I recently had dinner with a friend who told me that when he was younger he didn’t save any money because he knew he’d make more money later in life. His reasoning was, “Why should I live like I’m poorer now when I know I won’t be later?”
What my friend described is what economists refer to as consumption smoothing. The idea is to spend money at a similar rate throughout your life rather than allow it to fluctuate over time based on your wealth and income. This implies that young people should save little (or even take out debt) to enjoy their lifestyle now and then increase their savings later to make up for it.
I get the logic. If you knew your future cashflows with 100% certainty, you could perfectly time your consumption so that you wouldn’t have to worry about overspending or oversaving. Your dollars going out today could be covered by dollars coming in tomorrow (and vice versa).
While this idea is great in theory, it’s terrible in practice. The problem is that we don’t know our future cashflows with any reasonable certainty. As a result, we may save too little (or take out too much debt) while young, only to later discover that our future income wasn’t enough to keep us afloat.
The issue with my friend’s logic, and with consumption smoothing in general, is path dependence. In other words, to get to the future you have to survive the past. If you’re using consumption smoothing and you go through a rough patch financially, you may not make it out. Let’s look at an example to illustrate why.
Consider the person who finances their lifestyle in their 20s. They put everything on a credit card and tell themselves that they will pay it off later with future earnings. Before they know it, they are deeply in debt. In fact, they get so far behind that their car gets repossessed and they can no longer commute to work. Shortly thereafter, they lose their job and go into a downward financial spiral from there.
Was this person on a path to earn and save more money over time? Probably. Like most people, they likely would’ve gotten to a point in their career where their income increased and they saved more. Unfortunately, they never got to experience that outcome because their spending habits took them down a different road.
This is why path dependence is so important—because every action you take today influences what actions you can take tomorrow.
This idea also applies to your investments as well. For example, I’ve been asked by numerous people over the years what I think about the book Lifecycle Investing. The premise of the book is that young people should have 100% of their money in stocks with some added leverage because, historically, this would’ve generated a better return than a portfolio without leverage.
If you had followed this advice from the time of the book’s publication in April 2010 (and invested in a 3x levered S&P 500 index fund), you would’ve outperformed the S&P 500 by nearly 2,000%:
Of course, this is only true because U.S. stocks haven’t gone through an extended multi-year decline. Since 2010, U.S. stocks have avoided the kind of prolonged declines that investors experienced in the 1930s, 1970s, and 2000s.
While the performance of this 3x fund looks great in hindsight, if you examine it in more recent years, the results aren’t as impressive. Over the last 3 years, the 3x levered fund has performed basically the same as the S&P 500 with far more volatility:
And when I say far more volatility, I mean it.
Currently, the 3x fund is about 33% off its all-time highs and was down 77% during the March 2020 bottom:
Investing with leverage sounds easy until you have to actually do it.
Despite the insane volatility associated with this strategy, I don’t disagree with the math. In my own analysis on leveraged index funds, I found that a levered U.S. stock portfolio outperformed an un-levered one in all 30-year periods besides The Great Depression. In other words, if you knew with certainty that you wouldn’t experience another Great Depression-like event (in the next 30 years), then you’d probably be better off adding some leverage to your portfolio.
Unfortunately, this argument has the same problem as the argument for consumption smoothing—we don’t know the future. Yes, another Great Depression-like event is unlikely in the next three decades, but it isn’t zero. That’s the rub.
Though many young investors will likely be fine with some leverage in their portfolios, it’s not a recommendation I can safely make. All it takes is another 2008, 1974, or 1929 and this advice falls apart.
This is why I love Meb Faber’s advice, “Just survive.” It’s so simple, yet so true. Making it to the end of your investment journey in one piece is more important than maximizing your returns. Because the actions that you take to maximize your returns are indistinguishable from the ones that you take to minimize them.
That’s the cruel irony of investing. The people who take lots of risk (via big, concentrated bets) are some of the richest and poorest investors out there. And this information is only revealed after their bets play out.
This is why you should never borrow too much against your future. Because a brighter future is promised to no one.
It can be hard to remember this when most of what we’ve experienced in financial markets since 2010 has been up and to the right. It’s easy to convince yourself that this trend will continue and you should take on more risk. The recent trade war selloff (and partial recovery) may further persuade you of this point. But, I would advise caution.
Last weekend, Warren Buffett announced that he would be stepping down as CEO of Berkshire Hathaway at year-end. Throughout his career, Buffett used a modest 1.6-to-1 leverage on average. If the greatest investor of all time only used a little leverage, why would you consider using any?
Happy investing and thank you for reading!
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This is post 449. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data
