An allocation to equities of a fixed percentage of the present value of projected lifetime savings, instead of a fixed percentage of current savings, allows investors to accumulate the same ultimate amount of wealth with less risk. The implementation of this time-diversifying method requires the use of leverage when the present value of future savings allocated to equities is greater than current savings.
What’s Inside?
To extend the existing literature on time diversification and optimal equity allocation for individual retirement investment accounts, the authors present a theory that supports temporal diversification. They devise a methodology for demonstrating and quantifying their theory’s relative effectiveness, perform the historical backtest, and draw conclusions from the data. The scenarios presented for analysis include varying levels of equity exposure, leverage, risk aversion, and equity returns as well as varying starting dates and utility preferences.
How Is This Research Useful to Practitioners?
The authors present a framework that integrates projected life-cycle savings and investment to quantify the historical benefits of leveraged, time-diversified investment in U.S. equities. This methodology and its conclusions are useful to a wide spectrum of investment practitioners, financial planners, and individual investors.
Product development teams at asset managers and insurance companies may refer to these findings for the development of new, leveraged, and temporally diversified life-cycle funds with target date maturities or equity-indexed annuity products. Additionally, portfolio managers, retirement planners, risk managers, regulators, and life insurance actuaries may find this research useful when designing individual retirement plans or separately managed accounts, analyzing portfolio allocations for clients, or considering changes to the regulation of retirement savings accounts.
How Did the Authors Conduct This Research?
The authors create 96 separate annual cohorts of investors for the period of 1871–1966. Each cohort spans a presumed 44-year wealth accumulation phase of a worker’s life cycle, which begins at age 23 and ends at age 67. The ultimate wealth outcomes of these investment cohorts provide the data necessary to analyze and rank the risks and returns of various investment strategies.
The following assumptions are made about all of the investor cohorts:
- Investor earnings track the Social Security Administration’s “scaled medium earner” annual earnings data.
- Each investor has a constant 4% savings rate.
- Margin rates, used to determine the cost of leverage, equal the broker call rate plus 30 bps.
- Earnings are discounted at a real risk-free rate of 2.56%.
Given this flow of life-cycle savings contribution, the simulations assess how the following equity allocation methods would have performed:
- Constant percentage of discounted savings allocated to equity with a maximum leverage of 200%,
- Constant percentage of liquid savings allocated to equity with 0% leverage, and
- 90% of liquid savings initially allocated to equity, declining linearly to 50% at age 67.
The relative performance of temporal diversification across the various cohorts and strategies demonstrates its potential benefits for investors. The authors use empirical stress tests to address the results obtained during the most dire economic periods—the Great Depression and the equity bear markets of 1893, 1903, 1907, 1917, and 1920—for the most sensitive cohorts of leveraged investors.
Abstractor’s Viewpoint
The positive conclusions reached by the authors are consistent with the majority of previous research on the subject of time diversification; the authors mainly differ in terms of degree and methodology. Although the benefits are compelling and robust across a wide variety of market cycles, the barriers to real-world implementation are daunting. Commitment to a 44-year investment strategy, significant leverage in the early stages, and investors who are early in their careers and have the highest propensity for current consumption (as well as competing demands for their ability to leverage)—all pose significant hurdles. Practically, the inability to use leverage in 401(k) accounts and the scarcity of leveraged, temporally diversified investment vehicles present additional obstacles to implementation.
Areas for future research could include an exploration of the outcomes of this strategy when deployed in non-U.S. equity markets and the study of leveraged time-diversified and asset-diversified portfolios—for example, portfolios of bonds or real estate.