveraged ETF will have lost a bit of money. With the day-to-day fluctuations, it can lose a little many times in a year.

    Ed



  5. Mads Hennelund on January 20, 2022 at 4:53 AM

    Hi Ed,
    Thank you for your reply.
    Yeah I have a sort of 4%-rule-based target for future retirement nest egg that that I use as forecast, until which I personally have about 20 years of future expected contributions that I seek to frontload and get exposed to the equity market faster.

    Btw, what are your thoughts on utilizing different independent leverage options in combination? E.g. using for example both home equity line of credit as well as leveraged ETFs (2x S&P500) to get somewhere between 200-300% leverage of the equity portion in the first phase (high leverage)?

    Best
    Mads



  6. Ed Rempel on January 19, 2022 at 10:17 PM

    Hi Mads,

    “Dollar years” is the actual investments you have today plus the additional contributions you intend to make until you retire. Ideally, you should start with a Financial Plan to work out in detail the retirement lifestyle you want and how much you need to invest to achieve it. Find what works for you with both a retirement you are happy with and contributions that are doable for you.

    Then add today’s investments to the total you plan to invest (contributions only) until you retire. Then use that figure for your desired lifetime asset allocation.

    Ed



  7. Alexander Adams on January 8, 2022 at 12:21 PM

    Hi Ed. Thanks for the great article, I ended up reading the book afterwards. One of the methods the book recommends to achieve leverage is using long-term in-the-money call options (also referred to as LEAPs). How do you feel about this method, as opposed to a 3:1 investment loan?



  8. Mads on November 16, 2021 at 5:09 PM

    Hi Ed, thanks for a great article.

    Regarding “dollar years” and the total ammount you need to front-load as early as possible, you say the footnotes: “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.”

    Does this mean that you take the sum of current investments (contributions + returns) plus the amount of contributions from then on (no return included, just contributions) that get you to the desired level of retirement wealth in the future when counting also e.g. 7% CAGR (equity returns)? Or do you need to take the total amount of money (contributions + return) at desired level of retirement wealth and front-load this figure as early as possible?

    Best
    Mads (Denmark)



  9. Ed Rempel on April 27, 2021 at 10:13 PM

    Hi Scott,

    Good question. This is the challenge of Lifecycle Investing. It’s the best strategy Millennials can do, but at that age, it’s hard to get an investment loan.

    Qualifications usually require enough regular income to make the payments and a net worth. Investment loans are usually limited to your net worth.

    The best way to get it started is to be highly avid saver and investor early to build up some net worth. Then use it for a 3:1 investment loan.

    For example, save up $50,000 and pledge it for a loan of $150,000, to give yourself $200,000 in investments. If you have $200,000 in equity investments by your mid-20s, you can be quite wealthy relatively early in life. You have 40 years of compounding in front of you.

    Once the investments grow, you can pledge your growth for a larger 3:1 loan. It can build quickly if you have a decent income and a growing net worth.

    The other option for your 18-year-old is that a family member lends them money to invest.

    Ed



  10. Scott on April 14, 2021 at 7:21 PM

    Child number 1 just turned 18, how do you set them up for lifecycle investing? How do they get the loan with enough money to really super charge the plan?



  11. […] read through Ed Rempel’s article a few […]



  12. […] think of a home, this course of action is like taking out a mortgage on your future portfolio. “Borrow a large amount early and slowly pay it off in order to have the same amount invested every ye….” – Ed Rempel, fee-only financial advisor who is well known in the Canadian FI/RE […]



  13. Milestones of FI Update - Dr. FIREfly on November 15, 2020 at 3:42 PM

    […] of this boost came from dabbling with life cycle investing, using my (previously) fully paid down line of credit. Thank you to the FI Garage guys for going […]



  14. Matthew Latimer on July 5, 2017 at 3:44 PM

    Brilliant strategy, another article which would broaden the awareness of so many layperson investors – and many professionals too! Thanks Ed!



  15. […] The Ultimate Strategy for Millennials – Lifecycle Investing If you are under age 40 and saving to become financially independent, the ultimate strategy for you to understand is Lifecycle Investing. […]



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