Lifecycle Investing - Still the Right Strategy

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vineviz
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Re: Lifecycle Investing - Still the Right Strategy

Post by vineviz » Sat Mar 14, 2020 11:26 am

vineviz wrote:
Sat Mar 14, 2020 11:06 am
The level of leverage typically decreases pretty quickly, dropping considerably in the first 5-10 years. In these examples, Ayres & Nalebuff's approach results in a MORE conservative asset allocation than Vanguard after age 40 which is an effect of the superior risk-smoothing.
Just to illustrate it, here is the equity exposure expressed in dollars for two strategies (Lifecycle vs Vanguard Target Retirement) where I set the RRA such that the two strategies produced approximately the same portfolio value at age 66. In other words both investors contributed the same amount of money over their lifetimes, experienced the same market returns, and ended up with the same final value at the end.

The blue line (lifecycle investor) is significantly flatter than the red line, highlighting the fact that lifecycle investing is designed to emphasis a relative constant dollar exposure to risk over time rather than (in a more traditional glide path) a relatively constant percentage allocation of capital.

Image

If nothing else, this is a systematic application of the Boglehead mantra "once you've won the game, stop playing". The primary advantage is that it ensures you figure out whether you've "lost" early enough in life to do something about it.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Lifecycle Investing - Still the Right Strategy

Post by bobcat2 » Sat Mar 14, 2020 12:37 pm

Hi LadyGeek,
You wrote the following.
I am very confused. Can someone explain the difference between "lifecycle investing" as discussed here and Life-cycle finance as discussed in the wiki?

If they have nothing to do with each other, that's fine. I'm just having some difficulties to understand what is being spread over the investor's timeline.
Life-cycle finance or life-cycle economics as described in the Wiki is the general case. Life-cycle investing as discussed here is an extreme case of the general life-cycle approach that applies prudently to only a very small minority of households.

In general, from the life-cycle economics POV you should hold a large proportion of stocks in your portfolio when you are young and a much smaller proportion of stocks in your portfolio near retirement and in retirement. This is not because, as many believe, that stocks somehow become safe in the long-run as long as you remain faithful to your stock portfolio and don’t panic during a bear market. It is instead because when you are young, you are holding a great deal of safe human capital for retirement in the form of dedicated future contributions to your retirement accounts, which includes contributions to Social Security. In many cases your employer is also holding safe assets associated with your human capital targeted for retirement in terms of DB pension benefits, Social Security benefits, and matches to your DC retirement saving plan. As you age and approach retirement you hold little human capital targeted for retirement and therefore you reduce the proportion of equity in your portfolio significantly. By modifying the percentage of stocks in your investment portfolio this way over time you keep the percentage of equities relative to total resources devoted to retirement reasonably smooth throughout your life-cycle.

All of life-cycle economics agrees with the above. Where what is discussed in this thread, the Ayres & Nalebuff (A&N) approach, and life-cycle economics in general disagree is how much stock should be held in your portfolio when you are young. Mainstream life-cycle economics would say no more than about 90% of your portfolio should be held in stocks when you are young except for a very small minority of households – not a leveraged percentage somewhere above 100% to as high as 200%.

So why shouldn’t most, or at least a significant percentage, of young households hold a portfolio of well over 100% stocks.

Here are some of the reasons Ayres and Nalebuff themselves give for not holding a leveraged stock position when you are relatively young. According to A&N leverage is not appropriate for the following households.

- Leverage is not appropriate if you hold any credit card debt.
- Leverage is not appropriate if you have any student loan debt.

Also according to A&N
- Leverage should take a back seat if you have a company match in your 401k. Always fund your 401k up to the match first, only apply leverage to your additional retirement savings in an IRA.
A&N have other rules for when not to apply leverage, but the above are the big three, and the first two probably knock out a majority of young investors and for many of those remaining, the third reason greatly reduces the amount of leverage they can apply. (Few DC retirement saving plans allow leveraged investments.)

Here are additional reasons for not leveraging your portfolio.
- You use payday loans or finance your car by using a buy-here pay-here loan. This knocks out the crowd that doesn’t have student loan debt and can’t get credit cards, which is not an insignificant portion of young people.
- You don’t know a great deal about finance and investing. This is not a strategy for the casual Boglehead who just happened to come across this thread.
- You are not willing to pay a great deal of attention to your portfolio. This strategy requires maintenance over time. You can’t set it and forget it over significant periods of time.
- You know a lot about finance but your job is in some area of finance and thus your job security is directly affected by the performance of the capital markets.
- Your employment, regardless of the field, is not very stable should a recession hit. Severe bear markets in equities are almost always associated with recessions and you do not want to be taking withdrawals from a rapidly dwindling leveraged portfolio to support your unemployed self.
- You are of average or greater risk aversion. This applies particularly to those whose jobs are stable and safe and could employ this strategy. Many people who choose safe professions are not big risk takers.

As should be apparent, the above reasons for why you shouldn’t leverage your portfolio don’t leave room for more than a very small percentage of young people to prudently pursue this particular life-cycle strategy. This strategy does, however, open the door for a lot of young people to imprudently invest for retirement.

One thing that appears to separate this view of life-cycle investing from the general view is that the general view is typically cast in a goal based investing framework that involves a liability driven investment strategy as you near retirement. So roughly 15 years from your planned retirement year you set a desired and reasonable retirement spending goal and calculate the annual income required to support that level of consumption. You then set your portfolio strategy to meet that income goal by taking minimum risk (highest probability) of meeting that income goal. This is done by foregoing exceeding the goal in return for minimizing the probability of falling significantly short of the goal. Perhaps the A&N acolytes at Bogleheads do this, but I don’t see them writing much about it.

Another thing that seems to separate general life-cycle economics (LCE) from the A&N approach is the LCE approach explicitly takes into account all your financial resources which includes insuring, housing, DB pension, SS benefits, lifetime annuities, and borrowing decisions, particularly about your home equity both before and during retirement. It also takes into account how you should vary your saving percentage over time and how many years you need to work to meet your retirement goals. The A&N discussions here touch on these issues only in passing. They seem instead to be tightly focused on portfolio returns and mention these other issues lightly or not at all.

A lot of the discussion about this approach focuses on the work of Robert Merton in life-cycle economics. Here is a short article from a few years ago where Merton discusses how life-cycle economics should be applied to retirement planning for most people. The A&N approach is at best a distant cousin to Merton’s approach. Both approaches are life-cycle investing. Merton’s approach applies to most people. A&N’s approach applies to a small elite minority.

Link to Merton article. Click on "Applying life-cycle economics - NEST Pensions" at the top of the Google search page to go to the article.

https://www.google.com/search?source=hp ... CAc&uact=5

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

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Re: Lifecycle Investing - Still the Right Strategy

Post by vineviz » Sat Mar 14, 2020 1:34 pm

bobcat2 wrote:
Sat Mar 14, 2020 12:37 pm
Life-cycle finance or life-cycle economics as described in the Wiki is the general case. Life-cycle investing as discussed here is an extreme case of the general life-cycle approach that applies prudently to only a very small minority of households.
What Ayres & Nalebuff describe is a SPECIFIC application of lifecycle economics to retirement investing. One person might view it as "extreme" while others view it as entirely reasonable. YMMV.
bobcat2 wrote:
Sat Mar 14, 2020 12:37 pm
All of life-cycle economics agrees with the above. Where what is discussed in this thread, the Ayres & Nalebuff (A&N) approach, and life-cycle economics in general disagree is how much stock should be held in your portfolio when you are young. Mainstream life-cycle economics would say no more than about 90% of your portfolio should be held in stocks when you are young except for a very small minority of households – not a leveraged percentage somewhere above 100% to as high as 200%.
The conventional behavior of capping target retirement funds at a 90% equity allocation does not flow from any economic theory: it's entirely an accident of regulatory history based on rules from the Department of Labor.
bobcat2 wrote:
Sat Mar 14, 2020 12:37 pm
So why shouldn’t most, or at least a significant percentage, of young households hold a portfolio of well over 100% stocks.

Here are some of the reasons Ayres and Nalebuff themselves give for not holding a leveraged stock position when you are relatively young. According to A&N leverage is not appropriate for the following households.

- Leverage is not appropriate if you hold any credit card debt.
- Leverage is not appropriate if you have any student loan debt.

Those are also good reasons to avoid investing AT ALL in stocks. Investing in financial assets while holding loans or owing debt of ANY type is a form of leverage, regardless of whether the equity allocation in your investment portfolio is 90% stocks or 110% stocks. It's a matter of degree, not a substantive difference in approach or philosophy.

bobcat2 wrote:
Sat Mar 14, 2020 12:37 pm
As should be apparent, the above reasons for why you shouldn’t leverage your portfolio don’t leave room for more than a very small percentage of young people to prudently pursue this particular life-cycle strategy. This strategy does, however, open the door for a lot of young people to imprudently invest for retirement.
The Ayres & Nalebuff methodology allows for plenty of room for accommodating various levels of uncertainty and/or differences around things like risk aversion, future earnings, etc. Someone with very high risk aversion who follows their approach is not going to end up with a recommendation to use much leverage, if any, and never for very long.

I don't know what percentage of young investors should be using Ayres & Nalebuff's methodology but I suspect, as you do, that it is not a majority. Nonetheless, compared to much-less-defensible heuristics like "age in bonds" their methodology is virtually guaranteed to present a more appropriate glide path.

Even if an "average" investor decided to avoid leverage altogether, at ages 35-40 lifecycle investing would recommended an equity allocation of 95%-100% which is FAR more sensible than the 60% that the "age in bonds" advice would suggest.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Lifecycle Investing - Still the Right Strategy

Post by Silence Dogood » Sat Mar 14, 2020 2:16 pm

305pelusa wrote:
Fri Mar 13, 2020 11:02 pm
So it can really boil down to the target retirement fund. This has better temporal diversification than just contributing to a fixed allocated fund. But one can do even better by "breaking the ceiling" and going more aggressive at the start (say 200%) and more conservative at the end (say 20%).
Personally, I think I prefer to keep the ceiling intact, lest a storm comes through and damages the floor.

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Re: Lifecycle Investing - Still the Right Strategy

Post by Steve Reading » Sat Mar 14, 2020 2:47 pm

Silence Dogood wrote:
Sat Mar 14, 2020 2:16 pm
305pelusa wrote:
Fri Mar 13, 2020 11:02 pm
So it can really boil down to the target retirement fund. This has better temporal diversification than just contributing to a fixed allocated fund. But one can do even better by "breaking the ceiling" and going more aggressive at the start (say 200%) and more conservative at the end (say 20%).
Personally, I think I prefer to keep the ceiling intact, lest a storm comes through and damages the floor.
There are retirees right here on BHs with 60/40 and 50/50 allocations that have easily lost more than 3 times what I’ve lost so far. Maybe these retirees have no hole in their ceiling but they’re getting hit by Katrina and a magnitude 9 earthquake at the same time.

Smooth out your risk over time. Don’t just take it all at once.

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Re: Lifecycle Investing - Still the Right Strategy

Post by Lee_WSP » Sat Mar 14, 2020 3:04 pm

305pelusa wrote:
Sat Mar 14, 2020 2:47 pm
Silence Dogood wrote:
Sat Mar 14, 2020 2:16 pm
305pelusa wrote:
Fri Mar 13, 2020 11:02 pm
So it can really boil down to the target retirement fund. This has better temporal diversification than just contributing to a fixed allocated fund. But one can do even better by "breaking the ceiling" and going more aggressive at the start (say 200%) and more conservative at the end (say 20%).
Personally, I think I prefer to keep the ceiling intact, lest a storm comes through and damages the floor.
There are retirees right here on BHs with 60/40 and 50/50 allocations that have easily lost more than 3 times what I’ve lost so far. Maybe these retirees have no hole in their ceiling but they’re getting hit by Katrina and a magnitude 9 earthquake at the same time.

Smooth out your risk over time. Don’t just take it all at once.
True, even if I lost it all, in absolute terms, they lost more. They also have much more.

I still don't think borrowing is the way to equalize it though.

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Re: Lifecycle Investing - Still the Right Strategy

Post by Silence Dogood » Sat Mar 14, 2020 3:46 pm

305pelusa wrote:
Sat Mar 14, 2020 2:47 pm
Silence Dogood wrote:
Sat Mar 14, 2020 2:16 pm
305pelusa wrote:
Fri Mar 13, 2020 11:02 pm
So it can really boil down to the target retirement fund. This has better temporal diversification than just contributing to a fixed allocated fund. But one can do even better by "breaking the ceiling" and going more aggressive at the start (say 200%) and more conservative at the end (say 20%).
Personally, I think I prefer to keep the ceiling intact, lest a storm comes through and damages the floor.
There are retirees right here on BHs with 60/40 and 50/50 allocations that have easily lost more than 3 times what I’ve lost so far. Maybe these retirees have no hole in their ceiling but they’re getting hit by Katrina and a magnitude 9 earthquake at the same time.

Smooth out your risk over time. Don’t just take it all at once.
To be clear, I am invested in Vanguard Target Retirement 2055.

My stock exposure will be reduced as I age.

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Re: Lifecycle Investing - Still the Right Strategy

Post by YearTrader » Sat Mar 14, 2020 3:47 pm

vineviz wrote:
Fri Mar 13, 2020 7:21 pm
YearTrader wrote:
Fri Mar 13, 2020 5:13 pm
I found it hard to estimate my future cash flow / human capital and risk tolerance / utility function. Also AFAIK I'd need to estimate the long term expected risk and return of asset classes in my investing universe.

How sensitive is this strategy to these input parameters? I think it's still a valid strategy as long as the overall variance of long term investment return can be reduced.
I think you'd be surprised at how easy it is get a reasonably good approximation of these things, especially using the downloadable spreadsheets on the Ayres and Nalebuff website: http://www.lifecycleinvesting.net/resources.html

The PV of your future retirement savings, for example, requires just one piece of data (your current income) and two assumptions (your future savings rate and a discount rate).
Thanks for the link, that's indeed pretty easy. So they used SSA's medium earner wage profile to estimate future earnings, which should be more reliable than I extrapolating the current earnings. Looks like the most unreliable estimation would be my Relative Risk Aversion.

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Re: Lifecycle Investing - Still the Right Strategy

Post by bobcat2 » Sat Mar 14, 2020 3:49 pm

Hi vineviz,

The conventional advice to hold no more than about 90% of your total financial assets flows from a young investor having access to some safe liquid funds in case they are needed for a significant contingency such as involuntary unemployment or unanticipated out of pocket health expenditures - not some arcane DOL rule about DC plans.

BTW I'm not saying this strategy is intended for less than half of young investors. I'm saying this leveraged strategy is applicable to less than 2% of all young investors. First of all you have to be more risk tolerant than most people. That knocks out most people. You need to know a lot about finance and investing. Just those two requirements eliminate about 90% of young people. You shouldn't have an unstable job that could likely be eliminated during a recession. No student loan debt and no credit card debt allowed. You need to be saving a lot more than your 401k match for there to be much leveraged savings in an account other than your 401k. Just who is left?

I don’t see anything unreasonable in a 40 year old holding 85% or so of her retirement assets in equities. But once she reaches age 45 the life-cycle approach will have the percentage devoted to stocks declining rapidly between then and age 65. Of course, the percentage of equities to total financial assets at age 40 will be less than 85% due to the need for some liquid safe assets to meet immediate spending contingencies outside of the retirement portfolio.

I agree that people should not be following ad hoc rules such as the 4% rule, save 15% of your income every year rule, and the age in bonds rule. Instead people should adhere to the life-cycle economics framework. But only a very small minority should be using the A&N leveraged life-cycle approach.

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

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Re: Lifecycle Investing - Still the Right Strategy

Post by YearTrader » Sat Mar 14, 2020 3:55 pm

Uncorrelated wrote:
Sat Mar 14, 2020 3:41 am
YearTrader wrote:
Fri Mar 13, 2020 5:13 pm
I found it hard to estimate my future cash flow / human capital and risk tolerance / utility function. Also AFAIK I'd need to estimate the long term expected risk and return of asset classes in my investing universe.

How sensitive is this strategy to these input parameters? I think it's still a valid strategy as long as the overall variance of long term investment return can be reduced.
It's true that lifecycle investing requires you to estimate all those parameters, but a constant asset allocation also requires an estimation of risk tolerance and long term expected risk and return. Maybe your estimated risk tolerance and return are widely inaccurate, but in that case there is no reason to assume that a constant asset allocation is any better, since it (implicitly) depends on the same estimates.

The real question is: is it possible to make a better estimate of future cash flow than $0? If the answer is yes, then lifecycle investing results in higher utility. If the answer is no, then both lifecycle investing and a constant asset allocation end up with the same asset allocation.

A constant asset allocation isn't model free, it implicitly assumes exactly $0 cash flow, a fixed risk tolerance (to be exact, a CRRA) and certain return assumptions.
Good point. Is there some normalization technique to reduce the impact of estimation errors (especially future cash flow, it's hard to predict long term sector trends)? Perhaps I can simply use a higher discount rate?

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Re: Lifecycle Investing - Still the Right Strategy

Post by Steve Reading » Sat Mar 14, 2020 4:15 pm

Silence Dogood wrote:
Sat Mar 14, 2020 3:46 pm
305pelusa wrote:
Sat Mar 14, 2020 2:47 pm
Silence Dogood wrote:
Sat Mar 14, 2020 2:16 pm
305pelusa wrote:
Fri Mar 13, 2020 11:02 pm
So it can really boil down to the target retirement fund. This has better temporal diversification than just contributing to a fixed allocated fund. But one can do even better by "breaking the ceiling" and going more aggressive at the start (say 200%) and more conservative at the end (say 20%).
Personally, I think I prefer to keep the ceiling intact, lest a storm comes through and damages the floor.
There are retirees right here on BHs with 60/40 and 50/50 allocations that have easily lost more than 3 times what I’ve lost so far. Maybe these retirees have no hole in their ceiling but they’re getting hit by Katrina and a magnitude 9 earthquake at the same time.

Smooth out your risk over time. Don’t just take it all at once.
To be clear, I am invested in Vanguard Target Retirement 2055.

My stock exposure will be reduced as I age.
The Vanguard TDF becomes 50/50 on the retirement year so everything I said applies identically to you.

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Re: Lifecycle Investing - Still the Right Strategy

Post by MoneyMarathon » Sat Mar 14, 2020 4:30 pm

langlands wrote:
Sat Mar 14, 2020 11:23 am
I think your bias against mathematics and applications of quantitative methods to finance is understandable, but unwarranted.
I like math. I majored in math. I use it at work.

The models proposed do not match my own life situation and make assumptions that aren't true.

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Re: Lifecycle Investing - Still the Right Strategy

Post by vineviz » Sat Mar 14, 2020 4:40 pm

MoneyMarathon wrote:
Sat Mar 14, 2020 4:30 pm
langlands wrote:
Sat Mar 14, 2020 11:23 am
I think your bias against mathematics and applications of quantitative methods to finance is understandable, but unwarranted.
I like math. I majored in math. I use it at work.

The models proposed do not match my own life situation and make assumptions that aren't true.
With all due respect, the "models proposed" do no such thing. The lifecycle model, if you want to call it that, allows you to tailor ALL of its assumptions so that they fit your "own life situation".
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Lifecycle Investing - Still the Right Strategy

Post by MoneyMarathon » Sat Mar 14, 2020 5:02 pm

vineviz wrote:
Sat Mar 14, 2020 4:40 pm
MoneyMarathon wrote:
Sat Mar 14, 2020 4:30 pm
The models proposed do not match my own life situation and make assumptions that aren't true.
With all due respect, the "models proposed" do no such thing. The lifecycle model, if you want to call it that, allows you to tailor ALL of its assumptions so that they fit your "own life situation".
I understand they do let you adjust things like CRRA (if you believe you have one) and the bond-like-ness of income.

As for not matching my own life situation, among other things:

I don't have constant relative risk aversion (CRRA). No single CRRA variable represents my utility correctly.

I may need withdrawals before retirement (maybe this is in the book somewhere? not in the article).

I associate negative utility with blowing out my account. I don't just get utility from spending.

I also associate negative utility with working longer. I don't have a set date for retirement, and they operate on a model of retirement at a certain age, so they're not optimizing for what I want.

I commented on the paper previously:
MoneyMarathon wrote:
Fri Feb 21, 2020 4:38 am
Just reread the Ayres-Nalebuff paper. Some comments on it.

#1 They arbitrarily choose a long initial phase (as much as a decade or two, depending on how early returns pan out) of constant x2 leverage, relative to current financial assets, because it is the number used by a regulation.

This isn't rigorous. If the regulation said 4:1, apparently they'd use 4:1. If it said 1.5:1, they'd use 1.5:1. It's more reasonable to suppose that there is some non-regulatory reason for a bound or strategy on leverage to apply in the earliest phase. After all these regulations came about after the 1929 crash (first in the Securities Act of 1933). A reasonable investor (perhaps with math not yet developed...) would have had a way of determining the best margin to use other than calling their broker or lawmaker and asking their opinion on a good maximum.

"We propose a maximum leverage of 2:1."
"For most of the analysis, we assume that the maximum leverage on stocks is 2:1, pursuant to the Federal Reserve Regulation T."

Because this choice of how to leverage in the first phase is arbitrary and because the results of the first phase affect final savings, they haven't shown rigorously that their model of savings is optimal. Perhaps it should be lower, perhaps it should be higher and they should have used a technique for obtaining higher leverage. There's still a lot of value in the paper, but it does suggest more work could be done.

#2 They assume that it's only profitable to leverage stocks (implicitly or explicitly, since they don't investigate anything else), not profitable to leverage government bonds or another asset. Indeed their final asset allocation in retirement is divided between stocks and a risk-free rate of return, like T-bills. Since their model includes only stocks, margin rates, and risk-free rates, there's room for tinkering with other assets.

"the cost of borrowing on margin exceeds the bond rate"

This is true of brokerage margin rates, but with the borrowing costs implicit to the leverage implicit in treasury features, it's not true for longer duration government bonds, due to the low spread above LIBOR for borrowing and going out on the long end of the yield curve for investment. Also, government bonds have a non-interest component of their returns (price returns), which can play a part in constructing a balanced portfolio of stocks and bonds, which (under Modern Portfolio Theory) can increase risk-adjusted returns (Sharpe) and thus can increase returns over leveraging just stocks (whereas the author's framework is just leveraging up stocks).

Perhaps this chart may be illustrative of other possibilities for applying leverage to increase early returns (both positive and negative - thus also achieving temporal diversification by increasing the early volatility and returns if leverage is dialed down later), other than just leveraging stock:

https://www.portfoliovisualizer.com/bac ... ion3_3=-20

#3 They don't actually implement Samuelson-Merton's constant allocation.

They attempt to implement it by going as close as they can before bumping up into the 2:1 limit on current net assets. As Uncorrelated correctly points out, apart from the costs of the implementation (which leads the paper's authors to consider alternatives), the initial portfolio recommended by the paper is exactly the same as putting all of one's current financial wealth into a 2x stock LETF, such as SSO (Ultra S&P500) or the older mutual fund ULPIX (ProFunds UltraBull). This is constant leverage, not varying leverage, until the first phase is over.

This thread's approach is different and appears to attempt to vary leverage somewhat during the first phase, primarily in response to market movements and implicitly by holding options because this eliminates the path dependence (over a short term period). This difference isn't relevant to the point because it's still not implementing Samuelson-Merton's constant fraction of (lifetime) wealth in stocks.

The problem is that Samuelson-Merton's allocation is impossible to achieve for a very young saver with most wealth in the form of future savings, so an alternative must be considered, and the paper somewhat facilely slides into its arbitrary phase 1 recommendation as the alternative, when there are others as well. So not only is the idea of using the maximum leverage to buy stocks arbitrary, it doesn't satisfy the theory that is claimed to justify it, because it doesn't do what the theory asks for (only getting 'closer').

#4 The Samuelson-Merton recommendation assumes that all your wealth is available to invest (in stocks/t-bills) or consume.

When that assumption is contradicted, it's already unclear that Samuelson-Merton is the right framework. Instead of jerry-rigging its conclusions into a new theoretical framework where the assumptions are invalid, it would make more sense to develop the author's own justification regarding the optimal investment in stocks that is actually consistent with their assumptions. That is, to introduce the addition of income over time, as well as the various liquidity and leverage constraints, and derive the optimal investment based on utility with that model.

It's not easy, but it would seem that the right approach is to do it from scratch under the actual assumptions.

I've tried to work it out a bit on scratch paper. In the limit, when the additional income is a positive constant and it is the infinite case, the solution for the fraction to invest approaches the Merton solution (which is the Kelly limit modified by a utility function with a constant relative risk aversion) where wealth is just the same thing as current wealth. This suggests that the interesting work is to solve it for finite cases, especially in the early stages when the additional contributions are a considerable fraction of the initial investment, or in the late stages when taking money out. I'm not sure if this is an unsolved problem, or if someone has worked it out. It will take me some time to continue working on it or look up what's been done.

#5 They effectively defend the "leveraged glide path" as an approach during accumulation, empirically.

This much, taking more risk in early years, does seem justified by the empirical studies. They are persuasive in arguing that the basic problem with the old "glide path" is that it has too low of an average allocation to risky assets like stocks, as well as too small of a difference between starting risk and ending risk, to be effective. They are also persuasive in showing that a "glide path" incorporating leverage can overcome those two problems, provide enough risk up front and enough risk differential to matter and to reduce overall retirement risk through "temporal diversification."

However, the effect size isn't necessarily very large, when comparing to alternatives that are similarly exposed to stocks. Also, they've limited the solution space to those solutions that dial down to being unleveraged in retirement. This does represent a blind spot. If a portfolio is leveraged in retirement, there may be less room to create a large difference with the initial risk taken through leverage. They may have mostly just recreated an effect they criticize -- being able to achieve temporal diversification by artificially limiting later returns (as they point out, retirement accounts that are all or vastly bonds have no trouble being temporally diversified to stocks without leverage) -- in the new solution space where leverage is allowed.

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Re: Lifecycle Investing - Still the Right Strategy

Post by vineviz » Sat Mar 14, 2020 5:05 pm

bobcat2 wrote:
Sat Mar 14, 2020 3:49 pm
The conventional advice to hold no more than about 90% of your total financial assets flows from a young investor having access to some safe liquid funds in case they are needed for a significant contingency such as involuntary unemployment or unanticipated out of pocket health expenditures - not some arcane DOL rule about DC plans.
Thanks for the reply, bobcat2.

It might not be clear that the lifecycle investing approach being discussed here is specifically geared towards saving and investing for retirement. As such, it is silent on things such as whether young people should have emergency funds . Of course I think they generally should have emergency reserves, and I suspect Ayres and Nalebuff would agree.

Rather, the lifecycle investing approach is meant to apply an intelligent framework that will guide investors about HOW to best manage their retirement savings. As I said earlier, I can quibble with some of the details on the implementation but the basic concept is entirely sound and consistent with basic economic principles.
bobcat2 wrote:
Sat Mar 14, 2020 3:49 pm
BTW I'm not saying this strategy is intended for less than half of young investors. I'm saying this leveraged strategy is applicable to less than 2% of all young investors. First of all you have to be more risk tolerant than most people. That knocks out most people. You need to know a lot about finance and investing. Just those two requirements eliminate about 90% of young people.
As mentioned earlier, suggested equity exposures greater than 100% are merely one possible outcome of the lifecycle investing model. The individual investor may or may not arrive at that result depending on their risk aversion, savings rate, etc. The approach itself is universally applicable. Now the challenge that you need to understand finance and investing to apply this are probably true, and I agree that most investors would be better served with a target date fund. But virtually anyone who can build a DIY three- or four-fund portfolio is likely capable to manage the simple math that Ayres and Nalebuff summon
bobcat2 wrote:
Sat Mar 14, 2020 3:49 pm
You shouldn't have an unstable job that could likely be eliminated during a recession. No student loan debt and no credit card debt allowed. You need to be saving a lot more than your 401k match for there to be much leveraged savings in an account other than your 401k.
Job stability should factor into both your emergency reserves and also, within the model, into the human capital calculations. Not an intractable problem in the least.

Likewise, account constraints are also easily accomodated. An investor who is ONLY investing within a 401k, for instance, simply applies a 1:1 limit to the leverage instead of the 1.5:1 or 2:l limit proposed in the book. Such constraints are easily adapted within the framework that Ayres and Nalebuff lay out. Obviously it limits the temporal diversification, but it's a modification that is easy to implement.
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Re: Lifecycle Investing - Still the Right Strategy

Post by vineviz » Sat Mar 14, 2020 5:13 pm

MoneyMarathon wrote:
Sat Mar 14, 2020 5:02 pm
As for not matching my own life situation, among other things:

I don't have constant relative risk aversion (CRRA). No single CRRA variable represents my utility correctly.
No need to assume a CRRA: the RRA can be adjusted every period, based on changed circumstances or differences in accumulated wealth.
MoneyMarathon wrote:
Sat Mar 14, 2020 5:02 pm
I may need withdrawals before retirement (maybe this is in the book somewhere? not in the article).
The more uncertainty you want to accommodate with regard to future cash flows the more complicated the calculations become, but it's entirely within the scope of the approach to handle this.
MoneyMarathon wrote:
Sat Mar 14, 2020 5:02 pm
I associate negative utility with blowing out my account. I don't just get utility from spending.
This approach is specifically designed to reduced the probability of "blowing out" your account while increasing the probability that you'll have assets to spend when you want.
MoneyMarathon wrote:
Sat Mar 14, 2020 5:02 pm
I also associate negative utility with working longer. I don't have a set date for retirement, and they operate on a model of retirement at a certain age, so they're not optimizing for what I want.
Again, the assumption of a "fixed" retirement age generally simplifies the calculations but it's not a requirement: there's plenty of room in the model to optimize for a variable retirement age or some sort of optionality along those lines.

If you want to complicate it you certainly can, but that doesn't obviate the fundamental validity of the approach.
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Re: Lifecycle Investing - Still the Right Strategy

Post by TheoLeo » Sat Mar 14, 2020 5:17 pm

In regards to the points that disqualify young investors from following this strategy (debt, unstable job, lacking financial knowledge and experience), what are your opinions on renting? Renting to me is like carrying a debt of 200 to maybe 500 000 $ with 4 % interest around.

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Re: Lifecycle Investing - Still the Right Strategy

Post by Uncorrelated » Sat Mar 14, 2020 5:28 pm

YearTrader wrote:
Sat Mar 14, 2020 3:55 pm
Uncorrelated wrote:
Sat Mar 14, 2020 3:41 am
YearTrader wrote:
Fri Mar 13, 2020 5:13 pm
I found it hard to estimate my future cash flow / human capital and risk tolerance / utility function. Also AFAIK I'd need to estimate the long term expected risk and return of asset classes in my investing universe.

How sensitive is this strategy to these input parameters? I think it's still a valid strategy as long as the overall variance of long term investment return can be reduced.
It's true that lifecycle investing requires you to estimate all those parameters, but a constant asset allocation also requires an estimation of risk tolerance and long term expected risk and return. Maybe your estimated risk tolerance and return are widely inaccurate, but in that case there is no reason to assume that a constant asset allocation is any better, since it (implicitly) depends on the same estimates.

The real question is: is it possible to make a better estimate of future cash flow than $0? If the answer is yes, then lifecycle investing results in higher utility. If the answer is no, then both lifecycle investing and a constant asset allocation end up with the same asset allocation.

A constant asset allocation isn't model free, it implicitly assumes exactly $0 cash flow, a fixed risk tolerance (to be exact, a CRRA) and certain return assumptions.
Good point. Is there some normalization technique to reduce the impact of estimation errors (especially future cash flow, it's hard to predict long term sector trends)? Perhaps I can simply use a higher discount rate?
I don't know. I suppose it would be possible to change the model to take a probability distribution of cash flows, instead of fixed cash flows. That looks complicated.

The simplest solution would be to keep the discount rate as-is, but lowball the cashflows.

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Re: Lifecycle Investing - Still the Right Strategy

Post by Steve Reading » Sat Mar 14, 2020 5:35 pm

TheoLeo wrote:
Sat Mar 14, 2020 5:17 pm
In regards to the points that disqualify young investors from following this trategy (debt, unstable job, lacking financial knowledge and experience), what are your opinions on renting? Renting to me is like carrying a debt of 200 to maybe 500 000 $ with 4 % interest around.
I'll give my intuition in the matter and maybe others will comment with more technically correct nomenclature. Renting, just like food, clothing, trips, etc can be counted as consumption. Sure, think of it as a negative bond (or a debt). But you also have your job. And hopefully your income more than offsets this "debt" (i.e. you're not just consuming but you're also saving). It is on this additional leftover income (future savings contributions) that you apply temporal diversification to.

@bobcat2 and vineviz: Deja-vu?
viewtopic.php?p=4426190#p4426190
vineviz wrote:
Sat Mar 09, 2019 1:25 pm
bobcat2 wrote:
Sat Mar 09, 2019 1:03 pm
But adding leverage is suitable for only a tiny subset of all young investors. Here are the contraindications against using the leverage strategy that A&N list in their book. They state that you should not try their strategy if ANY of these situations apply to you:

* You have credit card debt.
* You have student loan debt
* You have less than $4,000 to invest.
* Your employer matches contributions to a 401k plan.
* You need the money to pay for your kids' college education.
* Your salary is correlated with the stock market.
* You would worry too much about losing money. (You are not extremely risk tolerant.)

To the above contraindications A&N list I would add:
* You need to be very knowledgeable about investing.
* You need to have a very stable job. (Very low probability of being involuntarily laid off.)
Some of those caveats are overly broad and most of the rest apply to ANY form of investing, leveraged or otherwise.

Furthermore, growth in ETF and fintech markets since they wrote their book has made it easier, cheaper, and safer to construct a modestly leveraged portfolio than it was just five years ago.

There certainly are simpler ways to invest, many of which might be more-than-good-enough, but that doesn't obviate the benefits of taking a lifecycle approach to investing.

It's funny how repetitive these topics become.

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Re: Lifecycle Investing - Still the Right Strategy

Post by Ben Mathew » Sat Mar 14, 2020 8:42 pm

LadyGeek wrote:
Fri Mar 13, 2020 7:55 pm
I am very confused. Can someone explain the difference between "lifecycle investing" as discussed here and Life-cycle finance as discussed in the wiki?

If they have nothing to do with each other, that's fine. I'm just having some difficulties to understand what is being spread over the investor's timeline.
Both are referring to the same underlying type of model. Generally speaking, lifecycle models try to solve the following problem:
  • Maximize utility of the consumption sequence (c0, c1,...),
    subject to the constraint that the value of the consumption sequence (c0, c1,...) does not exceed the value of the income stream (i1, i2,...)
This is the standard model of saving, investing and consuming in economics.

The case without risk is easy to solve, and the solution is easy to understand. Because of decreasing marginal utility of consumption in each period, you try to spread consumption out over time. For example, many people have incomes that are low towards the beginning (during education and start of career) and towards the end (after retirement), and are high in the middle (peak career). They can move consumption into the early years by borrowing, and into the later years by saving. (This is what the main graph early in the wiki shows.) You don't want to drop too low in any period because the utility from the first dollar is more than the utility from the second dollar. The ability to borrow and save in financial markets enable us to decouple consumption from income in any given period.

The case with risk is harder to solve. Consumption and income streams are now random variables. But the basic shape of the results are easy enough to understand. Just as you spread consumption across time, you will now also want to spread consumption across different states at a given time -- i.e. you don't want to be too badly off in any circumstance. So you will give up a lot of $ in good states to buy a little bit of $ in bad states. Buying insurance, holding bonds, etc. are examples of trying to do this. Also--and this is the part that Ayres Nalebuff emphasize--you will want to spread your risk exposure over time. If you are planning on funding consumption at time t with some combination of stocks and bonds, it would be best to keep the stock exposure somewhat even over all periods up to t. For example, going all stocks one period and then all bonds the next is clearly suboptimal. Keeping stock exposure relatively even across time will result in lower volatility. That would mean borrowing in the early years to gain the necessary stock exposure. The key here is that, just as in the case without risk, the decision of how much to consume, save, and invest is being decided on the basis of lifetime stream of income. That's the lifecycle perspective. You are simply recognizing today that you will have income and consumption needs over a lifetime. So you try to spread consumption into periods and states that you don't have income by saving, borrowing, asset allocation, and insurance. It's as simple as that.

Though it may seem like some sort of a niche strategy, the lifecycle model is the basic bread and butter model of consumption, saving, and investment in economics. You see it in undergraduate macroeconomics all the way through a Ph.D. It's THE model. It's a very general model. You can make various assumptions and extend it in endless ways, depending on what you think is important. Different assumptions about utility, income risk, borrowing constraints, etc. will all result in different results. For example, assuming CRRA utility will give a constant percentage of lifetime wealth allocated to stocks. But if you have a utility where you cannot tolerate consumption below a floor (and will give up large gains to achieve that floor), then the optimal solution will involve a bond ladder to fund essential consumption that you will never dip into no matter how much you gain or lose in the stock market. Different utilites, different result.

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Re: Lifecycle Investing - Still the Right Strategy

Post by LadyGeek » Sat Mar 14, 2020 9:00 pm

Ben Mathew wrote:
Sat Mar 14, 2020 8:42 pm
It's as simple as that.
Thanks! I didn't know the lifecycle model is an important model in economics.

Between your and bobcat2's posts, I think I've got it.
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Re: Lifecycle Investing - Still the Right Strategy

Post by MoneyMarathon » Sat Mar 14, 2020 9:03 pm

vineviz wrote:
Sat Mar 14, 2020 5:13 pm
MoneyMarathon wrote:
Sat Mar 14, 2020 5:02 pm
As for not matching my own life situation, among other things:

I don't have constant relative risk aversion (CRRA). No single CRRA variable represents my utility correctly.
No need to assume a CRRA: the RRA can be adjusted every period, based on changed circumstances or differences in accumulated wealth.
MoneyMarathon wrote:
Sat Mar 14, 2020 5:02 pm
I may need withdrawals before retirement (maybe this is in the book somewhere? not in the article).
The more uncertainty you want to accommodate with regard to future cash flows the more complicated the calculations become, but it's entirely within the scope of the approach to handle this.
MoneyMarathon wrote:
Sat Mar 14, 2020 5:02 pm
I associate negative utility with blowing out my account. I don't just get utility from spending.
This approach is specifically designed to reduced the probability of "blowing out" your account while increasing the probability that you'll have assets to spend when you want.
MoneyMarathon wrote:
Sat Mar 14, 2020 5:02 pm
I also associate negative utility with working longer. I don't have a set date for retirement, and they operate on a model of retirement at a certain age, so they're not optimizing for what I want.
Again, the assumption of a "fixed" retirement age generally simplifies the calculations but it's not a requirement: there's plenty of room in the model to optimize for a variable retirement age or some sort of optionality along those lines.

If you want to complicate it you certainly can, but that doesn't obviate the fundamental validity of the approach.
I think we're on the same page, then. My point really is exactly that "the calculations" are "more complicated." I am interested in making those more accurate calculations. I'm skeptical of some of the conclusions that might be made when they would be based on inaccurate assumptions - the "simpler" calculation. I don't actually dispute the "fundamental validity of the approach" but that "fundamental validity" isn't specific enough to make a decision based on it. It only means that it should be investigated further to see how that "approach" might validly be applied in my situation.

It's not entirely inaccurate just to call it an extension of the "glide path" idea, removing the constraint on leverage.

Still, the devil is in the details. It always is.
Last edited by MoneyMarathon on Sat Mar 14, 2020 9:05 pm, edited 1 time in total.

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Re: Lifecycle Investing - Still the Right Strategy

Post by bobcat2 » Sat Mar 14, 2020 9:04 pm

Ayres and Nalebuff have added nothing to life-cycle investing except for their emphasis on leveraged investing.

For at least the last 40 years financial economists have approached personal investing from the life-cycle investing POV. Most financial advisors and investment enthusiasts approach personal investing loosely from the mean/variance approach to investing that was developed by financial economists in the 1950s & 1960s. Many decades ago in financial economics that approach was superseded by the life-cycle approach, which treats the earlier mean/variance approach as a relatively unrealistic special case of the life-cycle approach to personal investing.

While there is a lot of overlap there are also some significant differences between the two investment approaches. Life-cycle investing is much more goal focused than the older method. Take retirement planning goals. In the conventional approach the goal is to maximize expected financial wealth in your targeted retirement year, given how much you are willing to save, and how much investment risk you can tolerate. From the life-cycle point of view the overall goal of retirement planning is to have roughly the same standard of living in retirement as before retirement. Therefore the retirement financial goal is to have reliable retirement income that sustains your standard of living. The way the income goal is usually framed is by pricing annuities that supply the retirement income target and not by applying arbitrary rules like 4% of financial assets at retirement converted to income every year. A stress is put on having two income goals. One is the aspirational income goal and the other is a lower floor income goal that is constructed entirely from relatively safe assets such as SS, DB pensions, life annuities, and TIPS & I-bonds.

Another key difference is how risk is managed, which is implicitly alluded to in the above aspirational and safe income goals. In the older conventional framework investment risk is almost entirely managed thru diversification. In the life-cycle approach all three risk transfer methods (hedging, insuring, and diversifying) are used without particular stress on diversifying. In other words the life-cycle approach relies explicitly on both matching strategies and the conventional diversification strategy in managing investment risk. Additionally, in the conventional framework risk is hardly ever approached thru a state price approach, but the state price approach to risk is often used in life-cycle finance.

Quantitative analysis also has a different emphasis.Go to a conventional financial advisor and he will often talk about Monte Carlo simulations of the portfolio. Go to an advisor steeped in the life-cycle approach and she will analyze the problem, at least informally, thru the lens of dynamic programming.

Nationally there are perhaps only two dozen financial planners that follow the life-cycle approach rather than the conventional approach based on the older MPT paradigm. Probably the best known of these planners is Paula Hogan, who is based in Milwaukee. Paula has written several articles on the differences between the conventional MPT approach and the life-cycle approach. Her articles are very accessible to lay readers, which is something that can't be said of many of the papers by economists written on life-cycle household economics. :)

Here is a link to some of Paula's articles that discuss these two approaches to personal finance and highlight the differences.
Link - https://paulahogan.com/

Life-Cycle Investing is Rolling Our Way

Human Capital and the Theory of Life-Cycle Investing

For Long-Term Investors The Focus Should Be on Risk co-authored with Zvi Bodie

Here are articles by three prominent economists on the life-cycle approach which are accessible to investment enthusiasts.

The first is from Robert Merton, one of the fathers of life-cycle economics, writing in the Financial Analysts Journal
Thoughts on the Future: Theory and Practice in Investment Management
link - https://www.math.nyu.edu/faculty/avellane/merton2.pdf

The second is by Larry Kotlikoff writing in the Journal of Financial Planning
Economics' Approach to Financial Planning - link https://kotlikoff.net/wp-content/upload ... 3-2008.pdf

The third is Zvi Bodie's paper from 2002, Life-Cycle Finance in Theory and in Practice.
Abstract:
This paper draws upon the modern science of finance to address several important practical issues in personal finance. Chief among these is how much to save for retirement and how to invest those savings. The paper suggests ways that advances in the theory of finance combined with innovations in financial contracting technology might be used to improve social welfare by designing and producing a new generation of user-friendly life-cycle products for consumers. It contrasts the old Markowitz single-period paradigm of efficient diversification with a new Mertonian paradigm that takes account of multi-period hedging, labor supply flexibility, and habit formation.
Download link - https://papers.ssrn.com/sol3/papers.cfm ... _id=313619

In addition there is Bodie's short companion piece to the above article, A Note on Economic Principles and Financial Literacy.
Abstract:
Finance is a branch of economics that deals with budgeting, saving, investing, borrowing, lending, insuring, diversifying, and matching. In setting standards of financial literacy we ought to make sure they are consistent with the basic principles taught in economics courses.
Download link - https://papers.ssrn.com/sol3/papers.cfm ... _id=923561

Here is a list of books and papers on life-cycle economics that in general is a little more advanced than the above list, but for the most part fairly accessible to the interested general reader. I have tried to identify which is the easier and which is the more difficult material.

The following books on life-cycle economics are accessible to the interested general reader. I believe they are all available at Amazon.

Financial Economics - Merton et al. (or its first and cheaper edition) Finance - Merton et al.
Pensionize Your Nest Egg - Milevsky et al.
Risk Less and Prosper - Bodie et al.
Personal Life-Cycle Economics – Aaron Stevens
Spend til the End - Kotlikoff et al.
Strategic Financial Planning over the Lifecycle - Charupat et al.
Worry-Free Investing - Bodie et al.
Retirement Portfolios – Michael Zwecher
Theory of the Consumption Function – Milton Friedman
Understanding Consumption - Angus Deaton

The two books on the top of my list would be the undergrad textbooks –
Financial Economics - Merton et al. (or its first and cheaper edition) Finance - Merton et al.
Personal Life-Cycle Economics – Aaron Stevens
OTOH I think the two books by Bodie are the easiest to get the general idea of applying life-cycle economics to your own life.

Here are some accessible papers and articles on life-cycle economics of the household.
The Future of Life-Cycle Saving and Investing Conference – 2006 papers
https://www.cfainstitute.org/-/media/do ... 5-pdf.ashx

The Future of Life-Cycle Saving and Investing Conference – 2008 papers
https://www.cfainstitute.org/-/media/do ... 009n4.ashx

The Future of Life-Cycle Saving and Investing Conference – 2011 papers
https://www.cfainstitute.org/-/media/do ... l-pdf.ashx

Investment in Human Capital: A Theoretical Analysis - Gary Becker
http://www-vip.sonoma.edu/users/c/cuell ... apital.pdf

Interpreting the Evidence of Life Cycle Skill Formation - Heckman et al
http://economics.uwo.ca/people/lochner_ ... idence.pdf

In 1985 Franco Modigliani won the Nobel Prize in Economics primarily for his pioneering work on the life-cycle hypothesis. In many ways he is the father of life-cycle economics. Here is his Nobel lecture on the life-cycle hypotheses.
http://www.nobelprize.org/nobel_prizes/ ... cture.html

Here is the original paper on the life-cycle hypothesis written by Modigliani and Richard Brumberg in 1953 and published in 1954. It is titled, UTILITY ANALYSIS AND THE CONSUMPTION FUNCTION: AN INTERPRETATION OF CROSS-SECTION DATA and is the first paper in Volume 6 of Franco Modigliani's Collected Papers. The following link takes you to a pdf form of Volume 6.
http://www.arabictrader.com/arabictrade ... B7AC83.pdf

Here is a paper by Nobelist Angus Deaton on the enduring importance of Modigliani’s life-cycle hypothesis.
https://www.princeton.edu/~deaton/downl ... ecture.pdf

The Life-Cycle Model of Consumption and Saving - Browning et al
https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.15.3.3

The theory of life-cycle economics in its modern state began with companion papers by Paul Samuelson and his student Robert Merton in 1969. These papers brought rigorous dynamics into Modigliani’s life-cycle hypothesis. Samuelson’s paper dealt with the discrete time case using stochastic dynamic programming. Merton dealt with the more difficult case of continuous time using optimal control methods to deal with continuous stochastic variation. These early papers used advanced math techniques and later research relies on math that is more advanced than these methods. While the math to prove these things is difficult, the underlying ideas are fairly intuitive. What makes this difficult is the dynamic nature of these problems. The decisions I make this year affect this year’s outcome and next year’s decisions, and next year’s outcome. This continues to play out this way for every year of my life from now until when I die.

Lifetime Portfolio Selection by Dynamic Stochastic Programming - Paul Samuelson (1969)
https://www.jstor.org/stable/1926559?re ... b_contents

Lifetime Portfolio Selection Under Uncertainty: The Continuous Time Case – Robert Merton (1969)
https://www.jstor.org/stable/1926560?Se ... b_contents

There have been many papers since these 1969 papers that have updated and refined the connection between human capital and the life-cycle model. In particular the best known and most influential of those papers, "Labor Supply Flexibility and Portfolio Choice in a Life-Cycle Model", by Bodie, Merton, and William Samuelson (Paul's son) written in 1992.
https://papers.ssrn.com/sol3/papers.cfm ... _id=420291

The economic literature on household life-cycle economics over the last 40 years is voluminous, but the above is a good start. :happy
Life-Cycle Economics is pretty central to the modern economics of the household and the consumer. Seven Nobel prize winners are on the above list of authors. In every case their work on life-cycle economics was a core portion of their research.

BobK

Edited to fix some of the links.
Last edited by bobcat2 on Sun Mar 15, 2020 3:15 pm, edited 3 times in total.
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Re: Lifecycle Investing - Still the Right Strategy

Post by vineviz » Sat Mar 14, 2020 9:11 pm

MoneyMarathon wrote:
Sat Mar 14, 2020 9:03 pm
It's not entirely inaccurate just to call it an extension of the "glide path" idea, removing the constraint on leverage.
Probably more accurate to call the "glide path" idea an extension of lifecycle investing, since the former is just an output of the latter.
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Re: Lifecycle Investing - Still the Right Strategy

Post by MoneyMarathon » Sat Mar 14, 2020 9:14 pm

vineviz wrote:
Sat Mar 14, 2020 9:11 pm
MoneyMarathon wrote:
Sat Mar 14, 2020 9:03 pm
It's not entirely inaccurate just to call it an extension of the "glide path" idea, removing the constraint on leverage.
Probably more accurate to call the "glide path" idea an extension of lifecycle investing, since the former is just an output of the latter.
In other words: lifecycle -> glide path -> the 2008 paper on leveraging when young.

Quoting bobcat2:
"Ayres and Nalebuff have added nothing to life-cycle investing except for their emphasis on leveraged investing."

For what it's worth, I apologize for the shorthand of referring to the 2008 paper as "lifecycle" (as we've previously discussed it on this forum), which is normally a term used for a bigger and older framework of ideas. The 2008 paper may be flawed, but considering consumption over one's lifetime is just too basic and flexible an idea to be impugned.

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Re: Lifecycle Investing - Still the Right Strategy

Post by bobcat2 » Sat Mar 14, 2020 9:59 pm

MoneyMarathon wrote:
Sat Mar 14, 2020 9:14 pm
Quoting bobcat2:
"Ayres and Nalebuff have added nothing to life-cycle investing except for their emphasis on leveraged investing."

For what it's worth, I apologize for the shorthand of referring to the 2008 paper as "lifecycle" (as we've previously discussed it on this forum), which is normally a term used for a bigger and older framework of ideas. The 2008 paper may be flawed, but considering consumption over one's lifetime is just too basic and flexible an idea to be impugned.
Of course it shouldn't be impugned, but it has nothing to do with A&N. That was discovered independently by Modigliani and Friedman back in the 1950s before Ayres and Nalebuff were born.

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Re: Lifecycle Investing - Still the Right Strategy

Post by MoneyMarathon » Sat Mar 14, 2020 10:00 pm

bobcat2 wrote:
Sat Mar 14, 2020 9:59 pm
MoneyMarathon wrote:
Sat Mar 14, 2020 9:14 pm
Quoting bobcat2:
"Ayres and Nalebuff have added nothing to life-cycle investing except for their emphasis on leveraged investing."

For what it's worth, I apologize for the shorthand of referring to the 2008 paper as "lifecycle" (as we've previously discussed it on this forum), which is normally a term used for a bigger and older framework of ideas. The 2008 paper may be flawed, but considering consumption over one's lifetime is just too basic and flexible an idea to be impugned.
Of course it shouldn't be impugned, but it has nothing to do with A&N. That was discovered independently by Modigliani and Friedman back in the 1950s before Ayres and Nalebuff were born.
It sounds like we're saying the same thing, Bob.

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Re: Lifecycle Investing - Still the Right Strategy

Post by marky2kk » Sat Mar 14, 2020 10:38 pm

Ben Mathew wrote:
Sat Mar 14, 2020 8:42 pm
LadyGeek wrote:
Fri Mar 13, 2020 7:55 pm
I am very confused. Can someone explain the difference between "lifecycle investing" as discussed here and Life-cycle finance as discussed in the wiki?

If they have nothing to do with each other, that's fine. I'm just having some difficulties to understand what is being spread over the investor's timeline.
Both are referring to the same underlying type of model. Generally speaking, lifecycle models try to solve the following problem:
  • Maximize utility of the consumption sequence (c0, c1,...),
    subject to the constraint that the value of the consumption sequence (c0, c1,...) does not exceed the value of the income stream (i1, i2,...)
This is the standard model of saving, investing and consuming in economics.

The case without risk is easy to solve, and the solution is easy to understand. Because of decreasing marginal utility of consumption in each period, you try to spread consumption out over time. For example, many people have incomes that are low towards the beginning (during education and start of career) and towards the end (after retirement), and are high in the middle (peak career). They can move consumption into the early years by borrowing, and into the later years by saving. (This is what the main graph early in the wiki shows.) You don't want to drop too low in any period because the utility from the first dollar is more than the utility from the second dollar. The ability to borrow and save in financial markets enable us to decouple consumption from income in any given period.

The case with risk is harder to solve. Consumption and income streams are now random variables. But the basic shape of the results are easy enough to understand. Just as you spread consumption across time, you will now also want to spread consumption across different states at a given time -- i.e. you don't want to be too badly off in any circumstance. So you will give up a lot of $ in good states to buy a little bit of $ in bad states. Buying insurance, holding bonds, etc. are examples of trying to do this. Also--and this is the part that Ayres Nalebuff emphasize--you will want to spread your risk exposure over time. If you are planning on funding consumption at time t with some combination of stocks and bonds, it would be best to keep the stock exposure somewhat even over all periods up to t. For example, going all stocks one period and then all bonds the next is clearly suboptimal. Keeping stock exposure relatively even across time will result in lower volatility. That would mean borrowing in the early years to gain the necessary stock exposure. The key here is that, just as in the case without risk, the decision of how much to consume, save, and invest is being decided on the basis of lifetime stream of income. That's the lifecycle perspective. You are simply recognizing today that you will have income and consumption needs over a lifetime. So you try to spread consumption into periods and states that you don't have income by saving, borrowing, asset allocation, and insurance. It's as simple as that.

Though it may seem like some sort of a niche strategy, the lifecycle model is the basic bread and butter model of consumption, saving, and investment in economics. You see it in undergraduate macroeconomics all the way through a Ph.D. It's THE model. It's a very general model. You can make various assumptions and extend it in endless ways, depending on what you think is important. Different assumptions about utility, income risk, borrowing constraints, etc. will all result in different results. For example, assuming CRRA utility will give a constant percentage of lifetime wealth allocated to stocks. But if you have a utility where you cannot tolerate consumption below a floor (and will give up large gains to achieve that floor), then the optimal solution will involve a bond ladder to fund essential consumption that you will never dip into no matter how much you gain or lose in the stock market. Different utilites, different result.
I agree and want to add that with CRRA utility you allocate a constant percentage of your total wealth in each period to equities. The key is that your total wealth includes the present value of your future income (=human capital), which essentially behaves much more like a risk-free bond paying interest in every period (=your labor income) than a stock. In early ears, your human capital is huge so you are basically endowed with large bond allocation. So, with whatever financial wealth you have go all-in in equities and may event want to lever up. Over time, your human capital declines, so your equity allocation decreases.

As a fraction of your financial wealth, excluding the non-tradable human capital (non-tradable because there is no slavery in our society) the allocation to equities over the life-cycle looks like http://faculty.london.edu/fgomes/cgm.pdf Figure 2, panel 3 in this paper. It's at 100% (there is a no-borrowing constraint, so levering up may actually give more utility) in early years and then it declines as of the age of 40.

Not saying that this is the way to invest for everybody, but it is a useful benchmark.

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Ben Mathew
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Re: Lifecycle Investing - Still the Right Strategy

Post by Ben Mathew » Sun Mar 15, 2020 9:51 am

Silence Dogood wrote:
Fri Mar 13, 2020 9:39 pm
Ben Mathew wrote:
Fri Mar 13, 2020 5:54 pm
I sometimes see comments that ask where are the "100% stocks" and "leveraged" posts when the market is down. I felt it's useful to let people know that the lifecycle strategy is an approach designed to work well through both the ups and the downs.
Specifically regarding leverage, wasn't that the strategy attempted by market timer?
Market timer deviated from Ayres & Nalebuff by not rebalancing with the drop. There is a chapter in Ayres Nalebuff on the difference between market timer and the strategy they recommend. But, even if he had rebalanced, he would have lost a ton of money. And that's fine. The point is that it was not a lot of money from a lifecycle perspective. It would have been worse if he had been 60 years old with a 50/50 allocation.

Nevertheless, it was psychologically excruciating for market timer as his thread shows. Which is why I think stopping at 100% stocks would be a good idea for most people.

Silence Dogood wrote:
Fri Mar 13, 2020 9:39 pm
Or are you advocating for something different?
Yes, I think stopping at 100% stocks and not going into leverage is something more people can handle psychologically. Also, it's less transaction costs and a lot less time, energy and attention needed. You don't need to check your balance in a drop, which is a wonderful thing. It's not mathematically optimal, but it's not too far off either.
Silence Dogood wrote:
Fri Mar 13, 2020 9:39 pm
Recently I read a post advocating for a fixed asset allocation for life. I find it interesting how different these two strategies are.
Yes. The fixed asset allocation would be optimal only if there are no future earnings. For most people, that would be true or nearly true when you get close to retirement, and all through retirement. Early in life, with a lot more savings on the way, most people should be a lot more aggressive. (If a young person inherits a lot of wealth early in life, substantial enough to dwarf their future savings, then a fixed allocation would be optimal.)

Lifecycle approach with CRRA utility would be a fixed allocation when you include expected future income in current wealth- you allocate a constant percentage of your wealth (including future labor income) to stocks.

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Re: Lifecycle Investing - Still the Right Strategy

Post by ChrisBenn » Sun Mar 15, 2020 10:15 am

Ben Mathew wrote:
Sun Mar 15, 2020 9:51 am
(...)
Yes, I think stopping at 100% stocks and not going into leverage is something more people can handle psychologically. Also, it's less transaction costs and a lot less time, energy and attention needed. You don't need to check your balance in a drop, which is a wonderful thing.
(...)
Wanted to note that the DITM leap call strategy is nice in that, unlike futures or selling the put for a full synthetic long, you have the property of not being on the hook for more than you put in (at the cost of higher implied financing rates).

In my mind that was key to managing the risk; if i'm fully invested with my "investable" income, and I don't have that optionality, then I feel like I'm gambling a bit on the market not dropping more than X, being able to get a personal loan to cover a margin call, etc.

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Re: Lifecycle Investing - Still the Right Strategy

Post by Steve Reading » Sun Mar 15, 2020 10:30 am

ChrisBenn wrote:
Sun Mar 15, 2020 10:15 am
Ben Mathew wrote:
Sun Mar 15, 2020 9:51 am
(...)
Yes, I think stopping at 100% stocks and not going into leverage is something more people can handle psychologically. Also, it's less transaction costs and a lot less time, energy and attention needed. You don't need to check your balance in a drop, which is a wonderful thing.
(...)
Wanted to note that the DITM leap call strategy is nice in that, unlike futures or selling the put for a full synthetic long, you have the property of not being on the hook for more than you put in (at the cost of higher implied financing rates).

In my mind that was key to managing the risk; if i'm fully invested with my "investable" income, and I don't have that optionality, then I feel like I'm gambling a bit on the market not dropping more than X, being able to get a personal loan to cover a margin call, etc.
An excellent point.

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Re: Lifecycle Investing - Still the Right Strategy

Post by Ciel » Sat May 02, 2020 9:01 pm

Does this strategy advocate that a young investor forego using his 401k (beyond employer match) in order to invest in taxable accounts to obtain the desired 2:1 leverage (or as close to that as possible)? Clearly, maxing out an IRA and using it for leverage would be important for such an investor if able. And some surely can afford to max out a 401k and still invest plenty in a leveraged taxable account.

But I'm struggling to see how this strategy would be implemented when the 401k is the primary vehicle for retirement investments. Would the recommendation be to contribute to 401k up to employer match, then max out IRA (and leverage it), then go back to 401k where leverage is not possible or to taxable account where leverage can be used? The latter doesn't seem prudent especially if one's income is taxed heavily and is higher than expected retirement income in the future.

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Re: Lifecycle Investing - Still the Right Strategy

Post by Ben Mathew » Sun May 03, 2020 11:03 am

Ciel wrote:
Sat May 02, 2020 9:01 pm
Does this strategy advocate that a young investor forego using his 401k (beyond employer match) in order to invest in taxable accounts to obtain the desired 2:1 leverage (or as close to that as possible)? Clearly, maxing out an IRA and using it for leverage would be important for such an investor if able. And some surely can afford to max out a 401k and still invest plenty in a leveraged taxable account.

But I'm struggling to see how this strategy would be implemented when the 401k is the primary vehicle for retirement investments. Would the recommendation be to contribute to 401k up to employer match, then max out IRA (and leverage it), then go back to 401k where leverage is not possible or to taxable account where leverage can be used? The latter doesn't seem prudent especially if one's income is taxed heavily and is higher than expected retirement income in the future.
I would not forgo 401k and other tax advantaged accounts to invest in taxable in order to access get leverage. You are giving up decades of tax free growth, as well as the opportunity to arbitrage marginal tax rates from high working years to low retirement years. I think 100% stocks in a tax advantaged account is close enough to optimal for most people. The low hanging fruit for young people is

- Don't pay off your mortgage early (I would still take a 15 year mortgage over a 30 year if the interest rate difference is large, as it is.)
- Don't hold bonds
- Don't have a large emergency fund. Have a flexible emergency strategy.

I suggest you do the math for your own personal situation and seeing how close you can get to optimal using tax advantaged accounts. Since all $ are discounted to present value, 100% of current savings might not be too far off from 50% of future savings.

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