Lifecycle Investing - Leveraging when young
- Steve Reading
- Posts: 2959
- Joined: Fri Nov 16, 2018 9:20 pm
Lifecycle Investing - Leveraging when young
Hello,
This thread has evolved into a discussion of all aspects of Lifecycle Investing. It has also gotten quite long. To that end, I have modified this OP to serve as a one-stop-shop of the most relevant information in the thread.
FAQs
What is this whole thing about?
The intuition behind Lifecycle Investing is explained here:
viewtopic.php?p=4425436#p4425436
Here’s a TLDR of the strategy:
viewtopic.php?p=4415395#p4415395
But you should really read the book (there’s an audible version, free with your first trial). No exception, it's required reading:
https://www.amazon.com/Lifecycle-Invest ... 170&sr=8-3
And their paper (optional reading):
https://papers.ssrn.com/sol3/papers.cfm ... id=1149340
So why should I use it?
This mitigates, to the extent possible, the sequence-of-return-risk of accumulators. See:
viewtopic.php?p=4419774#p4419774
Does this only work during good times?
Many people thought that too. Ex:
viewtopic.php?p=4412428#p4412428
viewtopic.php?p=4413164#p4413164
viewtopic.php?p=4427620#p4427620
viewtopic.php?p=4897974#p4897974
But the strategy historically was an excellent idea despite Bear markets, weathering the Financial Crisis, the Great Depression and now the March 2020 35% drop (in real time).
How does this compare to DCA?
Lifecycle Investing is basically the opposite of DCA. See:
viewtopic.php?p=4420588#p4420588
I’m not in my 20s any more. Am I too late?
Not at all. See:
viewtopic.php?p=5288280#p5288280
How much leverage to start with?
The book recommends 2x leverage but I actually like 1.5x leverage a little better. See:
viewtopic.php?p=5753451#p5753451
What are ways to leverage?
There are various ways, depending on your circumstances, what accounts you have, taxable situation, collateral, etc. In rough order of my preference:
1) Margin at Interactive Brokers (only possible in taxable). One can even sell SPX boxes on top to further reduce the margin interest to future-like interest levels. This is my preferred choice for taxable accounts. See:
viewtopic.php?p=5459791#p5459791
2) Futures (like the new S&P Micros). These have potentially significant tax drags depending on your circumstances but are my preferred method in tax-advantaged.
viewtopic.php?p=4731237#p4731237
3) You can buy an ATM call and sell an ATM SPX put (synthetic stock). Only doable in taxable. This has potentially significant tax drag:
viewtopic.php?p=4605692#p4605692
viewtopic.php?p=4633852#p4633852
4) Leveraged ETFs (UPRO or SOO). I don’t like the high fees and prefer rebalancing less frequently (say monthly, or based on rebalancing bands like in the book). That said, they are a good choice for Phase 1, Uncorrelated likes them and I trust him/her so it’s a possibility as well:
viewtopic.php?p=5101161#p5101161
5) Deep ITM LEAP calls. These have the highest implied borrowing costs due to the embedded downside protection, especially with the elevated VIX as of this writing (02/2021). I've found 3:1 leverage to offer the cheapest borrowing rate. See financing cost example:
viewtopic.php?p=73329#p73329
6) Alternative forms of borrowing (credit card promotional rates, not paying down car/home/student loans if rate is low-enough, family loan, etc).
Is it not better to leverage a balanced portfolio (using leveraged bonds)?
Yes, but it requires even more leverage. It is not my preference but you might do so. See:
viewtopic.php?p=4826710#p4826710
How do I determine my Relative Risk Aversion (RRA)?
The book uses the New Job Question (see example):
viewtopic.php?p=5063345#p5063345
Ben Matthew repurposed the TPAW spreadsheet for accumulation, allowing one to determine what stock/bond allocation suits their risk tolerance best:
viewtopic.php?p=5826439#p5826439
Can I backtest Lifecycle Investing?
Not easily (ex: not with portfolio visualizer). The asset allocation is changing constantly throughout the time period and depends on variables like future savings. You can download the data the Professors used to backtest it however:
http://www.lifecycleinvesting.net/resources.html
What if I have a mortgage?
The book does not deal with this but here’s what simplified way you might consider:
viewtopic.php?p=5151797#p5151797
viewtopic.php?p=5291638#p5291638
Is this anti-Boglehead?
It is, Bogle was adamantly against leverage. But the concept is sound and consistent with BH principles. And many BH-like authors (like William Bernstein) agree with the premise. See:
viewtopic.php?p=4422130#p4422130
How likely is the market to hit X value, and liquidate me?
It is possible to make an estimate with the delta of options. See:
viewtopic.php?p=281720#p281720
viewtopic.php?p=4722209#p4722209
Do you do any kind of market-timing (the book mentioned it was possible)?
I shift my stock percent target (Samuelson share) based on valuations to a small extent. See:
viewtopic.php?p=5644769#p5644769
viewtopic.php?p=5700039#p5700039
Is this just trying to maximize returns (i.e using the Kelly Criterion)?
While it is true leverage of 1.5-2x historically lead to the highest CAGR, Lifecycle Investing is not about max CAGR. It is about spreading risk across time. Accumulating investors can apply more leverage than the Kelly Criterion would suggest:
viewtopic.php?p=4415014#p4415014
Hey, I think I’ve seen this one before. What about Market Timer’s thread?
Market Timer absolutely had the right idea but made some mistakes in implementation. See:
viewtopic.php?p=4874404#p4874404
Implemented properly, the strategy would have worked out even during the Great Depression. So implement it properly!
I am convinced I want to do this but the market is at an all-time high. Any advice?
viewtopic.php?p=5667471#p5667471
What about a flash crash?
viewtopic.php?p=5323187#p5323187
Are you getting paid by the authors to say all of this?
Someone already implied it:
viewtopic.php?p=4416022#p4416022
But no, I don't get paid to do any of this. Although I probably should!
What does your current portfolio look like?
viewtopic.php?p=5459415#p5459415
And my updates below.
UPDATE: I am following this strategy and will update every 3 months.
May 2019
Stock Exposure = 235k
Debt = 92k
Equity in the exposure = 143k
Leverage = 1.64
Aug 2019
Stock Exposure = 251k
Debt = 101k
Equity in the exposure = 150k
Leverage = 1.68
Nov 2019
Stock Exposure = 412k
Effective Debt = 233k
Equity in the exposure = 179k
Leverage = 2.29
April 2020
Stock Exposure = 413k
Effective Debt = 301k
Equity in the exposure = 123k
Leverage = 3.69
August 2020
Total Stock Exposure = 540k
Effective Debt = 300k
Equity in the exposure = 241k
Leverage (@ IBKR) = 1.5
January 2021
Total Stock Exposure = 742k
Effective Debt = 361k
Equity in the exposure = 381k
Leverage (@ IBKR) = 2.0
This thread has evolved into a discussion of all aspects of Lifecycle Investing. It has also gotten quite long. To that end, I have modified this OP to serve as a one-stop-shop of the most relevant information in the thread.
FAQs
What is this whole thing about?
The intuition behind Lifecycle Investing is explained here:
viewtopic.php?p=4425436#p4425436
Here’s a TLDR of the strategy:
viewtopic.php?p=4415395#p4415395
But you should really read the book (there’s an audible version, free with your first trial). No exception, it's required reading:
https://www.amazon.com/Lifecycle-Invest ... 170&sr=8-3
And their paper (optional reading):
https://papers.ssrn.com/sol3/papers.cfm ... id=1149340
So why should I use it?
This mitigates, to the extent possible, the sequence-of-return-risk of accumulators. See:
viewtopic.php?p=4419774#p4419774
Does this only work during good times?
Many people thought that too. Ex:
viewtopic.php?p=4412428#p4412428
viewtopic.php?p=4413164#p4413164
viewtopic.php?p=4427620#p4427620
viewtopic.php?p=4897974#p4897974
But the strategy historically was an excellent idea despite Bear markets, weathering the Financial Crisis, the Great Depression and now the March 2020 35% drop (in real time).
How does this compare to DCA?
Lifecycle Investing is basically the opposite of DCA. See:
viewtopic.php?p=4420588#p4420588
I’m not in my 20s any more. Am I too late?
Not at all. See:
viewtopic.php?p=5288280#p5288280
How much leverage to start with?
The book recommends 2x leverage but I actually like 1.5x leverage a little better. See:
viewtopic.php?p=5753451#p5753451
What are ways to leverage?
There are various ways, depending on your circumstances, what accounts you have, taxable situation, collateral, etc. In rough order of my preference:
1) Margin at Interactive Brokers (only possible in taxable). One can even sell SPX boxes on top to further reduce the margin interest to future-like interest levels. This is my preferred choice for taxable accounts. See:
viewtopic.php?p=5459791#p5459791
2) Futures (like the new S&P Micros). These have potentially significant tax drags depending on your circumstances but are my preferred method in tax-advantaged.
viewtopic.php?p=4731237#p4731237
3) You can buy an ATM call and sell an ATM SPX put (synthetic stock). Only doable in taxable. This has potentially significant tax drag:
viewtopic.php?p=4605692#p4605692
viewtopic.php?p=4633852#p4633852
4) Leveraged ETFs (UPRO or SOO). I don’t like the high fees and prefer rebalancing less frequently (say monthly, or based on rebalancing bands like in the book). That said, they are a good choice for Phase 1, Uncorrelated likes them and I trust him/her so it’s a possibility as well:
viewtopic.php?p=5101161#p5101161
5) Deep ITM LEAP calls. These have the highest implied borrowing costs due to the embedded downside protection, especially with the elevated VIX as of this writing (02/2021). I've found 3:1 leverage to offer the cheapest borrowing rate. See financing cost example:
viewtopic.php?p=73329#p73329
6) Alternative forms of borrowing (credit card promotional rates, not paying down car/home/student loans if rate is low-enough, family loan, etc).
Is it not better to leverage a balanced portfolio (using leveraged bonds)?
Yes, but it requires even more leverage. It is not my preference but you might do so. See:
viewtopic.php?p=4826710#p4826710
How do I determine my Relative Risk Aversion (RRA)?
The book uses the New Job Question (see example):
viewtopic.php?p=5063345#p5063345
Ben Matthew repurposed the TPAW spreadsheet for accumulation, allowing one to determine what stock/bond allocation suits their risk tolerance best:
viewtopic.php?p=5826439#p5826439
Can I backtest Lifecycle Investing?
Not easily (ex: not with portfolio visualizer). The asset allocation is changing constantly throughout the time period and depends on variables like future savings. You can download the data the Professors used to backtest it however:
http://www.lifecycleinvesting.net/resources.html
What if I have a mortgage?
The book does not deal with this but here’s what simplified way you might consider:
viewtopic.php?p=5151797#p5151797
viewtopic.php?p=5291638#p5291638
Is this anti-Boglehead?
It is, Bogle was adamantly against leverage. But the concept is sound and consistent with BH principles. And many BH-like authors (like William Bernstein) agree with the premise. See:
viewtopic.php?p=4422130#p4422130
How likely is the market to hit X value, and liquidate me?
It is possible to make an estimate with the delta of options. See:
viewtopic.php?p=281720#p281720
viewtopic.php?p=4722209#p4722209
Do you do any kind of market-timing (the book mentioned it was possible)?
I shift my stock percent target (Samuelson share) based on valuations to a small extent. See:
viewtopic.php?p=5644769#p5644769
viewtopic.php?p=5700039#p5700039
Is this just trying to maximize returns (i.e using the Kelly Criterion)?
While it is true leverage of 1.5-2x historically lead to the highest CAGR, Lifecycle Investing is not about max CAGR. It is about spreading risk across time. Accumulating investors can apply more leverage than the Kelly Criterion would suggest:
viewtopic.php?p=4415014#p4415014
Hey, I think I’ve seen this one before. What about Market Timer’s thread?
Market Timer absolutely had the right idea but made some mistakes in implementation. See:
viewtopic.php?p=4874404#p4874404
Implemented properly, the strategy would have worked out even during the Great Depression. So implement it properly!
I am convinced I want to do this but the market is at an all-time high. Any advice?
viewtopic.php?p=5667471#p5667471
What about a flash crash?
viewtopic.php?p=5323187#p5323187
Are you getting paid by the authors to say all of this?
Someone already implied it:
viewtopic.php?p=4416022#p4416022
But no, I don't get paid to do any of this. Although I probably should!
What does your current portfolio look like?
viewtopic.php?p=5459415#p5459415
And my updates below.
UPDATE: I am following this strategy and will update every 3 months.
May 2019
Stock Exposure = 235k
Debt = 92k
Equity in the exposure = 143k
Leverage = 1.64
Aug 2019
Stock Exposure = 251k
Debt = 101k
Equity in the exposure = 150k
Leverage = 1.68
Nov 2019
Stock Exposure = 412k
Effective Debt = 233k
Equity in the exposure = 179k
Leverage = 2.29
April 2020
Stock Exposure = 413k
Effective Debt = 301k
Equity in the exposure = 123k
Leverage = 3.69
August 2020
Total Stock Exposure = 540k
Effective Debt = 300k
Equity in the exposure = 241k
Leverage (@ IBKR) = 1.5
January 2021
Total Stock Exposure = 742k
Effective Debt = 361k
Equity in the exposure = 381k
Leverage (@ IBKR) = 2.0
Last edited by Steve Reading on Mon Feb 22, 2021 10:29 am, edited 17 times in total.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
Re: Lifecycle Investing - Leveraging when young
Two threads of note are:
HEDGEFUNDIE's excellent adventure [risk parity strategy using 3x leveraged ETFs] and
Should I use margin to buy a balanced fund? by Rob Bertram
These two go for a more risk parity approach and leverage a stock & bond portfolio, whereas if I recall correctly Ayers just suggests leveraging stocks only. HEDGEFUNDIE uses leveraged ETFs and Rob Bertram uses futures. Ayers suggests using LEAPS (Long Term Equity Anticipation Security).
HEDGEFUNDIE's excellent adventure [risk parity strategy using 3x leveraged ETFs] and
Should I use margin to buy a balanced fund? by Rob Bertram
These two go for a more risk parity approach and leverage a stock & bond portfolio, whereas if I recall correctly Ayers just suggests leveraging stocks only. HEDGEFUNDIE uses leveraged ETFs and Rob Bertram uses futures. Ayers suggests using LEAPS (Long Term Equity Anticipation Security).
I'm just a fan of the person I got my user name from
Re: Lifecycle Investing - Leveraging when young
If you could get leverage for free it would be a no brainer. But no leverage comes for free.
You're either borrowing money, in which case you are paying interest, which reduces your return on the invested amount by the interest rate and exposes you to additional risk. Also as a young investor you're likely not getting amazing borrowing rates (you can tap your home equity with a HELOC and invest that, but even then, the rate isn't that awesome, and you have to lie and say you're not planning to use the HELOC for investing).
You could buy options (including LEAPS) but these have time decay. You stand to lose a lot of money if the markets go down in a given option time period, which you can't get back later like you would if you had invested directly in the market and just held.
Leveraged ETFs mathematically just don't work for long term buy and hold (this is apparently up for debate in hedgefundie's thread but as far as I can tell its a mathematical truism given that their goal is to provide leveraged daily returns).
As far as I can tell, futures are the cheapest form of leverage available to the individual investor. Holding futures effectively just costs the risk-free rate and (small) trading costs. However, you would have to have the discipline to keep rolling your futures contracts systematically every month/quarter even when the markets seem to be against you, which is probably a lot more psychologically difficult for most people than just investing in an ETF and forgetting about it.
You're either borrowing money, in which case you are paying interest, which reduces your return on the invested amount by the interest rate and exposes you to additional risk. Also as a young investor you're likely not getting amazing borrowing rates (you can tap your home equity with a HELOC and invest that, but even then, the rate isn't that awesome, and you have to lie and say you're not planning to use the HELOC for investing).
You could buy options (including LEAPS) but these have time decay. You stand to lose a lot of money if the markets go down in a given option time period, which you can't get back later like you would if you had invested directly in the market and just held.
Leveraged ETFs mathematically just don't work for long term buy and hold (this is apparently up for debate in hedgefundie's thread but as far as I can tell its a mathematical truism given that their goal is to provide leveraged daily returns).
As far as I can tell, futures are the cheapest form of leverage available to the individual investor. Holding futures effectively just costs the risk-free rate and (small) trading costs. However, you would have to have the discipline to keep rolling your futures contracts systematically every month/quarter even when the markets seem to be against you, which is probably a lot more psychologically difficult for most people than just investing in an ETF and forgetting about it.
- Steve Reading
- Posts: 2959
- Joined: Fri Nov 16, 2018 9:20 pm
Re: Lifecycle Investing - Leveraging when young
I had seen the first thread but had not seen the second one. Thanks.Day9 wrote: ↑Thu Feb 28, 2019 11:32 pm Two threads of note are:
HEDGEFUNDIE's excellent adventure [risk parity strategy using 3x leveraged ETFs] and
Should I use margin to buy a balanced fund? by Rob Bertram
These two go for a more risk parity approach and leverage a stock & bond portfolio, whereas if I recall correctly Ayers just suggests leveraging stocks only. HEDGEFUNDIE uses leveraged ETFs and Rob Bertram uses futures. Ayers suggests using LEAPS (Long Term Equity Anticipation Security).
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
- Steve Reading
- Posts: 2959
- Joined: Fri Nov 16, 2018 9:20 pm
Re: Lifecycle Investing - Leveraging when young
Yeah that makes sense. I think for myself, I'm considering margin as the most likely route. The rates don't seem bad at Interactive BrokersDonIce wrote: ↑Thu Feb 28, 2019 11:47 pm If you could get leverage for free it would be a no brainer. But no leverage comes for free.
You're either borrowing money, in which case you are paying interest, which reduces your return on the invested amount by the interest rate and exposes you to additional risk. Also as a young investor you're likely not getting amazing borrowing rates (you can tap your home equity with a HELOC and invest that, but even then, the rate isn't that awesome, and you have to lie and say you're not planning to use the HELOC for investing).
You could buy options (including LEAPS) but these have time decay. You stand to lose a lot of money if the markets go down in a given option time period, which you can't get back later like you would if you had invested directly in the market and just held.
Leveraged ETFs mathematically just don't work for long term buy and hold (this is apparently up for debate in hedgefundie's thread but as far as I can tell its a mathematical truism given that their goal is to provide leveraged daily returns).
As far as I can tell, futures are the cheapest form of leverage available to the individual investor. Holding futures effectively just costs the risk-free rate and (small) trading costs. However, you would have to have the discipline to keep rolling your futures contracts systematically every month/quarter even when the markets seem to be against you, which is probably a lot more psychologically difficult for most people than just investing in an ETF and forgetting about it.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
Re: Lifecycle Investing - Leveraging when young
Margin allows you to increase your "buying power"—the amount of money available in your account to purchase marginable securities. For example, if you have $50,000 in your money market settlement fund, your buying power is actually $100,000, because you're required to deposit just 50% when buying or selling short* most marginable securities.
To keep your line of credit open, you must maintain a certain amount of equity—the current value of your assets less the amount of the margin loan—in your account at all times. Margin trading can increase your return on an investment, but there's also the potential for significant loss.
A few things you should be aware of:
1) there is a base rate plus an interest rate. I believe that the current margin rate is 8.75%, but this varies by brokerage house. You have trading fees too.
2) you can only borrow based on a percentage of equity in your account. If your account balance goes down, do you have cash to transfer to your account bring the account ratio back into compliance?
3) Margin is a loan that can be called by the broker at anytime.
Good luck to you
To keep your line of credit open, you must maintain a certain amount of equity—the current value of your assets less the amount of the margin loan—in your account at all times. Margin trading can increase your return on an investment, but there's also the potential for significant loss.
A few things you should be aware of:
1) there is a base rate plus an interest rate. I believe that the current margin rate is 8.75%, but this varies by brokerage house. You have trading fees too.
2) you can only borrow based on a percentage of equity in your account. If your account balance goes down, do you have cash to transfer to your account bring the account ratio back into compliance?
3) Margin is a loan that can be called by the broker at anytime.
Good luck to you
"I started with nothing and I still have most of it left."
Re: Lifecycle Investing - Leveraging when young
The book also mentions including your human capital in the decision to incur leverage. If you are in a government job you are in the best position to be levered however if you are an investment banker you may want to have a bond heavy portfolio to diversify your total risk (human & financial capital).
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Buy cheap and something good might happen
- Steve Reading
- Posts: 2959
- Joined: Fri Nov 16, 2018 9:20 pm
Re: Lifecycle Investing - Leveraging when young
Great thoughts! The rate I'm seeing at Interactive Brokers is 3.4%, which I think is pretty reasonable. As for margin calls and equity, the strategy recommends selling if needed to maintain the leverage at 2:1. Ideally, my savings rate can make up any market drops to maintain the correct leverage without having to sell.Wiggums wrote: ↑Fri Mar 01, 2019 7:04 pm Margin allows you to increase your "buying power"—the amount of money available in your account to purchase marginable securities. For example, if you have $50,000 in your money market settlement fund, your buying power is actually $100,000, because you're required to deposit just 50% when buying or selling short* most marginable securities.
To keep your line of credit open, you must maintain a certain amount of equity—the current value of your assets less the amount of the margin loan—in your account at all times. Margin trading can increase your return on an investment, but there's also the potential for significant loss.
A few things you should be aware of:
1) there is a base rate plus an interest rate. I believe that the current margin rate is 8.75%, but this varies by brokerage house. You have trading fees too.
2) you can only borrow based on a percentage of equity in your account. If your account balance goes down, do you have cash to transfer to your account bring the account ratio back into compliance?
3) Margin is a loan that can be called by the broker at anytime.
Good luck to you
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
- market timer
- Posts: 6535
- Joined: Tue Aug 21, 2007 1:42 am
Re: Lifecycle Investing - Leveraging when young
For small accounts (<$100K), the leveraged ETF approach makes sense. I believe HEDGEFUNDIE is doing quarterly rebalancing, though I'd recommend rebalancing based on deviations from target AA and with new contributions, rather than a time-based approach.Day9 wrote: ↑Thu Feb 28, 2019 11:32 pm Two threads of note are:
HEDGEFUNDIE's excellent adventure [risk parity strategy using 3x leveraged ETFs] and
Should I use margin to buy a balanced fund? by Rob Bertram
These two go for a more risk parity approach and leverage a stock & bond portfolio, whereas if I recall correctly Ayers just suggests leveraging stocks only. HEDGEFUNDIE uses leveraged ETFs and Rob Bertram uses futures. Ayers suggests using LEAPS (Long Term Equity Anticipation Security).
For larger accounts, I think futures are best, as Rob Bertram is doing. It gets more complicated if this is done partly inside taxable accounts vs. retirement accounts.
-
- Posts: 4801
- Joined: Sun Oct 22, 2017 2:06 pm
Re: Lifecycle Investing - Leveraging when young
Glad to see you following my thread market timer.market timer wrote: ↑Fri Mar 01, 2019 11:28 pmFor small accounts (<$100K), the leveraged ETF approach makes sense. I believe HEDGEFUNDIE is doing quarterly rebalancing, though I'd recommend rebalancing based on deviations from target AA and with new contributions, rather than a time-based approach.Day9 wrote: ↑Thu Feb 28, 2019 11:32 pm Two threads of note are:
HEDGEFUNDIE's excellent adventure [risk parity strategy using 3x leveraged ETFs] and
Should I use margin to buy a balanced fund? by Rob Bertram
These two go for a more risk parity approach and leverage a stock & bond portfolio, whereas if I recall correctly Ayers just suggests leveraging stocks only. HEDGEFUNDIE uses leveraged ETFs and Rob Bertram uses futures. Ayers suggests using LEAPS (Long Term Equity Anticipation Security).
For larger accounts, I think futures are best, as Rob Bertram is doing. It gets more complicated if this is done partly inside taxable accounts vs. retirement accounts.
Hope you’re doing well these days.
Re: Lifecycle Investing - Leveraging when young
I'm a BH lurker who just made an account because actual examples of lifecycle investing seem to be rare.
I read Ayres and Nalebuff a few years ago and found it very persuasive. I spent a solid year looking over the numbers and creating my own simulations to see the impact of leverage on future portfolio values. In general, I (like them) found benefits to risk and return by diversifying across time. Just before implementing the leverage strategy I found markettimer's legendary thread which reinforced the need to approach the topic with caution.
Ayres and Nalebuff suggest limiting leverage to 2x, which means (correct me if I'm wrong) there are three stages to the strategy, based on a target final portfolio value:
Stage 1: 0% to 50% of portfolio target, using 2x leverage
Stage 2: 50% to 100% of portfolio target, with leverage decreasing from 2x to 1x
Stage 3: At 100% of portfolio target, you are delevered
One year ago I took the plunge and purchased LEAPS to move from 100% equity to 200%. I'm early in my career and have a relatively small portfolio size. I buy LEAPS that are 18 months from expiry, at about 75% ITM. To meet my AA I hold LEAPS options on SPY and EFA for US/International exposure, as well as ETFs for those markets plus emerging markets and Canada. One drawback of this method is the need to monitor the leverage as prices change; I track my total equity exposure monthly and buy/sell to stay close to 2x leverage. The first LEAPS I purchased expire later this month so I'll need to roll them over for another 18 months or so when that happens.
My last LEAPS purchase was around 3.2% implied interest, which is much better than what my broker offers in a margin account. In theory it should match the risk-free rate. In the book the authors mentioned futures and leveraged ETFs as other tools to achieve leverage which have been discussed above. I think I'm following Ayers and Nalebuff closer than most, and it looks like you have the same thing in mind. Let me know if you have questions about implementing the portfolio, as I found there are not many places online which discuss the book's strategy.
I read Ayres and Nalebuff a few years ago and found it very persuasive. I spent a solid year looking over the numbers and creating my own simulations to see the impact of leverage on future portfolio values. In general, I (like them) found benefits to risk and return by diversifying across time. Just before implementing the leverage strategy I found markettimer's legendary thread which reinforced the need to approach the topic with caution.
Ayres and Nalebuff suggest limiting leverage to 2x, which means (correct me if I'm wrong) there are three stages to the strategy, based on a target final portfolio value:
Stage 1: 0% to 50% of portfolio target, using 2x leverage
Stage 2: 50% to 100% of portfolio target, with leverage decreasing from 2x to 1x
Stage 3: At 100% of portfolio target, you are delevered
One year ago I took the plunge and purchased LEAPS to move from 100% equity to 200%. I'm early in my career and have a relatively small portfolio size. I buy LEAPS that are 18 months from expiry, at about 75% ITM. To meet my AA I hold LEAPS options on SPY and EFA for US/International exposure, as well as ETFs for those markets plus emerging markets and Canada. One drawback of this method is the need to monitor the leverage as prices change; I track my total equity exposure monthly and buy/sell to stay close to 2x leverage. The first LEAPS I purchased expire later this month so I'll need to roll them over for another 18 months or so when that happens.
My last LEAPS purchase was around 3.2% implied interest, which is much better than what my broker offers in a margin account. In theory it should match the risk-free rate. In the book the authors mentioned futures and leveraged ETFs as other tools to achieve leverage which have been discussed above. I think I'm following Ayers and Nalebuff closer than most, and it looks like you have the same thing in mind. Let me know if you have questions about implementing the portfolio, as I found there are not many places online which discuss the book's strategy.
Re: Lifecycle Investing - Leveraging when young
From April 2010 - The ideas that I have been criticizing do not shrivel up and die. They always come back.
Link to original thread - viewtopic.php?t=53714
BobK
bobcat2 wrote: ↑Sat Apr 17, 2010 9:08 am I notice at the Amazon preview of their book, Lifecycle Investing, Ayres and Nalebuff dedicate the book "to their teacher Paul Samuelson" and claim their book is a straightforward application of research done by Samuelson.
In October of 2008 Paul Samuelson attended an economics conference on lifecycle investing. I believe it was the last economics conference Samuelson attended. Here is what Paul Samuelson said about the investing strategy of Ayres and Nalebuff at that conference.Many analysts argue that when you average over many investment periods, so favorable are the long-run returns of stocks that while you are still young, you should borrow substantially to hold large positions in stocks and you should do so because some kind of “stochastic dominance” is supposed to justify it.
Now, when I read such things, my eyebrows arch upwards. I think I have written 27 articles rebutting this idea—with at least one article completely in one syllable words, except for the word “syllable” itself. It smacks of what I call the “Milton Friedman fallacy.” When that sage was a TIAA trustee before me, he believed that investing for a large number of future periods did, by some law of large numbers, mandate becoming more risk tolerant. The Milton Friedman fallacy is a simple one. Also called the Kelly criterion, it leads to the conclusion that, in contrast to utility theory, one should always maximize the geometric mean. It is the same as the 1738 Daniel Bernoulli conjecture that if you have a duel with your brother-in-law and you are faced with a stationary probability process—stationary through time—going to the geometric mean is the way to win. Being second in investing, unlike being second in dueling, is good, however, and very few attain it.
The ideas that I have been criticizing do not shrivel up and die. They always come back... Recently I received an abstract for a paper in which a Yale economist and a Yale law school professor advise the world that when you are young and you have many years ahead of you, you should borrow heavily, invest in stocks on margin, and make a lot of money. I want to remind them, with a well-chosen counterexample: I always quote from Warren Buffett (that wise, wise man from Nebraska) that in order to succeed, you must first survive. People who leverage heavily when they are very young do not realize that the sky is the limit of what they could lose and from that point on, they would be knocked out of the game.
So once Samuelson dies a year later Ayres and Nalebuff dedicate a book to Samuelson on an investment strategy Samuelson and his research had roundly rejected, while he was alive and able to defend his rejection of their strategy.
Shame on them. Shame.
BobK
PS - Link to conference proceedings that includes Samuelson quote.
http://www.cfainstitute.org/memresource ... cle_4.html
Link to original thread - viewtopic.php?t=53714
BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). |
The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.
Re: Lifecycle Investing - Leveraging when young
Ayers and Nalebuff claim that their strategy is based on research by both Paul Samuelson and Robert Merton. Paul Samuelson, while he was alive, most certainly did not agree with that assessment. Here is what Zvi Bodie has to say about Merton's research and Ayers and Nalebuff's strategy.
BobK
Even Ayers and Nalebuff concede that young people with credit card or student loan debt should not use this strategy. So here we have an investment strategy that applies to nearly no one, and that is supposedly built on research by two acclaimed economists who flatly reject that their research supports this strategy. Is there anything right about this picture?My own research with Merton and Bill Samuelson (Paul's son), which is cited in the Ayers & Nalebuff working paper, concludes that economic theory would support leveraging equities in a retirement portfolio only for individuals whose human capital is relatively safe. Do you know such young people?
BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). |
The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.
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Re: Lifecycle Investing - Leveraging when young
I do not like the daily rebalancing and high fees of the leveraged ETFs. The authors are also not big fans of them and recommend less frequent rebalancing. My account would be larger than 100k any ways, so I'm not considering these as options atm. Thanks for the thoughts on them.market timer wrote: ↑Fri Mar 01, 2019 11:28 pmFor small accounts (<$100K), the leveraged ETF approach makes sense. I believe HEDGEFUNDIE is doing quarterly rebalancing, though I'd recommend rebalancing based on deviations from target AA and with new contributions, rather than a time-based approach.Day9 wrote: ↑Thu Feb 28, 2019 11:32 pm Two threads of note are:
HEDGEFUNDIE's excellent adventure [risk parity strategy using 3x leveraged ETFs] and
Should I use margin to buy a balanced fund? by Rob Bertram
These two go for a more risk parity approach and leverage a stock & bond portfolio, whereas if I recall correctly Ayers just suggests leveraging stocks only. HEDGEFUNDIE uses leveraged ETFs and Rob Bertram uses futures. Ayers suggests using LEAPS (Long Term Equity Anticipation Security).
For larger accounts, I think futures are best, as Rob Bertram is doing. It gets more complicated if this is done partly inside taxable accounts vs. retirement accounts.
As for the futures, my limited understanding is that they offer much larger leverage than 2:1. They also seem to get traded outside of trading hours, which is not a plus in my book. That might get stressful. Do I have the correct understanding here?
Very glad to see someone else follow this. I hope we can stay in communication through the years as I follow this process. I'm still not fully decided on it but it's a good chance I will do it after all.NTropy wrote: ↑Sat Mar 02, 2019 7:56 am I'm a BH lurker who just made an account because actual examples of lifecycle investing seem to be rare.
I read Ayres and Nalebuff a few years ago and found it very persuasive. I spent a solid year looking over the numbers and creating my own simulations to see the impact of leverage on future portfolio values. In general, I (like them) found benefits to risk and return by diversifying across time. Just before implementing the leverage strategy I found markettimer's legendary thread which reinforced the need to approach the topic with caution.
Ayres and Nalebuff suggest limiting leverage to 2x, which means (correct me if I'm wrong) there are three stages to the strategy, based on a target final portfolio value:
Stage 1: 0% to 50% of portfolio target, using 2x leverage
Stage 2: 50% to 100% of portfolio target, with leverage decreasing from 2x to 1x
Stage 3: At 100% of portfolio target, you are delevered
One year ago I took the plunge and purchased LEAPS to move from 100% equity to 200%. I'm early in my career and have a relatively small portfolio size. I buy LEAPS that are 18 months from expiry, at about 75% ITM. To meet my AA I hold LEAPS options on SPY and EFA for US/International exposure, as well as ETFs for those markets plus emerging markets and Canada. One drawback of this method is the need to monitor the leverage as prices change; I track my total equity exposure monthly and buy/sell to stay close to 2x leverage. The first LEAPS I purchased expire later this month so I'll need to roll them over for another 18 months or so when that happens.
My last LEAPS purchase was around 3.2% implied interest, which is much better than what my broker offers in a margin account. In theory it should match the risk-free rate. In the book the authors mentioned futures and leveraged ETFs as other tools to achieve leverage which have been discussed above. I think I'm following Ayers and Nalebuff closer than most, and it looks like you have the same thing in mind. Let me know if you have questions about implementing the portfolio, as I found there are not many places online which discuss the book's strategy.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
Re: Lifecycle Investing - Leveraging when young
Not at all surprising. Happens all the time (see the book "Wrong", for one). This is why I view those who write about investing, personal finance, and microeconomics with a jaundiced eye. Much of the time their interests are diametrically opposed to my own. But this type of stuff will always be posted here because no one wants to get rich slowly (Buffett) and because appeal to authority prevents people from seeing Toto pull the curtain back on the man behind the curtain.
Re: Lifecycle Investing - Leveraging when young
I will check back on this thread after the next 40% decline in the market (which will come, we just don’t know when).
It's not an engineering problem - Hersh Shefrin | To get the "risk premium", you really do have to take the risk - nisiprius
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Re: Lifecycle Investing - Leveraging when young
Curious what deviation would target a rebalance? I am doing quarterly rebalances as well but was debating doing monthly contributions using M1, which would automatically do this to balance target AA.market timer wrote: ↑Fri Mar 01, 2019 11:28 pm
For small accounts (<$100K), the leveraged ETF approach makes sense. I believe HEDGEFUNDIE is doing quarterly rebalancing, though I'd recommend rebalancing based on deviations from target AA and with new contributions, rather than a time-based approach.
Nobody seems to have found a good target point for rebalancing that beats quarterly in backtesting, peculiar indeed.
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Re: Lifecycle Investing - Leveraging when young
I am 100/0 in unleveraged and 120/180 in leveraged. Depending on how the decline occurs a 3x daily rebalanced equity fund may actually drop less than a 3x a standard equity fund. Feel free to check in with me.
Re: Lifecycle Investing - Leveraging when young
Excellent post.DonIce wrote: ↑Thu Feb 28, 2019 11:47 pm If you could get leverage for free it would be a no brainer. But no leverage comes for free.
You're either borrowing money, in which case you are paying interest, which reduces your return on the invested amount by the interest rate and exposes you to additional risk. Also as a young investor you're likely not getting amazing borrowing rates (you can tap your home equity with a HELOC and invest that, but even then, the rate isn't that awesome, and you have to lie and say you're not planning to use the HELOC for investing).
You could buy options (including LEAPS) but these have time decay. You stand to lose a lot of money if the markets go down in a given option time period, which you can't get back later like you would if you had invested directly in the market and just held.
Leveraged ETFs mathematically just don't work for long term buy and hold (this is apparently up for debate in hedgefundie's thread but as far as I can tell its a mathematical truism given that their goal is to provide leveraged daily returns).
As far as I can tell, futures are the cheapest form of leverage available to the individual investor. Holding futures effectively just costs the risk-free rate and (small) trading costs. However, you would have to have the discipline to keep rolling your futures contracts systematically every month/quarter even when the markets seem to be against you, which is probably a lot more psychologically difficult for most people than just investing in an ETF and forgetting about it.
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Re: Lifecycle Investing - Leveraging when young
Agreed but would be curious to hear more about the mathematical truism on daily leveraged funds. I was previously quick to repeat what I had heard that they rebalance daily and are only meant to be held for short-term trades, but the more I read the more I realize they can be effective for long-term buy & hold as well and often the daily-rebalancing can come out ahead (both in up and down markets) relative to a naive-return (3x the overall return).AlphaLess wrote: ↑Sat Mar 02, 2019 12:53 pmExcellent post.DonIce wrote: ↑Thu Feb 28, 2019 11:47 pm If you could get leverage for free it would be a no brainer. But no leverage comes for free.
You're either borrowing money, in which case you are paying interest, which reduces your return on the invested amount by the interest rate and exposes you to additional risk. Also as a young investor you're likely not getting amazing borrowing rates (you can tap your home equity with a HELOC and invest that, but even then, the rate isn't that awesome, and you have to lie and say you're not planning to use the HELOC for investing).
You could buy options (including LEAPS) but these have time decay. You stand to lose a lot of money if the markets go down in a given option time period, which you can't get back later like you would if you had invested directly in the market and just held.
Leveraged ETFs mathematically just don't work for long term buy and hold (this is apparently up for debate in hedgefundie's thread but as far as I can tell its a mathematical truism given that their goal is to provide leveraged daily returns).
As far as I can tell, futures are the cheapest form of leverage available to the individual investor. Holding futures effectively just costs the risk-free rate and (small) trading costs. However, you would have to have the discipline to keep rolling your futures contracts systematically every month/quarter even when the markets seem to be against you, which is probably a lot more psychologically difficult for most people than just investing in an ETF and forgetting about it.
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Re: Lifecycle Investing - Leveraging when young
@packer16: Yes, the nature of the human capital is very relevant. I would argue it's more than just the correlation to the stock market; if the salary is in some way inconsistent or unreliable, I would say that should be taken into account. The strategy seems like a good fit for salaries that are uncorrelated with the market and reliable.
@bobcat2: Based on Samuelson's critique, It's my personal opinion that Samuelson did not take the time to read the book properly and report. After reading some of Samuelson's writings, I think it is a consistent fit. I seem to recall Samuelson only read the abstract but don't quote me on that.
That most people would not meet the requirements to use the strategy does not take away from its effectiveness for those that would be good fits. Personally, I don't carry credit card debt and my salary does not come from the finance/banking field. I don't know how common that is I suppose.
Regardless, the strategy does not just apply to youth. If you're 45 and will plan to work for another 15+ years, it's likely you would be recommended to use a much larger percentage of stocks than typically recommended to diversify effectively across time. Hopefully the number of 45 year olds with credit card debt is lower than 25 year olds, so it might be even more applicable to those populations.
@bobcat2: Based on Samuelson's critique, It's my personal opinion that Samuelson did not take the time to read the book properly and report. After reading some of Samuelson's writings, I think it is a consistent fit. I seem to recall Samuelson only read the abstract but don't quote me on that.
That most people would not meet the requirements to use the strategy does not take away from its effectiveness for those that would be good fits. Personally, I don't carry credit card debt and my salary does not come from the finance/banking field. I don't know how common that is I suppose.
Regardless, the strategy does not just apply to youth. If you're 45 and will plan to work for another 15+ years, it's likely you would be recommended to use a much larger percentage of stocks than typically recommended to diversify effectively across time. Hopefully the number of 45 year olds with credit card debt is lower than 25 year olds, so it might be even more applicable to those populations.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young
The uncertainty of the market crashes is a big reason why this strategy appeals to me. By diversifying across time, I can decrease my risk while maintaining the same returns. The more volatile the times, the more helpful it is. I have a hard time rationalizing against the lifecycle model of the authors personally.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
Re: Lifecycle Investing - Leveraging when young
I wish you well.305pelusa wrote: ↑Sat Mar 02, 2019 6:53 pmThe uncertainty of the market crashes is a big reason why this strategy appeals to me. By diversifying across time, I can decrease my risk while maintaining the same returns. The more volatile the times, the more helpful it is. I have a hard time rationalizing against the lifecycle model of the authors personally.
In 'Where are the Customers' Yachts', Fred Schwed wrote:There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description that I might offer here even approximate what it feels like to lose a real chunk of money that you used to own.
It's not an engineering problem - Hersh Shefrin | To get the "risk premium", you really do have to take the risk - nisiprius
Re: Lifecycle Investing - Leveraging when young
No offense but when I see trend like this (leverage to invest), things might head towards a crash. It’s like clockwork.305pelusa wrote: ↑Thu Feb 28, 2019 11:11 pm Hello,
I recently came across the research from Prof. Ayres and Nalebuff about lifecycle investing and time diversification. The cliffnotes is that if one thinks about every future year as a potential bet, then it's in your best interest to spread out your bets as uniformly as possible across all those years. This means investing, to the best of your ability, the same dollar amount in stocks every year throughout your life. Since people accumulate money as they age, the implication is to use leverage when young to get closer to that target. That increases short term risk but, paradoxically, lowers long term risk. There are some rules set (such as not borrowing on credit, keeping leverage at 2:1 max, taking into account the nature of your income, etc) but that's the general idea.
The paper is here:
http://faculty.som.yale.edu/barrynalebu ... _v2008.pdf
I decided to buy their book. I think their logic is sound and the results are extremely compelling. t was cool to read about MarketTimer since that's the thread that first got me thinking about it.
I found few threads opened in the past on the subject but they're a few years old so I wanted to start a new one to see if anyone is implementing the strategy, hear about other people's thoughts, recommendations for other forums where people implement similar strategies in the case that this forum is not appropriate for the topic, etc. I am basically right on the fence at the moment on whether to use the strategy or not.
Thank you
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Re: Lifecycle Investing - Leveraging when young
Yes, an individual futures contract gives much more than 2:1 leverage. An S&P e-mini contract currently requires about $6K of cash to get exposure to $140K of equities (50x S&P 500), so 23:1 leverage. However, you should think of this in the context of your entire account. As the S&P fluctuates day to day, cash will be moved to or from your account at the end of the day. If you don't have $6K in cash to maintain your position, you'll be forced to sell in a margin call. You could fully collateralize the position by depositing $140K of cash and buying an S&P e-mini. This would ensure you aren't forced to sell.
In a retirement account, I'd be inclined to use futures. In a taxable account, you lose the ability to defer capital gains taxes when you use futures, since they must be rolled quarterly.
Re: Lifecycle Investing - Leveraging when young
Hi 305pelusa,
I doubt very much if Paul Samuelson, one of the greatest economists of all time, misunderstood what Ayes and Nalebuff wrote. He simply disagreed with it. After all Samuelson wasn’t asked about it at the conference, but instead he brought it up as a classic example of poor financial reasoning that comes back every time there is an extended bull market.
Again this is what Samuelson said at the conference.
Lifecycle investing does call for a high percentage of investible assets be invested in risky assets for young investors no older than their early thirties, because so much of their wealth is in relatively safe human capital rather than financial capital. But their financial wealth wouldn’t be leveraged or even 100% because they need some safe assets to deal with bad financial states such as unemployment and bad health. For a young person to reasonably leverage their assets would require that she has no student debt, no credit card or other consumer debt such as car loan or lease, very stable employment such as tenured professor, physician, or law partner, employment not correlated with financial markets, and that she be very knowledgeable about financial markets and investing. The percentage of young investors that fit that leverage profile would appear to be less than 1% of the population of adults no older than their early thirties.
By the ages of 45-50 lifecycle finance calls for a smaller percentage of the portfolio to be invested in stocks than is conventionally recommended because the human capital portion of the investor’s wealth is so much smaller than it was when they were younger. For many investors around age 30 the relevant portion of their human capital devoted to retirement income dwarfs their financial wealth, but by their late 40’s financial wealth is likely much greater than their rapidly diminishing remaining safe human capital. You should be able to grasp this important aspect of lifecycle finance since you believe "human capital is very relevant".
BobK
I doubt very much if Paul Samuelson, one of the greatest economists of all time, misunderstood what Ayes and Nalebuff wrote. He simply disagreed with it. After all Samuelson wasn’t asked about it at the conference, but instead he brought it up as a classic example of poor financial reasoning that comes back every time there is an extended bull market.
Again this is what Samuelson said at the conference.
Many analysts argue that when you average over many investment periods, so favorable are the long-run returns of stocks that while you are still young, you should borrow substantially to hold large positions in stocks and you should do so because some kind of “stochastic dominance” is supposed to justify it.
Now, when I read such things, my eyebrows arch upwards. I think I have written 27 articles rebutting this idea—with at least one article completely in one syllable words, except for the word “syllable” itself. It smacks of what I call the “Milton Friedman fallacy.” When that sage was a TIAA trustee before me, he believed that investing for a large number of future periods did, by some law of large numbers, mandate becoming more risk tolerant. The Milton Friedman fallacy is a simple one. Also called the Kelly criterion, it leads to the conclusion that, in contrast to utility theory, one should always maximize the geometric mean. It is the same as the 1738 Daniel Bernoulli conjecture that if you have a duel with your brother-in-law and you are faced with a stationary probability process—stationary through time—going to the geometric mean is the way to win. Being second in investing, unlike being second in dueling, is good, however, and very few attain it.
The ideas that I have been criticizing do not shrivel up and die. They always come back... Recently I received an abstract for a paper in which a Yale economist and a Yale law school professor advise the world that when you are young and you have many years ahead of you, you should borrow heavily, invest in stocks on margin, and make a lot of money. I want to remind them, with a well-chosen counterexample: I always quote from Warren Buffett (that wise, wise man from Nebraska) that in order to succeed, you must first survive. People who leverage heavily when they are very young do not realize that the sky is the limit of what they could lose and from that point on, they would be knocked out of the game.
Lifecycle investing does call for a high percentage of investible assets be invested in risky assets for young investors no older than their early thirties, because so much of their wealth is in relatively safe human capital rather than financial capital. But their financial wealth wouldn’t be leveraged or even 100% because they need some safe assets to deal with bad financial states such as unemployment and bad health. For a young person to reasonably leverage their assets would require that she has no student debt, no credit card or other consumer debt such as car loan or lease, very stable employment such as tenured professor, physician, or law partner, employment not correlated with financial markets, and that she be very knowledgeable about financial markets and investing. The percentage of young investors that fit that leverage profile would appear to be less than 1% of the population of adults no older than their early thirties.
By the ages of 45-50 lifecycle finance calls for a smaller percentage of the portfolio to be invested in stocks than is conventionally recommended because the human capital portion of the investor’s wealth is so much smaller than it was when they were younger. For many investors around age 30 the relevant portion of their human capital devoted to retirement income dwarfs their financial wealth, but by their late 40’s financial wealth is likely much greater than their rapidly diminishing remaining safe human capital. You should be able to grasp this important aspect of lifecycle finance since you believe "human capital is very relevant".
BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). |
The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.
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Re: Lifecycle Investing - Leveraging when young
Optimizing backtesting results strikes me as overfitting.MotoTrojan wrote: ↑Sat Mar 02, 2019 12:51 pmCurious what deviation would target a rebalance? I am doing quarterly rebalances as well but was debating doing monthly contributions using M1, which would automatically do this to balance target AA.market timer wrote: ↑Fri Mar 01, 2019 11:28 pm
For small accounts (<$100K), the leveraged ETF approach makes sense. I believe HEDGEFUNDIE is doing quarterly rebalancing, though I'd recommend rebalancing based on deviations from target AA and with new contributions, rather than a time-based approach.
Nobody seems to have found a good target point for rebalancing that beats quarterly in backtesting, peculiar indeed.
I haven't put together a spreadsheet to optimize for the various complications: taxes, attention, trading fees, etc. In terms of general guidelines, I would:
1. Direct new contributions to the asset class most below target.
2. Have % rebalancing bands, similar to what many already use here, which would force a sale and purchase.
3. To the extent possible, use retirement accounts for rebalancing purposes, which could lead to very different allocations between retirement and taxable.
4. Try to maximize tax deferral by buying ETFs in taxable that I plan to hold for decades (e.g., VTI), then building leverage around these core holdings. For example, the taxable account might hold 95% VTI, 5% cash, and an ultra bond future (~30x leverage).
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Re: Lifecycle Investing - Leveraging when young
Yes, we are seeing a lot of interest in leverage and risk parity these days. Suggests cash might not be such a bad asset class to overweight.
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Re: Lifecycle Investing - Leveraging when young
Here is the irony. The people who have reliable incomes uncorrelated with the stock market probably took those jobs because of their conservative financial attitudes. Government, academic jobs come to mind first.305pelusa wrote: ↑Sat Mar 02, 2019 3:29 pm @packer16: Yes, the nature of the human capital is very relevant. I would argue it's more than just the correlation to the stock market; if the salary is in some way inconsistent or unreliable, I would say that should be taken into account. The strategy seems like a good fit for salaries that are uncorrelated with the market and reliable.
These are also the people least likely to be leveraging anything in their investment portfolio.
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Re: Lifecycle Investing - Leveraging when young
Makes sense. Specific to the Hedgefundie 3x leveraged ETF strategy one thought I had recently was that a time-based rebalance allows large momentum driven deviations to materialize while ensuring that SOME rebalancing happens during less volatile (or at-least lower magnitude) times. This allows you to capture large rebalance bonuses and also small ones during those range-bound periods, which could help to offset volatility drag. A combination of these may be best (time-based plus a large absolute delta). For now I am happy with the quarterly approach.market timer wrote: ↑Sat Mar 02, 2019 7:51 pmOptimizing backtesting results strikes me as overfitting.MotoTrojan wrote: ↑Sat Mar 02, 2019 12:51 pmCurious what deviation would target a rebalance? I am doing quarterly rebalances as well but was debating doing monthly contributions using M1, which would automatically do this to balance target AA.market timer wrote: ↑Fri Mar 01, 2019 11:28 pm
For small accounts (<$100K), the leveraged ETF approach makes sense. I believe HEDGEFUNDIE is doing quarterly rebalancing, though I'd recommend rebalancing based on deviations from target AA and with new contributions, rather than a time-based approach.
Nobody seems to have found a good target point for rebalancing that beats quarterly in backtesting, peculiar indeed.
I haven't put together a spreadsheet to optimize for the various complications: taxes, attention, trading fees, etc. In terms of general guidelines, I would:
1. Direct new contributions to the asset class most below target.
2. Have % rebalancing bands, similar to what many already use here, which would force a sale and purchase.
3. To the extent possible, use retirement accounts for rebalancing purposes, which could lead to very different allocations between retirement and taxable.
4. Try to maximize tax deferral by buying ETFs in taxable that I plan to hold for decades (e.g., VTI), then building leverage around these core holdings. For example, the taxable account might hold 95% VTI, 5% cash, and an ultra bond future (~30x leverage).
Also fwiw taxes and trading fees aren't an issue for my setup, and attention favors the time-based approach. I do agree with the new contributions idea but that will be short-lived as I don't plan to continue contributing to this side-portfolio forever.
Thanks for the input!
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Re: Lifecycle Investing - Leveraging when young
Yes, the core audience for this strategy is really investors approaching middle age, say 20-40% toward their ultimate net worth target. It's not people just starting out with under 10% saved. Leveraging a small portfolio 2:1 is not going to change much.305pelusa wrote: ↑Sat Mar 02, 2019 3:29 pmRegardless, the strategy does not just apply to youth. If you're 45 and will plan to work for another 15+ years, it's likely you would be recommended to use a much larger percentage of stocks than typically recommended to diversify effectively across time. Hopefully the number of 45 year olds with credit card debt is lower than 25 year olds, so it might be even more applicable to those populations.
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Re: Lifecycle Investing - Leveraging when young
That he was very intelligent doesn't mean he fully took the time to read/understand the paper. He was in his 90s and surely a busy fella. That he brought it up himself instead of being asked about it also doesn't convince me.bobcat2 wrote: ↑Sat Mar 02, 2019 7:46 pm Hi 305pelusa,
I doubt very much if Paul Samuelson, one of the greatest economists of all time, misunderstood what Ayes and Nalebuff wrote. He simply disagreed with it. After all Samuelson wasn’t asked about it at the conference, but instead he brought it up as a classic example of poor financial reasoning that comes back every time there is an extended bull market.
What does convince me a bit is that the authors say they corresponded with Samuelson, who admitted had only read the abstract. Additionally, in the past, Samuelson wrote in one of his papers:
"[The businessman] can look forward to a high salary in the future; and with so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary for the purpose, or accomplishing the same thing by selecting volatile stocks that widows shun."
You can read more about the story here:
http://freakonomics.com/2010/07/06/did- ... investing/
Either way, I don't think there's much point speculating in what Samuelson truly meant. I'm sure you'll find many other econ professors who oppose the strategy as well.
I agree with a few of these. I believe the loans depend on the rates. Credit card rates tend to be much higher, so you'll effectively get more bang for your buck by paying them off than investing in the market. I don't know what car/lease loans go for these days but as long as they're lower than the cost to borrow on margin/implied interest of LEAPS, then I don't see why you couldn't lifecycle while having those on the side.bobcat2 wrote: ↑Sat Mar 02, 2019 7:46 pm For a young person to reasonably leverage their assets would require that she has no student debt, no credit card or other consumer debt such as car loan or lease, very stable employment such as tenured professor, physician, or law partner, employment not correlated with financial markets, and that she be very knowledgeable about financial markets and investing. The percentage of young investors that fit that leverage profile would appear to be less than 1% of the population of adults no older than their early thirties.
Once again, I have absolutely no clue what percentage of people fit the criteria. But as mentioned before, whether many or few people are "cleared" to follow the strategy has no bearing on how effective the strategy is for those that meet the requirements.
To be frank, the biggest reason I think that would "deny" you of this strategy is probably behavioral (what authors refer as "fear to lose money"). Finding people who can handle 100% equites, let alone 200%, is most likely the biggest filter in my opinion. It's interesting you don't even mention this factor; I think it's the most important and hardest to gauge one.
This makes sense but I'm afraid I've missed your point. If you're simply recapping the advice to make sure I follow it, then it makes sense to me. But perhaps you meant something else with this paragraph so let me know if I've missed something here.bobcat2 wrote: ↑Sat Mar 02, 2019 7:46 pm By the ages of 45-50 lifecycle finance calls for a smaller percentage of the portfolio to be invested in stocks than is conventionally recommended because the human capital portion of the investor’s wealth is so much smaller than it was when they were younger. For many investors around age 30 the relevant portion of their human capital devoted to retirement income dwarfs their financial wealth, but by their late 40’s financial wealth is likely much greater than their rapidly diminishing remaining safe human capital. You should be able to grasp this important aspect of lifecycle finance since you believe "human capital is very relevant".
Thank you for your comments
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young
I had somehow missed this comment. What exactly is a 120/180 leverage? You're buying bonds with the loaned money?MotoTrojan wrote: ↑Sat Mar 02, 2019 12:53 pmI am 100/0 in unleveraged and 120/180 in leveraged. Depending on how the decline occurs a 3x daily rebalanced equity fund may actually drop less than a 3x a standard equity fund. Feel free to check in with me.
Also, I believe daily rebalancing helps if the market continues to go down or up. It's the up-then-down that deliver lower returns. So I guess in this light, it's more about picking your poison.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
Re: Lifecycle Investing - Leveraging when young
I've always been interested in leverage and have started a couple of threads on using the Kelley Criterion (aka the maximizing geometric mean). I've ordered the Ayres and Nalebuff book and look forward to reading it. I've contributed a bit to the Hedgefundie thread which I think is a very interesting idea. Some thoughts:
1) The benefits of leveraging are typically massively overstated. Averaged over the last 50 years, the optimal (in the geometric mean sense) leverage on the S&P is something like 1.5 This is making assumptions about reasonable borrow rates (1-month T-bill + 1). By doing that, instead of a long term real rate of return of 7, you can get up to 9.
If you leverage up stock/bond portfolio, you can do better ... higher leverage ratios are optimal (it seems to be 3 to 5 ish) and you can get one or two more percentage points of return.
2) We have had an extraordinary bull bond market for several decades .... there has been an extraordinary stock bull market going on (still?). Backtests based on the last 30 years or so (as Portfolio Visualizer does) gives a very rosy picture of leverage. I would proceed with extreme caution with results that depend heavily on especially the the bull bond market of the last few decades. Interest rates really can't fall much farther to keep getting those great returns on long term treasuries.
3) For implementation, borrowing costs are crucial. It seems that futures will allow you to borrow very close to the Libor rate over the time that the contract is in force. One e-mini 500 contract wields like 140,000 dollars right now. So if you wanted a leverage on 3 on stocks you need to come up with 47K. If you wanted say the optimal 1.5 leverage, you need to put in 93K. For my little portfolio, these are big contracts! The LEAPS seem to be much more appealing. One year Libor is 2.98% ... I thought NTropy's numbers were very interesting:
4) I respect the people working, investing, and trying to understand the 3x leveraged ETFs. My impression is that they are relatively expensive and have features that are not really desirable. The daily resets on the leverage while allowing for some compounding benefits also create losses in up-down sidewise moving markets. I personally just think there are too many moving parts to the strategy. Certainly the backtests over the last 30 years are impressive with this strategy.
1) The benefits of leveraging are typically massively overstated. Averaged over the last 50 years, the optimal (in the geometric mean sense) leverage on the S&P is something like 1.5 This is making assumptions about reasonable borrow rates (1-month T-bill + 1). By doing that, instead of a long term real rate of return of 7, you can get up to 9.
If you leverage up stock/bond portfolio, you can do better ... higher leverage ratios are optimal (it seems to be 3 to 5 ish) and you can get one or two more percentage points of return.
2) We have had an extraordinary bull bond market for several decades .... there has been an extraordinary stock bull market going on (still?). Backtests based on the last 30 years or so (as Portfolio Visualizer does) gives a very rosy picture of leverage. I would proceed with extreme caution with results that depend heavily on especially the the bull bond market of the last few decades. Interest rates really can't fall much farther to keep getting those great returns on long term treasuries.
3) For implementation, borrowing costs are crucial. It seems that futures will allow you to borrow very close to the Libor rate over the time that the contract is in force. One e-mini 500 contract wields like 140,000 dollars right now. So if you wanted a leverage on 3 on stocks you need to come up with 47K. If you wanted say the optimal 1.5 leverage, you need to put in 93K. For my little portfolio, these are big contracts! The LEAPS seem to be much more appealing. One year Libor is 2.98% ... I thought NTropy's numbers were very interesting:
To get 3.2% money is not paying much of a premium over a futures contract I wouldn't think ... and the smaller possible contract sizes gives you a chance to get your feet wet. I still don't feel comfortable with the idea of trying to leverage a bond/stock portfolio with options mainly because of the bond side. You get no dividends with a bond option. And if there are no dividends, you are basically speculating on interest rates. I'm not going to do that.NTropy wrote: ↑Sat Mar 02, 2019 7:56 am
One year ago I took the plunge and purchased LEAPS to move from 100% equity to 200%. I'm early in my career and have a relatively small portfolio size. I buy LEAPS that are 18 months from expiry, at about 75% ITM. To meet my AA I hold LEAPS options on SPY and EFA for US/International exposure, as well as ETFs for those markets plus emerging markets and Canada. One drawback of this method is the need to monitor the leverage as prices change; I track my total equity exposure monthly and buy/sell to stay close to 2x leverage. The first LEAPS I purchased expire later this month so I'll need to roll them over for another 18 months or so when that happens.
My last LEAPS purchase was around 3.2% implied interest, which is much better than what my broker offers in a margin account. In theory it should match the risk-free rate. In the book the authors mentioned futures and leveraged ETFs as other tools to achieve leverage which have been discussed above. I think I'm following Ayers and Nalebuff closer than most, and it looks like you have the same thing in mind. Let me know if you have questions about implementing the portfolio, as I found there are not many places online which discuss the book's strategy.
4) I respect the people working, investing, and trying to understand the 3x leveraged ETFs. My impression is that they are relatively expensive and have features that are not really desirable. The daily resets on the leverage while allowing for some compounding benefits also create losses in up-down sidewise moving markets. I personally just think there are too many moving parts to the strategy. Certainly the backtests over the last 30 years are impressive with this strategy.
Re: Lifecycle Investing - Leveraging when young
IMO, leveraging makes little sense if your asset allocation isn't 100% equities or you're investing in bonds. It's all about the borrowing rates and how much you can borrow and the liquidity risk you want to take. Just like the perennial question of whether you should pay off your mortgage or invest instead (or borrow from your home to invest), it's all about the rates, and whether the risk/benefit is worth it for you.
The basic way I see it is if you're using leverage, you're borrowing to invest, so in effect you're a bond seller. If you're a bond investor (i.e. part of your AA is bonds), you're a bond buyer. Being on both sides of the trade only make sense if you can arbitrage the interest rate to overcome any trading fees. (And if you can successfully do that, you should just stick to trading/hedging bonds and scale up to the max without the added risk of equities)
OP, how do you intend to leverage, and what is your borrowing cost and capacity? Where can you beat 3-4% margin up to 50% (at Interactive Brokers) or 2X leverage for stocks? How will you deal with margin calls that could force you to sell low?
Using Options and Futures carries their own risks and costs, and managing them over turbulent periods can be challenging. Over the long run, if you can borrow at a lower rate than the return of your investment, and you can remain solvent, you will come out ahead. You just need to find a path that doesn't dead end, which is a big danger of using too much leverage. (I think even a 1.5X leverage of SP500 could have resulted in a margin call in 2008?)
The basic way I see it is if you're using leverage, you're borrowing to invest, so in effect you're a bond seller. If you're a bond investor (i.e. part of your AA is bonds), you're a bond buyer. Being on both sides of the trade only make sense if you can arbitrage the interest rate to overcome any trading fees. (And if you can successfully do that, you should just stick to trading/hedging bonds and scale up to the max without the added risk of equities)
OP, how do you intend to leverage, and what is your borrowing cost and capacity? Where can you beat 3-4% margin up to 50% (at Interactive Brokers) or 2X leverage for stocks? How will you deal with margin calls that could force you to sell low?
I'm not sure what all this refers to, but a 2% annual difference over 50 years is a 100% or doubling in end result. If you're able to leverage a 1.5X SP500 that returns 7% over 50 years, you'd be getting 10.5% return, so the borrowing rate is about 1.5% similar to the up to 2% gains from leveraging (compounding will alters this simple math). What AA would you be leveraging 3-5X? IMO, there's no point in leveraging a 20/80 AA 5X and paying for all those borrowing costs when you can simply invest in a 100/0 AA and likely do better.pezblanco wrote: ↑Sun Mar 03, 2019 10:47 am1) The benefits of leveraging are typically massively overstated. Averaged over the last 50 years, the optimal (in the geometric mean sense) leverage on the S&P is something like 1.5 This is making assumptions about reasonable borrow rates (1-month T-bill + 1). By doing that, instead of a long term real rate of return of 7, you can get up to 9.
If you leverage up stock/bond portfolio, you can do better ... higher leverage ratios are optimal (it seems to be 3 to 5 ish) and you can get one or two more percentage points of return.
Using Options and Futures carries their own risks and costs, and managing them over turbulent periods can be challenging. Over the long run, if you can borrow at a lower rate than the return of your investment, and you can remain solvent, you will come out ahead. You just need to find a path that doesn't dead end, which is a big danger of using too much leverage. (I think even a 1.5X leverage of SP500 could have resulted in a margin call in 2008?)
Last edited by inbox788 on Sun Mar 03, 2019 12:40 pm, edited 1 time in total.
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Re: Lifecycle Investing - Leveraging when young
120/180 is a 40/60 equity/bond portfolio levered up 3x on both sides. I am not borrowing money.305pelusa wrote: ↑Sun Mar 03, 2019 8:46 amI had somehow missed this comment. What exactly is a 120/180 leverage? You're buying bonds with the loaned money?MotoTrojan wrote: ↑Sat Mar 02, 2019 12:53 pmI am 100/0 in unleveraged and 120/180 in leveraged. Depending on how the decline occurs a 3x daily rebalanced equity fund may actually drop less than a 3x a standard equity fund. Feel free to check in with me.
Also, I believe daily rebalancing helps if the market continues to go down or up. It's the up-then-down that deliver lower returns. So I guess in this light, it's more about picking your poison.
Re: Lifecycle Investing - Leveraging when young
How are you able to implement this? What is the cost? A 3X ETF? Doesn't return 3X underlying after fees. Implicitly, you're borrowing somewhere.MotoTrojan wrote: ↑Sun Mar 03, 2019 12:39 pm120/180 is a 40/60 equity/bond portfolio levered up 3x on both sides. I am not borrowing money.
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Re: Lifecycle Investing - Leveraging when young
viewtopic.php?f=10&t=272007inbox788 wrote: ↑Sun Mar 03, 2019 12:41 pmHow are you able to implement this? What is the cost? A 3X ETF? Doesn't return 3X underlying after fees. Implicitly, you're borrowing somewhere.MotoTrojan wrote: ↑Sun Mar 03, 2019 12:39 pm120/180 is a 40/60 equity/bond portfolio levered up 3x on both sides. I am not borrowing money.
The ETF is borrowing at 1-month libor, correct. Depends on the period but since inception I believe UPRO has returned >5x it's underlying index thanks to compounded daily returns (but it can also do worse than 1x the underlying in other flatter periods).
Re: Lifecycle Investing - Leveraging when young
I don't quite follow what you're saying. I'm not saying you're wrong. I just don't follow it completely. Calculating the average returns from leverage is not just a simple scaling of the average unleveraged returns, right? Volatility matters a lot! The optimal AA for leveraging 3-5x is something between 40/60 and 50/50 ... There are lots of assumptions here (check my thread on leveraging stock/bond portfolios and the Kelly criterion). Basically, what you're missing here is that the bond parts of the portfolio are assumed to be long term treasuries .... borrow rates are based on short term instruments .... so you're "not just borrowing at the bond rate, to leverage and buy at the bond rate". Diversifying a portfolio (even a leveraged one) brings about a lot of benefits ....inbox788 wrote: ↑Sun Mar 03, 2019 12:35 pmI'm not sure what all this refers to, but a 2% annual difference over 50 years is a 100% or doubling in end result. If you're able to leverage a 1.5X SP500 that returns 7% over 50 years, you'd be getting 10.5% return, so the borrowing rate is about 1.5% similar to the up to 2% gains from leveraging (compounding will alters this simple math). What AA would you be leveraging 3-5X? IMO, there's no point in leveraging a 20/80 AA 5X and paying for all those borrowing costs when you can simply invest in a 100/0 AA and likely do better.pezblanco wrote: ↑Sun Mar 03, 2019 10:47 am1) The benefits of leveraging are typically massively overstated. Averaged over the last 50 years, the optimal (in the geometric mean sense) leverage on the S&P is something like 1.5 This is making assumptions about reasonable borrow rates (1-month T-bill + 1). By doing that, instead of a long term real rate of return of 7, you can get up to 9.
If you leverage up stock/bond portfolio, you can do better ... higher leverage ratios are optimal (it seems to be 3 to 5 ish) and you can get one or two more percentage points of return.
Re: Lifecycle Investing - Leveraging when young
The total return looks impressive, but annualized returns 1 and 5 years are only 2.6X and 2.2X. To me, that's one of the hidden costs. Another is SPXU (ProShares UltraPro Short S&P500), which you may avoid, but the short sell has paid for it. I'm not sure how they're achieving their daily 3X goal, especially when the complement funds aren't balancing out, but besides the heavily active daily management cost, they have to take the extra 2% from somewhere whenever the index moves 1%. With 50% margin, you might be able to leverage up to 2X more cheaply by paying margin interest rates and a low cost SP500 index.MotoTrojan wrote: ↑Sun Mar 03, 2019 1:19 pmviewtopic.php?f=10&t=272007inbox788 wrote: ↑Sun Mar 03, 2019 12:41 pmHow are you able to implement this? What is the cost? A 3X ETF? Doesn't return 3X underlying after fees. Implicitly, you're borrowing somewhere.MotoTrojan wrote: ↑Sun Mar 03, 2019 12:39 pm120/180 is a 40/60 equity/bond portfolio levered up 3x on both sides. I am not borrowing money.
The ETF is borrowing at 1-month libor, correct. Depends on the period but since inception I believe UPRO has returned >5x it's underlying index thanks to compounded daily returns (but it can also do worse than 1x the underlying in other flatter periods).
https://www.etf.com/UPROPERFORMANCE [as of 02/28/19] 1 MONTH 3 MONTHS YTD 1 YEAR 3 YEARS 5 YEARS 10 YEARS
UPRO 9.28% -0.15% 35.39% -0.85% 39.76% 23.98% --
UPRO (NAV) 9.19% -0.68% 35.47% -0.93% 39.55% 23.95% --
S&P 500 3.21% 1.42% 11.48% 4.68% 15.28% 10.68%
Re: Lifecycle Investing - Leveraging when young
I'm oversimplifying the complexity, which I'm sure introduces lots of errors, but the gist my argument is that the whole is the sum of the parts. When you borrow to invest in a stock/bond portfolio, you're doing 3 things.pezblanco wrote: ↑Sun Mar 03, 2019 1:25 pmI don't quite follow what you're saying. I'm not saying you're wrong. I just don't follow it completely. Calculating the average returns from leverage is not just a simple scaling of the average unleveraged returns, right? Volatility matters a lot! The optimal AA for leveraging 3-5x is something between 40/60 and 50/50 ... There are lots of assumptions here (check my thread on leveraging stock/bond portfolios and the Kelly criterion). Basically, what you're missing here is that the bond parts of the portfolio are assumed to be long term treasuries .... borrow rates are based on short term instruments .... so you're "not just borrowing at the bond rate, to leverage and buy at the bond rate". Diversifying a portfolio (even a leveraged one) brings about a lot of benefits ....
1) You're investing in equities
2) You're in bonds
3) You're rebalancing and diversifying
My premise is #1 is the major factor and you shouldn't bother with bonds. If the SP went up 10% and your 50/50 AA portfolio leveraged 4X went up 20%, how much is attributable to what component? Would you expect much different from 20%?
There may be minor contributions from bonds or diversification and rebalancing, but to me, they confuse heart of the matter.
As far as #2, if you're borrowing short term bonds and investing long term, you're basically in the same boat as the banks. What will happen when the yield curve inverts? One may ask, is this a good investment, risk/return, as a stand alone investment and how does it compare to other investment options? Why not borrow at short term interest and invest in long term treasury bonds?
Re: Lifecycle Investing - Leveraging when young
As I said before, volatility matters a lot. A stock/bond mix allows for a lowering a volatility and thus more leverage which actually gives you a greater long term geometric mean than just leveraging a stock fund alone. This is counterintuitive but true.inbox788 wrote: ↑Sun Mar 03, 2019 3:03 pm
I'm oversimplifying the complexity, which I'm sure introduces lots of errors, but the gist my argument is that the whole is the sum of the parts. When you borrow to invest in a stock/bond portfolio, you're doing 3 things.
1) You're investing in equities
2) You're in bonds
3) You're rebalancing and diversifying
My premise is #1 is the major factor and you shouldn't bother with bonds. If the SP went up 10% and your 50/50 AA portfolio leveraged 4X went up 20%, how much is attributable to what component? Would you expect much different from 20%?
No, not at all. They are the heart of the matter.
inbox788 wrote: ↑Sun Mar 03, 2019 3:03 pm As far as #2, if you're borrowing short term bonds and investing long term, you're basically in the same boat as the banks. What will happen when the yield curve inverts? One may ask, is this a good investment, risk/return, as a stand alone investment and how does it compare to other investment options? Why not borrow at short term interest and invest in long term treasury bonds?
This is exactly what is being proposed for all of the leveraged stock/bond schemes.
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Re: Lifecycle Investing - Leveraging when young
Yes, I've read your analysis on the Kelly Criterion. To be completely honest (and I will admit I could be totally wrong and I accept that), I'm not quite sure I follow how the Kelly Criterion applies to leveraging stocks. Many assumptions seem to be key in the Kelly game that aren't in stocks.
The Kelly Criterion arises from a coin flip game where when you lose, you lose the entire bet. When you win, you get some extra over your bet. If the game was to be played infinitely, the correct strategy is to bet p-q fraction of your wealth on every flip (p being chances of a win while q are chances of a loss).
Investing in the stock market isn't an infinite number of bets; I only live so many years. I also don't lose the entire quantity on bad years. Nor am I assured a certain payoff on good years. All in all, I can only presume a lot of the the Kelly Criterion boils down to a very simple answer precisely due to many of these simplifying assumptions.
People come up with the 1.17 or 1.5 leverage number from backtesting. That's another reason it's unconvincing to me. I don't want to base a strategy based on what worked best, using a theoretical game that I'm unsure really applies. Again, I will admit right now, it's just my intial impression.
What I CAN say is that given a game with 50 independent coin tosses where you don't know the odds or payoffs of any of them, the game that minimizes the standard deviation of results is one where you bet the same amount on every coin toss. So I want to do that. That might mean I leverage 2:1 when young, 1.5:1 when older, and use no leverage at all when close to retirement.
It'll be a family loan. We settled on 3.2% and it's not callable. This gives me the option to leverage further (although I think I will stick to 2:1) while still not selling during a market downturn.
We started with 30k, which gives me 1.25:1 leverage, just to get things started little by little (no rush here). But in the near future, I will try to increase that. For now, I'm still deciding whether to truly go for it or not.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
Re: Lifecycle Investing - Leveraging when young
I believe that out of the people here who actually hold some sort of leveraged position, mine is among the most conservative.
I understand the basic argument that a secure future income stream should be considered when deciding on investments. The problem, as many posters (and paul samuelson) have pointed out, is that a leveraged investment in a brokerage account comes with a risk of ruin. The only way to (mostly) avoid this is to keep a constant leverage ratio, selling into losses and buying into gains... but you don't want to have to sell when the market crashes, if your whole justification for holding the position in the first place is that your future income stream makes it the right position to hold.
It seems like the fundamental problem is that positions in a brokerage account (futures, options, leveraged etfs) do not accept your future income stream as collateral, and so will close you out if there are large losses, even if you could actually pay them off from your future income.
There is a leveraged investment that effectively uses your future income as collateral. One of my friends (with a government job) bought a multifamily apartment building and lived in one of the units. In a real estate crash, the bank does not go back and check the market value of the building and foreclose if it is too low. As long as you can make the mortgage payments out of your income you are safe. In his case he could cover the mortgage even if the other units were empty.
Basically, it seems to me that if you want to invest based on your future income, you need to get the type of loan that considers (and hopefully verifies!) that income.
I understand the basic argument that a secure future income stream should be considered when deciding on investments. The problem, as many posters (and paul samuelson) have pointed out, is that a leveraged investment in a brokerage account comes with a risk of ruin. The only way to (mostly) avoid this is to keep a constant leverage ratio, selling into losses and buying into gains... but you don't want to have to sell when the market crashes, if your whole justification for holding the position in the first place is that your future income stream makes it the right position to hold.
It seems like the fundamental problem is that positions in a brokerage account (futures, options, leveraged etfs) do not accept your future income stream as collateral, and so will close you out if there are large losses, even if you could actually pay them off from your future income.
There is a leveraged investment that effectively uses your future income as collateral. One of my friends (with a government job) bought a multifamily apartment building and lived in one of the units. In a real estate crash, the bank does not go back and check the market value of the building and foreclose if it is too low. As long as you can make the mortgage payments out of your income you are safe. In his case he could cover the mortgage even if the other units were empty.
Basically, it seems to me that if you want to invest based on your future income, you need to get the type of loan that considers (and hopefully verifies!) that income.
Re: Lifecycle Investing - Leveraging when young
How long is the duration of the loan? You've got a rate (3.2%) that is slightly lower than the current market rate, with the added benefit it appears to be a fixed rate vs. 3-4% variable margin rate. Borrowing at bond rates (3%) to invest in stock returns (6%) is often a positive yielding endeavor, but carries risk. Having the security of a fixed rate is that much more reason to do it, especially if you can tolerate the illiquidity risk. Also, what happens is rates drop? Are you stuck with the rate or can you refinance/recast?305pelusa wrote: ↑Sun Mar 03, 2019 5:34 pmIt'll be a family loan. We settled on 3.2% and it's not callable. This gives me the option to leverage further (although I think I will stick to 2:1) while still not selling during a market downturn.
We started with 30k, which gives me 1.25:1 leverage, just to get things started little by little (no rush here). But in the near future, I will try to increase that. For now, I'm still deciding whether to truly go for it or not.
I ask the question in isolation, not as part of a package where the sum of the parts is greater than the whole. I think the sum of the parts is equal to the whole, and each part can stand on it's own merit. One can evaluate each part and rank them in order of benefit and choose the one that the investor thinks gives him the best risk/reward. If you're only trading bonds, you can decide to stop or exit if the yield curve flattens or inverts. As part of a more complex package, that option isn't so clear.
One has limited capital to invest and I'm not convinced that a 100% equity portfolio is all that difference from a 2X leveraged 50/50 AA, and the stock and bond portions can largely be viewed independently. [Not sure how to model this in portfolio visualizer. Tried 50% ULPIX vs 100% VFINX and the rest CASHX or 25% ULPIX/50% VFINX, but something still seems wrong. Is there a suitable proxy fund for borrowing rate?]
Anyway, I view leveraging as an AA question, and investing in bonds vs stocks and either or question, not both. YMMV.
I've come across the number 1.6 somewhere as the maximum historic survivable leverage ratio, also from backtesting, but don't recall where. As far as independent coin tosses, daily market fluctuations do appear to be independent, but I'm not convinced they truly are. After 5 or 15 straight up days in a row, do you really think the next day is independent? It's no fair coin or well balanced roulette wheel AFAIK.305pelusa wrote: ↑Sun Mar 03, 2019 5:34 pmPeople come up with the 1.17 or 1.5 leverage number from backtesting. That's another reason it's unconvincing to me. I don't want to base a strategy based on what worked best, using a theoretical game that I'm unsure really applies. Again, I will admit right now, it's just my intial impression.
What I CAN say is that given a game with 50 independent coin tosses where you don't know the odds or payoffs of any of them, the game that minimizes the standard deviation of results is one where you bet the same amount on every coin toss. So I want to do that. That might mean I leverage 2:1 when young, 1.5:1 when older, and use no leverage at all when close to retirement.
Last edited by inbox788 on Sun Mar 03, 2019 7:07 pm, edited 1 time in total.
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Re: Lifecycle Investing - Leveraging when young
LETFs are not subject to margin call. You may lose a substantial amount of money, but you will never be "closed out".rhe wrote: ↑Sun Mar 03, 2019 5:43 pm It seems like the fundamental problem is that positions in a brokerage account (futures, options, leveraged etfs) do not accept your future income stream as collateral, and so will close you out if there are large losses, even if you could actually pay them off from your future income.
As for futures, maintenance margin on a S&P e-mini contract is only $6k, which is 4.3% of the full contract value (as of Friday). If you were leveraged 3:1, you would have $47k put up as collateral, and the S&P would have to fall 29% for you to get a margin call.
Re: Lifecycle Investing - Leveraging when young
I may have found a way to model or compare different strategies. Begin with $100k cash and only invest a portion to see the differences. In all cases, about $10k is invested in equities.
Portfolio 1 "borrow" $10k and invests $20k in 50/50 AA
Portfolio 2 invests $5k in 2X fund and $5k in BND
Portfolio 3 invests $10k in SP500
https://www.portfoliovisualizer.com/bac ... tion7_1=10
Portfolio 1 "borrow" $10k and invests $20k in 50/50 AA
Portfolio 2 invests $5k in 2X fund and $5k in BND
Portfolio 3 invests $10k in SP500
https://www.portfoliovisualizer.com/bac ... tion7_1=10
- market timer
- Posts: 6535
- Joined: Tue Aug 21, 2007 1:42 am
Re: Lifecycle Investing - Leveraging when young
Due to its historic association with the game of blackjack, where Ed Thorp famously applied the Kelly criterion to "Beat the Dealer," people often think of Kelly as useful only to bets. However, the concept of optimizing for geometric mean returns, equivalent to maximizing the expected value of the logarithm of wealth, can be applied over any probability distribution. A very good book on the history of this technique is Poundstone's Fortune's Formula. There are many applications outside of gambling/investing, such as signal processing and entropy.305pelusa wrote: ↑Sun Mar 03, 2019 5:34 pmYes, I've read your analysis on the Kelly Criterion. To be completely honest (and I will admit I could be totally wrong and I accept that), I'm not quite sure I follow how the Kelly Criterion applies to leveraging stocks. Many assumptions seem to be key in the Kelly game that aren't in stocks.
The Kelly Criterion arises from a coin flip game where when you lose, you lose the entire bet. When you win, you get some extra over your bet. If the game was to be played infinitely, the correct strategy is to bet p-q fraction of your wealth on every flip (p being chances of a win while q are chances of a loss).
Investing in the stock market isn't an infinite number of bets; I only live so many years. I also don't lose the entire quantity on bad years. Nor am I assured a certain payoff on good years. All in all, I can only presume a lot of the the Kelly Criterion boils down to a very simple answer precisely due to many of these simplifying assumptions.
One important condition for the application of Kelly is that the portfolio does not have any inflows or outflows (savings or withdrawals). Clearly, this is not the case with lifecycle investing, since we are generally either adding to the portfolio with savings or subtracting from it. Accumulating investors could apply more leverage than what is optimal under Kelly due to savings.
- Steve Reading
- Posts: 2959
- Joined: Fri Nov 16, 2018 9:20 pm
Re: Lifecycle Investing - Leveraging when young
It'll be 5 years of only interests and then 2-3 years to pay it off a la amortization way. As of now, the interest is fixed but we're both willing to change it as necessary so it's still a good deal for the both of us. Neither one is trying to take advantage of the other and we both fully trust each other. He's in retirement so this is basically a way for him to invest further in stocks through me. I keep all the risk and keep most of the premium.inbox788 wrote: ↑Sun Mar 03, 2019 7:00 pmHow long is the duration of the loan? You've got a rate (3.2%) that is slightly lower than the current market rate, with the added benefit it appears to be a fixed rate vs. 3-4% variable margin rate. Borrowing at bond rates (3%) to invest in stock returns (6%) is often a positive yielding endeavor, but carries risk. Having the security of a fixed rate is that much more reason to do it, especially if you can tolerate the illiquidity risk. Also, what happens is rates drop? Are you stuck with the rate or can you refinance/recast?305pelusa wrote: ↑Sun Mar 03, 2019 5:34 pmIt'll be a family loan. We settled on 3.2% and it's not callable. This gives me the option to leverage further (although I think I will stick to 2:1) while still not selling during a market downturn.
We started with 30k, which gives me 1.25:1 leverage, just to get things started little by little (no rush here). But in the near future, I will try to increase that. For now, I'm still deciding whether to truly go for it or not.
I can believe daily market fluctuations are not independent. But I have no way of determining that relationship. So the best I can do with the information I have is to treat it as a coin toss game.inbox788 wrote: ↑Sun Mar 03, 2019 7:00 pm I've come across the number 1.6 somewhere as the maximum historic survivable leverage ratio, also from backtesting, but don't recall where. As far as independent coin tosses, daily market fluctuations do appear to be independent, but I'm not convinced they truly are. After 5 or 15 straight up days in a row, do you really think the next day is independent? It's no fair coin or well balanced roulette wheel AFAIK.
Unlike a coin toss event, however, because they are not independent, it will be possible to look back after 50 years and realize my strategy was nowhere near ideal. I should've bet more on the 23th "toss" (a bull year) and less on the 24th "toss" (a bear year), had I known a bear year was much more likely after a bull (let's just say that's the dependence I learned in retrospect). This is in stark contrast to a coin game where regardless of the results after 50 tosses, if you were to look back at your strategy, you'd know betting uniformly was still ideal.
But I'm cool with that. I do the best with what I have and I know it won't be the ideal; but ideal is only possible to find in retrospect. That's my take.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
- Steve Reading
- Posts: 2959
- Joined: Fri Nov 16, 2018 9:20 pm
Re: Lifecycle Investing - Leveraging when young
Very interesting, especially that last sentence. I will check out the book. I like reading about this sort of thing and will admit know nowhere near enough of it to intelligently discuss it.market timer wrote: ↑Sun Mar 03, 2019 7:53 pmDue to its historic association with the game of blackjack, where Ed Thorp famously applied the Kelly criterion to "Beat the Dealer," people often think of Kelly as useful only to bets. However, the concept of optimizing for geometric mean returns, equivalent to maximizing the expected value of the logarithm of wealth, can be applied over any probability distribution. A very good book on the history of this technique is Poundstone's Fortune's Formula. There are many applications outside of gambling/investing, such as signal processing and entropy.305pelusa wrote: ↑Sun Mar 03, 2019 5:34 pmYes, I've read your analysis on the Kelly Criterion. To be completely honest (and I will admit I could be totally wrong and I accept that), I'm not quite sure I follow how the Kelly Criterion applies to leveraging stocks. Many assumptions seem to be key in the Kelly game that aren't in stocks.
The Kelly Criterion arises from a coin flip game where when you lose, you lose the entire bet. When you win, you get some extra over your bet. If the game was to be played infinitely, the correct strategy is to bet p-q fraction of your wealth on every flip (p being chances of a win while q are chances of a loss).
Investing in the stock market isn't an infinite number of bets; I only live so many years. I also don't lose the entire quantity on bad years. Nor am I assured a certain payoff on good years. All in all, I can only presume a lot of the the Kelly Criterion boils down to a very simple answer precisely due to many of these simplifying assumptions.
One important condition for the application of Kelly is that the portfolio does not have any inflows or outflows (savings or withdrawals). Clearly, this is not the case with lifecycle investing, since we are generally either adding to the portfolio with savings or subtracting from it. Accumulating investors could apply more leverage than what is optimal under Kelly due to savings.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson