It seems like Ben Todd is saying that increasing one’s exposure to stocks increases risk, but Lifecycle Investing is saying this decreases risk when done early on. How should we reconcile these two views?
Both are correct. The claim made by Lifecycle Investing is not that increasing stock exposure decreases risk in general. The claim is that by increasing stock exposure early in life and decreasing late in life, while keeping net lifetime exposure the same, you decrease risk.
The argument for this claim is that you have more dollars when you’re older, therefore market swings in later years have a bigger effect on your portfolio than in earlier years. But you can negate this effect by using leverage when you’re young, thus effectively increasing how much money you’re investing with, and holding more bonds/cash when you’re older.
Simplified example: suppose you have $100 today and will get another $100 next year. If you invest all your money in stocks during both years, then you are exposing $100 to equity risk this year, but $200 next year. If instead you invest with 1.5:1 leverage this year, and then next year you only invest 75% of your money, that means you’re exposing $150 to equity risk during both years. Either way, you’re investing $150 per year on average. But in the former scenario, you are taking twice as much risk in year 2, whereas in the latter scenario, you take the same amount of risk both years, which is better.
I’m not sure I’m explaining it well, so let me know if that doesn’t make sense.
It seems like Ben Todd is saying that increasing one’s exposure to stocks increases risk, but Lifecycle Investing is saying this decreases risk when done early on. How should we reconcile these two views?
Both are correct. The claim made by Lifecycle Investing is not that increasing stock exposure decreases risk in general. The claim is that by increasing stock exposure early in life and decreasing late in life, while keeping net lifetime exposure the same, you decrease risk.
The argument for this claim is that you have more dollars when you’re older, therefore market swings in later years have a bigger effect on your portfolio than in earlier years. But you can negate this effect by using leverage when you’re young, thus effectively increasing how much money you’re investing with, and holding more bonds/cash when you’re older.
Simplified example: suppose you have $100 today and will get another $100 next year. If you invest all your money in stocks during both years, then you are exposing $100 to equity risk this year, but $200 next year. If instead you invest with 1.5:1 leverage this year, and then next year you only invest 75% of your money, that means you’re exposing $150 to equity risk during both years. Either way, you’re investing $150 per year on average. But in the former scenario, you are taking twice as much risk in year 2, whereas in the latter scenario, you take the same amount of risk both years, which is better.
I’m not sure I’m explaining it well, so let me know if that doesn’t make sense.
OK that makes sense, thanks.