We thought we had left the topic of time diversification behind in our post:  Lifecycle investing on steroids.  The experience of the past decade should have driven home the point that a leveraged approach to retirement investing flies in the face of the many behavioral issues individuals deal with in their investing.  However developments in the meantime have brought the issue back to the forefront including a post by author Ian Ayres at the Freakonomics blog.

There are a number of arguments against leveraging your retirement savings so as to take advantage of time diversification.  One argument that both David Merkel at Aleph Blog and Tyler Cowen at Marginal Revolution agree on is that the historical equity risk premium may in fact have been an historical accident.  Cowen writes:

If I were a young man, I would not take this plunge, mostly out of fear that a historically unique equity premium configuration was doing the major work of the argument.

Merkel writes:

Even in the US stocks don’t outperform bonds by that much.  My estimate of the equity premium is around 1%.  Yes, the economics profession says the equity premium is higher, but they use a wrong metric; they should use dollar-weighted returns, not time-weighted returns.  The estimate of 4% equity returns over margin rates, which are higher than bond yields, is hooey.

Merkel also notes the historical accident that is the US experience.  Many other countries have seen their stock markets go to zero due (usually) to war or hyperinflation.  That gets to the point which we want to note here.  In short, there is a big difference between risk and uncertainty.

Ayres and Nalebuff necessarily rely on statistics that describe the risk (and return) of the stock market.  However basing future investing decisions based on these statistics, especially in a leveraged fashion, leaves aside the broader issue of uncertainty.  Uncertainty being those risks that cannot be quantified in this fashion.

We will leave it to a couple of other thinkers to help illustrate this point.  Nassim Taleb speaking with Russ Roberts on the EconTalk podcast said the following:

Forecasting ten years down the road has an error rate several billion times the error rate for a five-day forecast…What’s worth forecasting and what isn’t; what do you need to insulate yourself from? Point in the essay, and underlying point in the book–you need some redundancy. Since you know your errors are going to grow over time, and since you know that your ability to predict the future is imperfect, you want to create some redundancy.

Applying this logic to portfolio construction should make the idea of leverage seem chancy, at best.  Redundancy in a portfolio implies some sort of risk-free asset that would both cushion a portfolio in bad times and provide dry powder to take advantage of market dislocations.

Alexander Ineichen* writes directly to the issue of time diversification and uncertainty:

We believe time amplifies risk. It is true that the annual average rate of return has a smaller standard deviation for a longer time horizon. However, it is also true that the uncertainty compounds over a greater number of years. Unfortunately, this latter effect dominates in the sense that the total return becomes more uncertain the longer the investment horizon. The logic here is that over the longer term, more bad things can happen and the probability of failure (i.e., non-survival) is higher. The probability, for example, of San Francisco being wiped out by a large earthquake over the next 100 years is much larger than over the next 100 days. If accidents happen in the short term, one might not live long enough to experience the long term. After all, the long term is nothing else than many short term periods adjoined together.

Ineichen uses the recent example of Japan showing that sometimes a market, even a developed one, can go down and stay down.  The issue isn’t one of better estimating the equity risk premium or volatility of returns.  It stems more from the fact that we really don’t know what the future holds.  Recognizing the limitations of our statistical knowledge is a necessary step in facing uncertainty.

As Ineichen note, “accidents happen.” Whether they be economic, financial, political or natural.  The past few weeks filled with earthquakes, oil spills and sovereign credit crises should be a reminder that the world is filled not only with risk but with uncertainty as well.

*Incheichen, Alexander, Joe Taussig and Henrik de Koning, “Absolute returns revisited,” Ineichen Research and Management, 2010. via All About Alpha