it might sound counter-intuitive but the theory put forward by two Yale professors (Ayres & Nalebuff) in their book called Lifecycle Investing proposes a leveraged index investment strategy to improve the risk-return profile for long term index / ETF investors. In the following I will shortly outline the basics concerning this strategy and would like to infer if somebody has successfully applied this theory (or somewhat differently) in practice.
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Why should one use this strategy?
If you don't inherit a lot of money, when starting to invest, you most likely accumulate wealth at a somewhat exponential rate throughout your life. This means that your risk exposure is likely to be very tilted. In practice this means that in your early years (20–40) you have relatively little money invested compared to what you will likely have in your investment account when retiring (60+).
What is the goal?
Your goal is to control more of your target equity value early on. Basically you compute a certain dollar amount that you want to hold in equities at the moment of retiring (based on current savings and future income x savings rate). Let's say for me this is $500k but I am still very far from controlling such a large sum. To achieve this you use leverage in your early years (max 2:1) and deleverage over the years. Clearly, even with a 2:1 leverage ratio I still need several years until I can start decreasing the leverage to effectively control $500k.
Managing risk
We all know the concept of compounded interest, so gains in your early years affect you very positively later on. While you are exposed to more risk when using leverage you can effectively only loose a relatively small dollar amount compared to what you are likely to own in the long term (20+ years — less leverage then). Therefore, the authors point out that even with a very strong market correction in the early years of your investment career you are still able to catch up.
Leverage over time
2:1 Fully leveraged: Approximately first 13 working years
Partially leveraged (>2:1 leverage): Approximately 14 working years
No leverage: Last 17 working years
How to implement the theory effectively
Buy long term LEAP call options on a broad market index such as the S&P 500 with an expiration date of at least two years in the future. They need to be deep in the money (cost: approx. 50% of the underlying) to get a 2:1 leverage. Over time you would have to swap the options in order to still have approximately the 2:1 exposure.
Why this theory might fail in practice
This basically boils down to human psychology and the tendency to change strategy over the course of time. The authors show that this strategy has proven to either yield higher returns or a lower standard deviation if implemented as outlined. However, the average investor is unlikely to implement this theory so stringently over time (due to unforeseen circumstances etc.). Especially in the event of loosing all savings (in a crash such as COVID) most investors would probably go back to a simple buy & and hold strategy without leverage.
What am I doing with this knowledge
I read their book quite enthusiastically but would at most dedicate 20% of my portfolio to rolling LEAP contracts on a large index over the next 10 years. Firstly, I am too risk-averse to loose all my portfolio if something unforeseen happens and secondly I don't want to put all my eggs into one basket.
What are you doing?
Has somebody implemented this strategy entirely or partly and what is your experience so far? Have you changed your strategy over the course of time or are you strictly adhering to it?
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