Reading Rational Expectations, I came across one really interesting portfolio management idea for life-cycle investing: leverage holdings at a young age.
This follows from research by Nalebuff-Ayres which runs a bit like:
- A young person generally begins her career with a lot of human capital (future earnings power) and near-zero financial capital (actual savings).
- The young person saves regularly towards retirement. How should she invest her savings?
- With maximum human capital and minimal financial capital, the ‘right’ thing to do is leverage what financial capital is available, buying stocks on margin or using index option strategies.
- As the person ages, the leverage comes down, until it goes away in her 40s/50s.
I like this idea: buy stock index options as a youngster, so one can make a leveraged stock investment when one’s risk tolerance is highest. Using options rather than margin loans means the maximum loss is limited to the amount paid for the options – you’ll never be called by the brokerage to put up more funds. I’d further offset the implied interest rate on the index options (the extrinsic, or time, value of the option) by selling out of the money nearer-term options. Oh wait, that’s what I’m doing!!