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Recently, a younger, intelligent, and well-educated relative approached me with questions about the book Lifecycle Investing by Ian Ayres and Barry Nalebuff. His curiosity piqued my interest, so I decided to read the book myself.
In essence, the book suggests that when you’re young, your future earnings (your “human capital”) are substantial and behave similarly to a bond. To balance your lifetime risk exposure, you could invest heavily in stocks early, even using leverage, and then gradually reduce risk as you age.
My relative asked me about his plan to sensitize his portfolio 100% via a call spread option. Knowing that he’s a thoughtful person, I didn’t immediately dismiss him. But, I remembered Bill Bernstein’s quote, “Investing is 50% math and 50% Shakespeare.” So, I decided to share my thoughts with him.
I’d value the opinions of this community before I send it to him. Thank you.
Lifecycle Investing is elegant but fragile
The mathematical assumptions in the book are thoughtful, and the concept of temporal diversification is solid. However, the challenge lies in the behavioral assumptions:
These are demanding tasks, even for disciplined investors. Strategies fail not because they’re incorrect, but because they’re difficult to live with.
In practice, it’s far more comfortable to modestly increase exposure rather than relying on extreme leverage. With a modest tilt, one can:
In other words, a modest leverage plan with a 20% risk tolerance is more likely to survive in reality. This relatively modest increase in risk allows investors to weather bad markets, boring markets, and scary headlines. It is almost always preferable to a theoretically optimal plan that may be abandoned at the wrong moment.
If you’re young and want leverage, then have a mortgage and don’t try to pay it off, invest the money instead. You don’t have to have the debt in the same place as your investments, you have to look at your total personal balance sheet.
My son tells me this sort of thinking–“leverage is good”–pervades his young, rich, and smart peer group. (He works for one of those companies we’ve all heard about.) I know my thoughts in this regard are of little value and even less respect for that peer group. They are, after all, younger and smarter.
If they had ears to hear, though, I would talk about the selective bias in storytelling, since those who don’t survive do not tell their stories, and stories of loss are less exciting than stories of risk followed by reward.
Since they are young, smart, and rich, they have the opportunity to choose security, yet risk sits at the door and flashes enticing glimpses of an even more wonderful life, no matter how wonderful life already is.
If that was once you and something helped you, what was it? I was one of those looking on and thinking I do not have the luxury of making such foolish choices if I am going to survive and live well in my own situation.
Today’s newsletter added the word “have” which completely reversed the meaning of the snippet from this post.
While the concept is intellectually interesting, get him to ask himself: do I want to spend the next 30 years managing option rollovers every quarter? One missed rollover during a family crisis or a technical outage and you lose everything. Maybe go for 100% stocks, buy a modest house with a mortgage. If he really wants to leverage his human capital, consider starting a business in his field. That’s leverage you can maybe live with for 30 plus years. In my experience, simple, robust strategies beat complex, fragile ones almost every time.
His strategy was to buy SPY LEAPS 24 months out with a call spread where the long trade is deep ITM and a short trade OTM to achieve the delta that expresses his sensitivity. He plans to roll once every year when the new LEAPS for a later year becomes available.
I am being a little less prescriptive about what he should do since there is a lot to learn from the follies of youth and decades of earnings ahead.
That is why I focused on being more modest rather than the churn that comes with a high delta spread.
Wow, you’re definitely pushing my knowledge envelope here. Two cups of coffee required to decipher your reply!
In a more reasonable market, this strategy might, and I stress might, have legs. But in my view, we’re currently in a very expensive market, and he’s veering into aggressive speculation.
The SPY is heavily weighted toward tech (about 30%), so taking out long calls right now is a brave move, to say the least. He’s essentially locking in a massive bet at all-time highs; if the market even just trades sideways, ‘negative theta’ will start eating his lunch.
I think you’re doing the right thing by talking him off the ledge. He’s certainly braver than I am… the invincibility of youth is a hell of a drug.
Yeah! It takes some time to understand the concept of time diversification.
Just like asset allocation, lifecycle investing is age- and wealth-dependent rather than based on stock market valuation. It’s more natural for me to advise, “Use a target date fund and ignore the market!”
Your young relative could take a time-tested and more conservative approach to this. Save up a down payment and then take out a 30-year mortgage for 80%-90% of the value of a primary residence. Consistently add money to your equity portfolio through workplace retirement plans, IRAs and brokerage accounts while you deleverage through monthly mortgage payments. Rinse and repeat for 30 to 40 years and you will have a substantial portfolio and will have paid off the debt in the process! Not flashy and won’t make you rich quickly, but a strategy that worked for me and millions of others.