The Ages of the Investor

Different stages of life call for different investing approaches and the need for transitioning from one stage to the next. William J. Bernstein addresses this challenge in his short book The Ages of the Investor: A Critical Look at Life-cycle Investing, the first book in his four part Investing for Adults series. His suggested method of transitioning toward retirement is very sudden.

Bernstein splits life-cycle investing into opening moves, middle game, and endgame. When you’re young, he suggests taking on as much risk as you can handle. Because this book is aimed at “investing adults,” he presumes the reader knows that stock picking and market timing are losing strategies. So, in this context, “risk” means compensated risk that comes with higher expected returns and comes mainly from stocks. Young investors are best off taking as much risk as they can handle without losing their nerve and selling out when stocks hit a difficult patch. “The young investor’s first encounter with a significant market decline serves mainly to ascertain her true risk tolerance.”

The book covers the life-cycle investing approach promoted by Ayres and Nalebuff that has young investors taking on 2:1 leverage using margin investing or call options on stock indexes. Bernstein lists some problems with this approach but leaves out the most serious problem: your ability to save in the future (and even to avoid withdrawing from savings) is highly risky. Losing your job during a stock market crash could completely wipe out leveraged savings.

An alternative to leverage is stock market investing using factor tilts. I tend to be skeptical that factor tilts will give future results that match past apparent success. Perhaps a slight tilt to small value stocks is sensible, but there is nothing wrong with an unleveraged position in low-cost stock indexes.

Because a mortgage is like a “negative bond,” it’s best to “Pay the damned thing off” rather than own bonds at the same time as holding a mortgage.

Bernstein portrays value averaging (VA) as an alternative to dollar-cost averaging (DCA) and describes VA as “a clever technique pioneered by Michael Edelson.” Value averaging doesn’t work. The main problems are 1) the return calculations supporting VA ignore opportunity costs of cash on the sidelines and interest on borrowed money, and 2) VA can lead to unsafe levels of leverage. I did some experiments to examine actual VA returns if we modify the strategy to eliminate these problems.

As you near retirement (the “endgame”), Bernstein suggests splitting your portfolio into two parts, a “liability matching portfolio” (LMP), and a “risk portfolio.” The idea is that the LMP contains completely safe assets that cover your basic needs for the rest of your life. The challenge is to create a LMP free from inflation risk, longevity risk, and counterparty risk (insurance company bankruptcy).

After examining several LMP approaches that all have risks, Bernstein chooses a ladder of inflation-protected bonds as the best option. This means Real-Return Bonds (RRBs) in Canada and Treasury Inflation-Protected Securities (TIPS) in the U.S. The challenge I see here is that we still have longevity risk. How many years of RRBs are safe?

During the middle game of your investing life “If, at any point, a bull market pushes your portfolio over the LMP “magic number” of 20 to 25 times your annual cash-flow needs beyond Social Security and pensions, you’ve won the investing game. Why keep playing? Start bailing.” The author calls for a sudden sell off of risky assets to buy the LMP. Then any new savings can be invested as riskily as you like.

This LMP idea would be more appealing if it handled longevity risk. How do I know that 20 to 25 times my annual spending needs is enough? If an investor bails out into a LMP in her 50s anticipating working to 65, but loses her job, the LMP is suddenly not enough for a longer retirement.

One side note most Canadians would agree with: the U.S. has “a dysfunctional health-care system and an inadequate safety net.”

On the subject of safe spending from a portfolio: “Below the age of 65, a 2% spending rate is bulletproof, 3% is probably safe, and 4% is taking chances. Above 5%, you’re taking an increasingly serious risk of dying poor. (For each five years above 65, add perhaps half a percentage point to those numbers.)”

It has become popular to plan for reduced spending throughout retirement. I’ve written many times about flaws in this idea. Bernstein takes this further by explaining why we might want to spend more in the future, even in inflation-adjusted terms. “Worker productivity, wages, and per capita GDP all grow at a real rate of about 2% per year. So will your expectations. Would you be happy with a 1960s standard of living? When everyone else has or will soon have an iPad, could you stand to live without one?”

Overall, I recommend this book for its critical thinking about life-cycle investing. However, I take issue with some of the specific recommendations.