Here’s a Different Way to Think About Stock Diversification
Everybody knows to spread money across many investments. Fewer think about diversifying over time.
Everybody knows to spread money across many investments. Fewer think about diversifying over time.
Investors often think of diversification as a free lunch—it allows them to maintain returns while reducing risk. But most people only get part of diversification right, and that can hurt them later in life.
With traditional diversification, people spread money around different kinds of investments to mitigate risk. That approach misses a key opportunity: “diversifying” how you invest over time.
Most people start investing with a small amount of money, because that is all they can afford, and ramp it up as their earnings grow. But investing so much later in life unnecessarily puts people at greater risk when they are close to retirement. They end up with far greater exposure to stock-market risk in their 50s and 60s than in their 20s and 30s, even if they are buying diversified mutual funds.
We propose a different method: People ought to borrow money to make their initial investments larger, so that they can invest closer to the same amount every year over their lifetime. Think of investing $2 a decade steadily for three decades, instead of $1 for the first, $2 for the next and $3 for the third.
The overall amount they invest stays the same—$2 of average market exposure—but when it is a steady amount, instead of an increasing one, the market exposure is larger than otherwise earlier on ($2 versus $1) and then smaller than otherwise in later life ($2 versus $3).
Both choices—investing $2 each decade instead of $1, $2 and $3—provide the same expected return, since they both have $6 accumulated market exposure over time. But risks associated with the two strategies are different: Our time-diversified path brings lower variance in returns than one with increasing investments.
When investment exposure varies over time, the market’s ups and downs don’t balance out as well. With 2/2/2, an up in the first decade balances out with a down in the third, and vice versa. But with 1/2/3, an up in the first decade is dominated by a down in the third, and a down in the first decade is also dominated by an up in the third. Consequently, the 1/2/3 investment pattern leads to larger swings in lifetime accumulations. The 1/2/3 strategy has too little dependence on the first decade’s stock return and too much on the third. By comparison, the 2/2/2 approach is evenly spread out and thus better diversified.
People might think they can’t follow a 2/2/2 type of strategy because they haven’t saved enough when young: They can’t invest $2 because they only have $1. But that’s not true. Using leverage—that is, borrowing money to buy stocks—people can use $1 of capital to borrow another $1 and thereby get $2 of market exposure in their first decade.
Sound risky? Consider that young people do the same thing with housing when they borrow money to buy a house they live in for decades—and there the leverage often involves borrowing $9 for every $1 of equity. We propose borrowing only $1 for each $1 invested. Limiting ourselves to 2:1 leverage means we don’t hit a perfectly even market exposure over time, but gets us closer to that ideal.
Using an initial 200% allocation—and gradually reducing the allocation to stocks over time, down to 83% at retirement age—is a winning strategy. In a 2010 book, we found that this “leveraged life cycle” approach produced superior retirement accumulation for each and every cohort retiring from 1914 to 2009. We now have more than a dozen years of post-publication returns where we can evaluate how the strategy actually worked in practice. Leveraged life-cycle returns have continued to provide superior retirement accumulation for each and every cohort through mid-2022.
Average investors using our method—assuming they invested 4% of their annual income, which rose during their careers to $100,000 in their final year of work—accumulated $1,255,000, while a traditional target-date fund investment, starting at 90% stocks and going down to 50%, produced only $675,000, and a constant 75% strategy led to $774,000.
Of course, these higher returns are partly due to more stock exposure and not to the diversifying benefits of the leveraged life-cycle strategy. To focus solely on the diversification benefits, we compared the retirement accumulations of a less-aggressive life-cycle strategy, one that again starts with 200% in stock but ramps down to 50% at retirement. We compared this to a constant 75% of savings in stocks and 25% in bonds. We chose this particular 75% allocation because it produces the same average accumulation ($774,000) across the retiring cohorts. Therefore, any difference in the strategies won’t be because one has more lifetime exposure to the stocks, which on average outperform bonds.
Comparing these two strategies shows that the leveraged life-cycle strategy decreases the standard deviation of retirement accumulation across retiring cohorts by an impressive 19%. Our more time-diversified, leveraged strategy produces higher returns for cohorts that experienced the worst stock returns (the 10th-percentile accumulation increases by 10.9% relative to the constant 75% strategy) and lower returns for cohorts that lived through the best stock returns (the 90th-percentile accumulation also decreases by 10.9% relative to the constant 75% strategy).
Producing the same average return with less risk is compelling evidence of how a leveraged life-cycle strategy can diversify market risk. Of course, ramping down to 50% instead of 83% in stocks at retirement has less market exposure and therefore lower average returns. The investor can choose: the same returns as a constant 75% exposure strategy with less risk, or the same risk but with higher expected return. Time diversification makes either possible.
Our strategy works in theory and in practice. But there are possible objections that might hold people back.
For one, people might say that it is expensive to invest on margin. But competitive margin loans are cheaper than home mortgages (though you may need to consider online brokerages).
A second objection is that leverage is risky. But when you are more evenly exposed to market risk across time, you have less risk. Using leverage to go from 1/2/3 to 2/4/6 would be adding risk and market exposure. But a 2/2/2 strategy doesn’t.
When markets drop, those investors near retirement who have followed 1/2/3 are in trouble. If stocks fall by 25% in their last decade of investing, they would lose 25% of their $3 investment—while a 2/2/2 investor would lose just 25% of $2. That is a 50% greater loss on the $3 investment.
One objection that does have some merit is that our approach requires discipline. Some people can’t bring themselves to borrow money to buy stock or would bail out at the first downturn in the market. We would like to see target-date funds make things easier for investors by automating the process, borrowing at low cost and automatically adjusting a portfolio. People could put in money each month and forget about it.
Meantime, young investors can move to 100% equities. That isn’t 200%, but it is a step in the right direction and doesn’t require the psychological or logistical burdens of borrowing to buy. And even if this advice is coming a bit late for readers in their 50s and 60s, this is advice to pass along to the next generation. They don’t have to repeat our mistakes.
Dr. Ayres is the William Townsend professor at Yale Law School, and Dr. Nalebuff is the Milton Steinbach professor at the Yale School of Management. Together, they are the authors of “Lifecycle Investing.”
Americans now think they need at least $1.25 million for retirement, a 20% increase from a year ago, according to a survey by Northwestern Mutual
Equities are often seen as expensive after promising start to 2023
A new trading year kicked off just weeks ago. Already it bears little resemblance to the carnage of 2022.
After languishing throughout last year, growth stocks have zoomed higher. Tesla Inc. and Nvidia Corp., for example, have jumped more than 30%. The outlook for bonds is brightening after a historic rout. Even bitcoin has rallied, despite ongoing effects from the collapse of the crypto exchange FTX.
The rebound has been driven by renewed optimism about the global economic outlook. Investors have embraced signs that inflation has peaked in the U.S. and abroad. Many are hoping that next week the Federal Reserve will slow its pace of interest-rate increases yet again. China’s lifting of Covid-19 restrictions pleasantly surprised many traders who have welcomed the move as a sign that more growth is ahead.
Still, risks loom large. Many investors aren’t convinced that the rebound is sustainable. Some are worried about stretched stock valuations, or whether corporate earnings will face more pain down the road. Others are fretting that markets aren’t fully pricing in the possibility of a recession, or what might happen if the Fed continues to fight inflation longer than currently anticipated.
We asked five investors to share how they are positioning for that uncertainty and where they think markets could be headed next. Here is what they said:
Cliff Asness, founder of AQR Capital Management, acknowledges that he wasn’t expecting the run in speculative stocks and digital currencies that has swept markets to kick off 2023.
Bitcoin prices have jumped around 40%. Some of the stocks that are the most heavily bet against on Wall Street are sitting on double-digit gains. Carvana Co. has soared nearly 64%, while MicroStrategy Inc. has surged more than 80%. Cathie Wood‘s ARK Innovation ETF has gained about 29%.
If the past few years have taught Mr. Asness anything, it is to be prepared for such run-ups to last much longer than expected. His lesson from the euphoria regarding risky trades in 2020 and 2021? Don’t count out the chance that the frenzy will return again, he said.
“It could be that there are still these crazy animal spirits out there,” Mr. Asness said.
Still, he said that hasn’t changed his conviction that cheaper stocks in the market, known as value stocks, are bound to keep soaring past their peers. There might be short spurts of outperformance for more-expensive slices of the market, as seen in January. But over the long term, he is sticking to his bet that value stocks will beat growth stocks. He is expecting a volatile, but profitable, stretch for the trade.
“I love the value trade,” Mr. Asness said. “We sing about it to our clients.”
For Richard Benson, co-chief investment officer of Millennium Global Investments Ltd., no single trade was more important last year than the blistering rise of the U.S. dollar.
Once a relatively placid area of markets following the 2008 financial crisis, currencies have found renewed focus from Wall Street and Main Street. Last year the dollar’s unrelenting rise dented multinational companies’ profits, exacerbated inflation for countries that import American goods and repeatedly surprised some traders who believed the greenback couldn’t keep rallying so fast.
The factors that spurred the dollar’s rise are now contributing to its fall. Ebbing inflation and expectations of slower interest-rate increases from the Fed have sent the dollar down 1.7% this year, as measured by the WSJ Dollar Index.
Mr. Benson is betting more pain for the dollar is ahead and sees the greenback weakening between 3% and 5% over the next three to six months.
“When the biggest central bank in the world is on the move, look at everything through their lens and don’t get distracted,” said Mr. Benson of the London-based currency fund manager, regarding the Fed.
This year Mr. Benson expects the dollar’s fall to ripple similarly far and wide across global economies and markets.
“I don’t see many people complaining about a weaker dollar” over the next few months, he said. “If the dollar is falling, that economic setup should also mean that tech stocks should do quite well.”
Mr. Benson said he expects the dollar’s fall to brighten the outlook for some emerging- market assets, and he is betting on China’s offshore yuan as the country’s economy reopens. He sees the euro strengthening versus the dollar if the eurozone’s economy continues to fare better than expected.
Even after the S&P 500 fell 15% from its record high reached in January 2022, U.S. stocks still look expensive, said Rupal Bhansali, chief investment officer of Ariel Investments, who oversees $6.7 billion in assets.
Of course, the market doesn’t appear as frothy as it did for much of 2020 and 2021, but she said she expects a steeper correction in prices ahead.
The broad stock-market gauge recently traded at 17.9 times its projected earnings over the next 12 months, according to FactSet. That is below the high of around 24 hit in late 2020, but above the historical average over the past 20 years of 15.7, FactSet data show.
“The old habit was buy the dip,” Ms. Bhansali said. “The new habit should be sell the rip.”
One reason Ms. Bhansali said the selloff might not be over yet? The market is still underestimating the Fed.
Investors repeatedly mispriced how fast the Fed would move in 2022, wrongly expecting the central bank to ease up on its rate increases. They were caught off guard by Fed Chair Jerome Powell‘s aggressive messages on interest rates. It stoked steep selloffs in the stock market, leading to the most turbulent year since the 2008 financial crisis. Now investors are making the same mistake again, Ms. Bhansali said.
Current stock valuations don’t reflect the big shift coming in central-bank policy, which she thinks will have to be more aggressive than many expect. Though broader measures of inflation have been falling, some slices, such as services inflation, have proved stickier. Ms. Bhansali is positioning for such areas as healthcare, which she thinks would be more insulated from a recession than the rest of the market, to outperform.
“The Fed is determined to win the war since they lost the battle,” Ms. Bhansali said.
Gone are the days when tumbling bond yields left investors with few alternatives to stocks. Finally, bonds are back, according to Niall O’Sullivan of Neuberger Berman, an investment manager overseeing about $427 billion in client assets at the end of 2022.
After a turbulent year for the fixed-income market in 2022, bonds have kicked off the new year on a more promising note. The Bloomberg U.S. Aggregate Bond Index—composed largely of U.S. Treasurys, highly rated corporate bonds and mortgage-backed securities—climbed 3% so far this year on a total return basis through Thursday’s close. That is the index’s best start to a year since it began in 1989, according to Dow Jones Market Data.
Mr. O’Sullivan, the chief investment officer of multi asset strategies for Europe, the Middle East and Africa at Neuberger Berman, said the single biggest conversation he is currently having with clients is how to increase fixed-income exposure.
“Strategically, the facts have changed. When you look at fixed income as an asset class…they’re now all providing yield, and possibly even more importantly, actual cash coupons of a meaningful size,” he said. “That is a very different world to the one we’ve been in for quite a long time.”
Mr. O’Sullivan said it is important to reconsider how much of an advantage stocks now hold over bonds, given what he believes are looming risks for the stock market. He predicts that inflation will be harder to wrangle than investors currently anticipate and that the Fed will hold its peak interest rate steady for longer than is currently expected. Even more worrying, he said, it will be harder for companies to continue passing on price increases to consumers, which means earnings could see bigger hits in the future.
“That is why we are wary on the equity side,” he said.
Among the products that Mr. O’Sullivan said he favours in the fixed-income space are higher-quality and shorter-term bonds. Still, he added, it is important for investors to find portfolio diversity outside bonds this year. For that, he said he views commodities as attractive, specifically metals such as copper, which could continue to benefit from China’s reopening.
Ramona Persaud, a portfolio manager at Fidelity Investments, said she can still identify bargains in a pricey market by looking in less-sanguine places. Find the fear, and find the value, she said.
“When fear really rises, you can buy some very well-run businesses,” she said.
Take Taiwan’s semiconductor companies. Concern over global trade and tensions with China have weighed on the shares of chip makers based on the island. But those fears have led many investors to overlook the competitive advantages those companies hold over rivals, she said.
“That is a good setup,” said Ms. Persaud, who considers herself a conservative value investor and manages more than $20 billion across several U.S. and Canadian funds.
The S&P 500 is trading above fair value, she said, which means “there just isn’t widespread opportunity,” and investors might be underestimating some of the risks that lie in waiting.
“That tells me the market is optimistic,” said Ms. Persaud. “That would be OK if the risks were not exogenous.”
Those challenges, whether rising interest rates and Fed policy or Russia’s war in Ukraine and concern over energy-security concerns in Europe, are complicated, and in many cases, interrelated.
It isn’t all bad news, she said. China ended its zero-Covid restrictions. A milder winter in Europe has blunted the effects of the war in Ukraine on energy prices and helped the continent sidestep recession, and inflation is slowing.
“These are reasons the market is so happy,” she said.
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