Should Younger Investors Borrow To Invest?

Key Concepts

Human Capital: A young investor's total wealth is primarily composed of their future earning potential.
Temporal Diversification: A strategy that uses leverage early in an investment career to build wealth rapidly and spread market risk over many decades.
Leverage: Using borrowed funds or derivatives to increase investment exposure.
2:1 Leverage: Doubling stock market exposure by borrowing funds.
Heirs and Nailbuff's 250 Strategy: A leveraged life cycle investing approach that starts with 200% stock exposure and gradually tapers to 50% by retirement.
Volatility Decay (Compounding): A phenomenon where daily resets in leveraged products can cause returns to drift from the expected multiple of the index over longer periods, especially in volatile markets.
LEAPS (Long-Term Equity AnticiPation Securities): Long-term call options used as a form of derivative leverage.
Buying on Margin: Borrowing money from a broker to purchase securities.
ETPs (Exchange Traded Products): Financial instruments traded on exchanges, including leveraged ETPs.
ISA (Individual Savings Account) and SIPP (Self-Invested Personal Pension): Tax-advantaged investment wrappers in the UK.
Dynamic Asset Allocation: Investment strategies that adjust asset allocation based on market conditions and financial goals.

The Case for Young Investors Using Leverage

Conventional wisdom advises young investors against using leverage due to its inherent risks. However, this video explores academic research suggesting that a conservative approach might hinder long-term returns for those starting out. The core argument is that by considering an investor's total future wealth (human capital) rather than just current savings, leverage can be a tool to optimize lifetime returns and smooth market risk.

Temporal Diversification and Wealth Accumulation

Traditional investing often results in a "shark fin" shaped investment pot, where savings gradually increase and then are drawn down in retirement. This approach concentrates risk around the retirement point. Temporal diversification, conversely, advocates for using leverage early in one's career to accelerate wealth accumulation, particularly in equities. This allows investors to reach their optimal lifetime stock allocation sooner, potentially boosting returns and smoothing market risk over decades.

Heirs and Nailbuff's Research and the 250 Strategy

Academic research by Heirs and Nailbuff rigorously tested these concepts. Their findings suggest that a simple 2:1 leverage strategy, doubling stock market exposure, can be beneficial. The "250 strategy" involves young workers borrowing to invest up to 200% of their savings in stocks. As savings grow, leverage is gradually reduced, maintaining a target of approximately 50% of lifetime wealth in equities. By retirement, no borrowing is required, and the portfolio naturally settles into a balanced 50/50 mix.

Key Benefits of the 250 Strategy:

Risk Spreading: Risk is distributed more evenly across an investor's lifetime, avoiding concentration in the years leading up to retirement.
Volatility Reduction: This approach can reduce portfolio volatility by approximately 20% compared to a standard constant allocation strategy.
Simulation Results: Simulations of 96 cohorts over 44-year careers (1871-2009) showed that the leveraged approach achieved the same average retirement wealth as a constant mix strategy (74% stocks) but with significantly less volatility (21% less). The glide path strategy performed worse in terms of mean and median wealth.
Robustness: These conclusions held true across US, UK, and Japanese markets and were validated through Monte Carlo analysis.
Margin Call Rarity: In 2:1 leverage strategies with sensible risk controls, margin calls were found to be very rare.

Practical Implementation of Leverage

The effectiveness of a leveraged investment strategy hinges on the cost of borrowing. Low costs make leverage attractive, while high costs undermine its benefits.

Methods of Leverage:

Buying on Margin: Obtaining a loan from a broker to purchase securities.
LEAPS (Long-Term Equity AnticiPation Securities): Long-term call options, a form of derivative.

Funding Costs:

The implied interest cost for 2:1 leverage can be as low as 1% during periods of low interest rates, as observed in Heirs and Nailbuff's research.
Higher leverage ratios (e.g., 3:1) incur significantly higher borrowing costs.
The margin rate is crucial as it reduces the effective equity premium and the optimal stock allocation.
Leverage is only beneficial when the expected return on stocks comfortably exceeds the cost of borrowing.

Estimating Borrowing Costs:

A good proxy for the cost of borrowing is the central bank's policy rate plus a risk premium.
In the UK, the Bank of England's Bank Rate (e.g., 4% as of the video's creation) plus a risk premium for retail investors (e.g., 1.5 percentage points, leading to a potential 5.5% rate) can be considered.
Derivatives may embed lower borrowing rates due to institutional investors' cheaper access to capital markets.
The current falling interest rate environment could make leveraged strategies more attractive.

Leveraged ETPs and Their Characteristics

While margin loans and LEAPS are not permitted within ISAs or SIPs, daily leveraged exchange traded products (ETPs) offer a way to access leverage within these tax-advantaged wrappers. Wisdom Tree provides 2x and 3x equity ETPs.

Important Considerations for Leveraged ETPs:

Magnified Market Movements: Leveraged ETPs amplify both gains and losses, potentially leading to a total loss of investment.
Daily Reset and Volatility Decay: ETPs reset daily. Over longer periods, especially in volatile markets, returns can deviate from the expected multiple of the index due to volatility decay.
Recommended Holding Period: Wisdom Tree's leveraged ETPs have a recommended holding period of one day and are designed for short-term tactical use, not long-term buy-and-hold strategies without monitoring.
Combining with Lower Risk Assets: Leveraged ETPs can be combined with lower-risk assets like gilts or money market funds to adjust effective leverage. For example, a 2:1 allocation of a 3x S&P 500 ETP to a money market fund approximates a 2x S&P 500 ETP exposure while offering flexibility.

Advantages and Drawbacks of Leveraged Approaches

Advantages:

Accessibility within ISAs/SIPs: Leveraged ETPs can be held within tax-advantaged wrappers, avoiding capital gains and income tax.
Fine-Tuning Exposure: The ability to combine leveraged products with safer assets allows for precise control over investment exposure.
Flexibility: Exposure can be adjusted over time based on life stage, market conditions, or investment targets.

Drawbacks:

Volatility Decay: Daily resets can lead to losses in sideways or volatile markets.
Complexity: These strategies are more complex to understand than simple buy-and-hold index investing.
Monitoring Required: They are not "set and forget" strategies and necessitate active monitoring.
Funding Costs: Rising risk-free rates can make these strategies less attractive due to increased borrowing costs.

Alternatives to Leverage

For investors uncomfortable with leverage, several alternatives exist:

Increased Savings: While requiring careful budgeting and discipline, saving more can achieve similar wealth accumulation goals without the volatility of leverage.
Standard Life Cycle Investing: A gradual reduction in equity exposure as retirement approaches, which, while potentially less performant than leveraged strategies, is suitable for most investors.
Dynamic Asset Allocation Strategies: These strategies adapt to market conditions and financial goals, potentially offering superior risk-return characteristics.

Example of a Dynamic Allocation Strategy:

Target Retirement Fund: A target amount is set for retirement.
Initial 20 Years: 100% equity allocation.
End of Year 20:
- If target achieved: Portfolio switches to 80% stocks, 20% fixed income.
- If target not achieved: Remains 100% stocks.
Next 10 Years:
- If target achieved: Portfolio switches to 60% stocks, 40% fixed income.
- If target not achieved: Remains 100% stocks.

Conclusion

The theory behind using leverage for young investors is compelling, particularly for diversifying risk across an entire lifetime. When borrowing costs are low and investors possess the discipline to withstand market downturns, a modest amount of leverage early in an investment journey can be beneficial. However, potential pitfalls such as borrowing rates, product complexities, emotional challenges, and regulatory restrictions necessitate a realistic and thoughtful approach. Leverage can offer significant advantages, but only to those who fully understand the risks, are committed to monitoring their portfolios, and utilize these tools with caution. For the majority, a slightly higher savings rate or a dynamic allocation strategy might be a safer path.