After last week's post on the relative benefits of renting versus buying a home, Ryan Decker sent me to his earlier post on the subject. In it Ryan mentions an interesting concept I'd never heard of before; lifecycle investing. Developed by Ian Aryes and Barry Nalebuff (pdf), the idea is that investors in their twenties can reduce risk and improve returns not only by investing all their savings in the stock market, but by going one step further and taking out a loan to buy stock.
Odd advice, right? But there are good reasons for this. Aryes and Nalebuff's thesis begins with the idea that we all own something called a "human capital bond." This is the present value of our lifetime stream of saved wages. Imagine a young investor with an average tolerance for risk who has just entered the labour force. He/she possesses a human capital bond that is currently worth, say, $500,000. Let's assume that this bond is expected to be quite stable in value, maybe because the young investor has just taken on a unionized government job. It make senses for our investor to reduce their allocation to this low-risk human capital bond in order to get exposure to an appropriate amount of riskier equity, thus boosting overall returns. Say the ideal equity share is around 50%, or $250,000. Waiting for the paychecks to roll in is far too slow a way to build a $250,000 stake in equities. Far quicker to sell half the human capital bond right now—or $250,000—and use it to buy the stake in equities outright.
The problem is that our investor can't simply sell away $250,000 worth of human capital. A spot market for human capital bonds doesn't exist. Absent the appropriate market, Aryes and Nalebuff believe that the way to approximate the ideal ratio is to use debt. By leveraging their meagre savings at a ratio of 2:1, a young investor with (say) $5,000 in savings in the first year of employment can get exposure to $10,000 worth of stock, thus getting twice as close to the ideal amount of diversification. Ayres and Nalebuff refer to this as time diversification. Rather than waiting till mid age to have accumulated an appropriately diversified portfolio, do so as early as possible.
I think that it makes a lot of sense to imagine ourselves as if we held a Ayres/Nalebuff human capital bond and make our best effort to diversify around this asset. However, what if our bond is risky rather than safe? Maybe we make ends meet via a series of freelance jobs rather than perpetual government employment, or maybe we get by on commission income which can vary dramatically year-over-year. If so, the asset that represents our capitalized savings should probably be conceived not as a bond, but as a relatively volatile human capital "share." Instead of levering up to buy even more shares, a freelancer or salesperson seeking to diversify across time should borrow and acquire a stable asset with low drift, say like a mortgaged home.*
Liquidity is another facet worth considering. To own a human capital bond (or share) means to be terribly illiquid. Unlike a regular bond (or share), these instruments can't be rapidly swapped for other assets.
Owning an illiquid portfolio comes at large emotional cost. Consider that we are mere specks of dust being tossed around by currents far too large and complex to control, let alone understand. Against this awful uncertainty, extremely liquid financial assets, specifically instruments like deposits and banknotes, are our best lines of defence. When the universe suddenly knocks us down, liquid assets can be deployed to cope. When it throws us a bone, they can help us seize the moment. So while deposits and cash provide little in the form of a financial return (they are expected to steadily inflate away in value), they compensate by providing huge non-pecuniary flows of convenience, relief, and confidence.
When a young investor is advised to lever up and invest in either stocks or real estate, both of which are more liquid than a human bond but still not terribly liquid, they are being asked to bear some of the burdens of uncertainty. After all, leverage means running down inventories of cash and deploying back up lines of credit. Too much leverage and our investor loses their only hedge against the unknown. This lack of liquidity could subject them to enormous emotional costs when the proverbial shit hits the fan (or an unforeseen life changing opportunity must be passed up).
So young investors need to be careful that they take on an appropriate amount of debt (too little may be as bad as too much) and acquire suitable assets. To begin with, they must do their best to estimate the present value and riskiness of their largest asset, their Aryes/Nalebuff human capital bond. Only then can they determine the merits of borrowing to diversify across time; some assets promise significant returns (like shares) and some of them don't (like houses), the best option depending on the nature of the individual's capital bond. They also need to ask themselves a philosophical question: to what degree can the world be understand and controlled and to what degree is their fate governed by random and unpredictable forces? The more chaos our young investor sees, the more they should keep themselves liquid; the more order they see, the less liquid. There is no one-size fits all solution here, no trustworthy rule of thumb. But I'm sure you'll figure it out.
Related post: Labour Shares™: Beating capital at its own game
*Could housing booms be a function of forces that make human capital bonds increasingly risky, say like increased contract work and the demise of the traditional promise of lifetime employment offered by corporations? To offset the growing risk of the standard human capital bond, everyone may simultaneously try to offset by purchasing a home, traditionally a low return asset.
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