Why 20-year-olds should invest way more in the stock market, and 50-year-olds, way less.

The economic mysteries of daily life.
Nov. 15 2008 7:41 AM

Only the Good Buy Young

Why 20-year-olds should invest way more in the stock market, and 50-year-olds, way less.

Traders work on the floor of the New York Stock Exchange
Traders on the floor of the New York Stock Exchange 

Here are the chief investment lessons of the financial crisis for today's young people: They should be buying more stocks and running up debts to do so. I'm not saying that the market is undervalued—how would I know? I am merely suggesting a way of reducing risks.

If that seems strange, reflect for a moment. We know that stocks can be very volatile. We also know that some generations have been luckier than others when it comes to the performance of the stock market. The baby boomer who started regular purchases of U.S. stocks in 1970 and sold in 2000 would have felt pretty sick after the awful bear market of 1974, but in retrospect, his timing would have been perfect, filling his pockets with bargain late-1970s and early-1980s shares and selling out right at the top. His daughter, entering the stock market in 1995 and aiming to retire in 2025, would have spent the past 13 years buying shares at prices that now seem to range from high to extortionate. We could call this "generational risk."

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Now think about the current prevailing wisdom on investing in shares, which reflects the fact that shares tend to produce high but risky returns. It is to start by putting most of one's savings into the stock market and as retirement approaches, increasingly shift one's portfolio to bonds and other less volatile investments. That seems to make sense. In fact, it is nonsense.

For one thing, there is nothing particularly safe about holding stocks for the long term. Whether you plan to sell a portfolio of stocks next week or hold them for another 40 years, a 20 percent fall in the stock market this week reduces the eventual value of that portfolio by 20 percent, relative to where they would have been had you sold them the day before the crash and reinvested afterward.

Further, a long-term investor following the consensus advice is exposed to stock-market risk in a very strange way. When young, he has almost no exposure. Although his tiny pot of savings is largely invested in stocks, that tiny pot contains almost none of the shares he eventually plans to own. That's too conservative. In middle age, he is overexposed in a desperate attempt to enjoy the high returns on stocks. Then as he approaches retirement, he becomes too conservative again, as he pours his portfolio back into safe assets. It is this bizarre pattern that produces generational risk.

The logical way to fight generational risk is to borrow money to make large, regular investments in stocks while young, then use a proportion of later savings to pay back the loan rather than to pile into the stock market in middle age. That sounds risky, but it is, in fact, exactly what people do in the housing market. Knowing that they will need a place to live all their lives, they tend to buy a small house and gradually trade up to a bigger one, paying off their mortgages only late in life.

Most of us need a retirement fund as well as a place to live; there is nothing intrinsically risky about regular borrowing to get that fund off to an early start.

Not only does the concept—"mortgage your retirement"—make sense; it has paid off in the past. The Yale academics who proposed it, Ian Ayres and Barry Nalebuff, have looked at historical stock market data covering 94 cohorts who retired between 1913 and 2004. For every single cohort, the early-leverage strategy beat the conventional wisdom; it also almost always beat the gambler's strategy of investing every penny in stocks until the moment of retirement. Only the blessed cohorts who retired in 1998 and 1999 did better. Such gambles rarely pay off, so if you're 20 years old and want to spread your risks, mortgage your retirement today.

Tim Harford is a Financial Times columnist. His latest book, The Logic of Life, will be published in paperback on Feb. 10.

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