Lifecycle Investing for Reduced Risk

Lifecycle investing is an under-utilized strategy that can significantly increase your long-term wealth while reducing your risk.

While the strategy is more geared towards younger investors at the start of their saving and investing journey, an older investor can use Lifecycle Investing if they shrink the timelines to suit their risk tolerance and target allocation by retirement.

While I don't believe Lifecycle Investing is tied to any one particular investment approach, in this post I will explore the strategy in the context of a fixed allocation stock and bond portfolio such as the Couch Potato portfolio. The researchers use this benchmark in their own analysis.

Standard Allocation Portfolio

In a standard Couch Potato style portfolio, the investor will typically choose an allocation that suits their long-term risk tolerance.

Generally, the investor assumes the stock portion can drop about 50 percent in value in a market downturn. There is a paired assumption that bonds will be stable or increase slightly if stocks are falling in value (slight inverse correlation).

This investment approach is mathematically simple to understand. Better yet, it is easy for an investor to manage their portfolio with minimal thought put into the strategy.

While the relative effects of the drawdowns are "managed" carefully based on expected impacts of stocks and bonds on the portfolio, the gross effects are not considered. I believe this is a statistical error often misunderstood by investors and investment managers.

Drawbacks of Standard Allocation Portfolios

We've all seen the upwards sloping curve of a compound interest chart:

Source: TheRichMoose.com

The total monetary impact of investment performance in the first decades of the strategy are very minimal since there is not a lot of money invested in this stage.

However, in the final third of the curve, the impact of investment performance is exponentially higher. Poor performance at this stage will significantly restrict portfolio value at retirement while great performance is going to make the investor very wealthy.

This effectively means an investor in a static allocation portfolio model is entirely dependent on the investment performance of the stock market in the final decade before retirement. The final third of the investing journey is where all of the gross impact of investing is realized.

To simplify, if you only have $10,000 invested, a 30 percent annual return is worth just $3,000. If you have $500,000 invested, a 30 percent return is worth $150,000. The relative performance is the same, the gross impact is very different!

The same impacts are present on the downside. Losing 50 percent of a $10,000 portfolio means a total loss of just $5,000. That's the equivalent of a month's gross income for the average investor. Losing 50 percent of a $500,000 portfolio means a total loss of $250,000—several years worth of gross salary.

There are strategies which attempt to address this discrepancy between relative impacts (percent of portfolio changes) and gross impacts (total dollar value changes).

The overall method is simple: invest aggressively in your early years and reduce risk as your portfolio grows.

Target Retirement Investing

The less risky strategy to address the gross impact issue is often called Target Retirement Investing.

Early in their investing path, the investor chooses a heavy allocation to stocks—typically 90 percent stocks or higher. The idea is that stocks provide higher returns than bonds, but are also more risky than bonds. As each portfolio contribution has a high impact on the total portfolio, the large swings characteristic of stocks have less impact.

However, the investor will slowly shift the portfolio towards more bonds over time. By retirement, an investor may have an allocation of just 40 percent stocks to reflect the decreased capacity for risk in retirement.

This approach has been popularized by Vanguard (U.S.) who offers managed index funds following the target retirement date approach. These funds are particularly appealing to investors in defined contribution pension plans where it may be more difficult to change investments regularly.

The drawback of Target Retirement Investing is that the impacts are still quite subdued. The overall return of a portfolio with 90 percent stocks is actually not that different from a portfolio of 50 percent stocks over ten or twenty year periods.

Lifecycle Investing Strategy

The Lifecycle Investing strategy takes a much more aggressive approach to address the gross impact issue of stock returns on portfolios.

Although arguments can be made that this research isn't new, the Lifecycle Investing Strategy has been popularized in recent years by the authors of this working academic paper: Lifecycle Investing and Leverage. It is worth a read for anyone interested in this strategy.

In the paper, Professors Ayres and Nalebuff advocate investment allocation based on a mathematical model using liquid current savings (S) and the present discounted value of future savings (W). The investor targets stock exposure equal to 88 percent of S+W.

There are three stages which could roughly be summarized as follows:

  1. Stage 1 (age 20 to mid-30's): Invest entirely in stocks leveraged up 2:1 for the entire period.
  2. Stage 2 (mid-30s to 65): Slowly deleverage by paying off margin debt, then begin accumulating bonds to your desired retirement asset allocation.
  3. Stage 3 (retirement 65+): Invest at your desired allocation based on long-term risk tolerance. While I believe it is overly aggressive for most, the authors suggest 88 percent stocks is ideal.

This investment process tilts the standard portfolio value slope quite significantly. First, it shifts more of the gross portfolio impacts to the earlier decades. Second, it allows you to reduce risk as your approach retirement without sacrificing overall returns or your ability to retire.

The theory is that your portfolio growth looks a lot smoother over the entire investment period:

Source: TheRichMoose.com

Or, under ideal conditions, returns are tilted toward centre peak earning years, then tapering down somewhat as the investor approaches retirement:

Source: TheRichMoose.com

The calculation that Ayres and Nalebuff use actually recommends leverage use greater than 2:1 during the earliest phases of investing; however, they suggest 2:1 should be the maximum leverage due to market restrictions and risk of loss.

I would argue this is no longer a concern given the 3x leveraged ETFs on the market. Following this method, a young investor can easily put all of their money in 3x leveraged ETFs and slowly pull back their leverage ratio in Stage 2 by purchasing short-term bond ETFs.

Using 3x leveraged ETFs (or simulating these returns with LEAPS options) would often allow the investor to begin tapering back leverage—Stage 2 of the process—earlier in their investment journey.

Under this method, an investor would roughly match a 100 percent stock portfolio when they hold 35 percent leveraged ETFs and 65 percent short-term bonds. For 60 percent stocks, the investor could alternatively hold 20 percent 3x leveraged ETFs and 80 percent short-term bonds.

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Markets I Trade: January 8, 2019

In my non-registered investment account I am developing my trend following strategy continuously. I don't pretend to have all the answers; I am always exploring and learning and I am sharing that journey with you on this blog.

All I know for sure is that I want every trade to end in three ways: a small loss, a small gain, or a large gain. I predetermine my risk on each trade and aim to make sure that risk is never exceeded.

A big focus of my trading is to expand my access to a broad range of markets while using my investment capital very efficiently. Instead of holding standard positions in ETFs or stocks, I am using LEAPS options and futures contracts.

Options and futures contracts allow me to bet on the upside or on the downside of trends with minimal penalties. They also require a small capital allocation to control a large position. Unlike with common stock or ETFs, options and futures do not require borrowing costs to short an asset.

I try to limit my investing process to liquid markets that have the highest potential for bigger price movements. This generally means using LEAPS options on the largest ETFs and using futures contracts for commodities and currencies.

Thanks to the wide range of choices in the ETF markets and the massive breadth of the futures markets, I can theoretically get easy exposure to hundreds of different assets across the planet.

To monitor each instrument I trade, I look at moving averages and volatility measurements. Although there is no holy grail indicator, looking at these tools can help paint a pretty solid picture of where the markets are going. This can improve the odds of success in trading.

Moving averages help identify the direction of trends and can help show turning points in direction. Using volatility measures makes it easy to size each position based on pre-determined exit points. High volatility markets translate to smaller positions while low volatility markets allow for larger positions.

I also look at breakouts, although I am not using them to enter or exit positions. Breakouts can be very helpful in confirming trends and seeing points of previous resistance.

Silver (SI=F)

In today's post I will share my analysis on my latest large trade in silver. I used futures contracts in this trade as the LEAPS options market on the silver ETF (SLV) is pretty thin. A single futures contract for silver gives exposure to 5,000 ounces for delivery at a future date. Most contracts are settled financially rather than being physically delivered.

I have been watching precious metals quite closely for the past year looking for an entry point. In the late summer, gold prices seem to have made a bottom which later set up my entry for the options trade on GLD.

Gold and silver often trade in tandem, but throughout the late summer and fall, silver prices kept falling while gold prices inched upwards. In late November, it required more than 86 ounces of silver to buy a single ounce of gold. That's one of the highest ratios in several decades.

Silver appears to have made an interim bottom in November and has shown strong upside movement since then. Since my entry point, my silver trade has done very well. It has jumped about $0.85 per ounce from my purchase price and I am holding exposure to 10,000 ounces.

Silver (Weekly Bar)

Source: StockCharts.com

In the beginning of September 2018, silver was oversold on a technical indicator and had a bounce up from that low point around $14.00 per ounce to about $14.90 per ounce.

Prices quickly turned down and dropped below $14.00 per ounce in early November 2018—once again touching an oversold metric. This time, selling volumes were high but buying volumes were lower on the upside than the previous move in September-October 2018.

Silver has shot up from my entry point a bit over $14.80 per ounce and volume is still pretty subdued.

Upside Optimism

  • An interim higher high was made when silver jumped over $14.90 price level in September-October.
  • Silver moved from a technical oversold period which can indicate a longer term bottom due to seller exhaustion.
  • The price moved strongly above the 10-week SMA.
  • At the end of December, the price soared up and closed above the 40-week SMA for the first time since early 2018.

Upside Caution

  • The 40-week SMA is still declining at the moment, indicating a long-term downtrend.
  • Betting on a pivot point (change in direction against the long-term trend) always has more risk than buying into a confirmed uptrend.
  • If the price continues to expand aggressively, silver could quickly become technically overbought and that would signal a good probability of a price pullback.
  • The range from $16 to $18 per ounce could see a lot of selling pressure.

Although I don't trade based on stories, silver prices have been depressed for nearly seven years. It costs more than $15 per ounce for major miners to produce silver. I don't believe prices could fall much lower than they are.

SI=F (Daily Bar)

Source: StockCharts.com

This chart shows my entry point (blue) and my current stop level (red). The price has pulled away strongly from my stop, so I will carefully monitor my risk on this trade to prevent over-exposure.

I entered this trade using silver futures contracts on the COMEX exchange for March 2019 delivery. The margin (or deposit) per contract is just US$3,600 plus any applicable paper losses.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.