A different approach to asset allocation

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A different approach to asset allocation

Postby market timer » Sun Sep 16, 2007 12:51 pm

Summary: Econ grad student applies Mortgage Your Retirement theory at the top of the last bull market, starting around 2x leverage, loses $210K of borrowed money, and is forced is to sell what's left of his portfolio at S&P 821 in November 2008. The complete wipeout results in a reflective period where he recollects the circumstances that led him to adopt this strategy, some of which will be included in a book. He spends five weeks in Asia and begins writing about how risk and progress can be framed. Returning to the US, he slashes his expenses, finds several ways to increase income, earns 914% on the IRBLTG Fund, and pays off all his high interest credit card debt. Net worth tracker continues to be updated.

Current equity exposure target: N/A
Net worth: -$2K

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"Fate does not always let you fix the tuition fee. She delivers the educational wallop and presents her own bill, knowing you have to pay it, no matter what the amount may be." -Jesse Livermore in Reminiscences of a Stock Operator

From September 16, 2007:

It is possible to improve on the traditional approach to asset allocation. By improve, I mean keep the same expected return with less risk.

I've read several pages of Q&A on this forum and it surprised me that nobody directly considers future savings in their asset allocation decision. Most analysis on this forum takes historical returns to asset classes as a reasonable estimate of the future, and then determines an asset allocation that has desirable risk-return characteristics for a single year. This is reasonable if your nest egg is very large relative to the size of future savings. It leads to inefficient risk taking, however, for those still in the accumulation phase.

For simplicity, suppose there is a risky asset (e.g., stocks) and a riskless asset (e.g., cash). The question is, how much to allocate to each asset class? Applying the logic of this forum, we would identify the efficient frontier, and somewhat arbitrarily determine an 80/20 or 60/40 allocation based on an acceptability of risk for a given year. Little thought is directly given to future savings. This would only minimize risk over time if exposure to the risky asset were constant in real dollars. I could prove this for you if it isn't obvious.

How many of us try to maintain constant equity exposure? Note that this naturally leads to a decreasing fraction of wealth in equities if we have positive savings. This conclusion provides a simple solution to the retirement investment decision: one should borrow as a lump sum enough money to fund retirement in expectation as early as possible, then spend the working years servicing this debt and eventually saving the remainder in cash/bonds once the debt is paid. This is my retirement plan. Clearly, the size of one's eventual estimated nest egg is ever changing (responding to promotions, job loss, etc.), so equity exposure will likewise vary. The key point is that risk bearing is dramatically smoothed over time under my plan.

FAQ

1. How much additional risk do I need to take today to benefit from this strategy?

If you have less stock market exposure today than you reasonably expect to have over the course of your investment career, you will benefit from any incremental increase in your market exposure that you transfer from the future to today. This is because there is an idiosyncratic risk to time just as there is an idiosyncratic risk to stocks. As a Boglehead, you don't hold a concentrated portfolio of individual stocks, so why do you intend to hold a concentrated portfolio in time, specifically the years 2025-2035? This is when most 20-somethings can expect to have their greatest equity exposure. Any transfer of risk from that time back to today is risk reducing in the long run. This is particularly true if the stock market returns are mean reverting, so that periods of strong performance are likely followed by underperformance. Our biggest risk could be a strong bull market over the next few years that inflates asset prices to a point where real returns are depressed during the 2015-2035 range.

2. Who is crazy enough to lend me money to invest in the stock market?

Consider any of the following: credit card promotional offers, student loans, HELOCs, and family. These lines of credit can further be levered via LEAPS at near risk-free tax-deductible interest. A good discussion of credit card promotions is at the FatWallet Forum (http://www.fatwallet.com/t/52/632935), where at least several dozen people have documented their experience borrowing up to several hundred thousand dollars at near 0% interest. A word of caution on using credit card debt: this cannot be considered a reliable source of borrowing over the long run, unless indicated in the Terms & Conditions as a "for life" offer. So you should only invest in the market with CC debt up to what you can expect to save in cash during the course of the promotion. Deep in the money LEAPS behave just like a margin loan at a favorable interest rate, without the risk of margin call.

3. Do I have to understand options to benefit from this strategy?

Options are an underutilized tool for most investors. There is the perception that they are especially risky or "not productive assets" (as one poster mentioned). In fact, many people with equity holdings could borrow at cheaper terms in the options market than is available through mortgages, but they are not aware of this option. You should learn the basics of options, even as a Boglehead. That said, using options is not a requirement to this strategy, but it helps.

4. What if I lose all my money? Won't I have to file for bankruptcy?

Let's consider an example. Suppose you've just started working, have a net worth of $20K, decide to invest $100K through lines of credit you've obtained, and the market falls 20%. You will have lost your entire net worth, and this is certainly unfortunate. But the proper way to view this situation is that you have really lost $20K, which is not such a large amount of money in relation to your future retirement portfolio. Assuming you were not counting on tapping into your retirement funds for 30-40 years, does it really matter that your net worth is $0 instead of $20K? Remember that these are investments that you plan to hold for a long time, so you have not realized any loss.

5. A Nobel Laureate says that it is best to use a [insert investment strategy here] strategy, and this has been proven using Monte Carlo analysis and/or utility theory. Why should I trust you?

You should carefully evaluate any investment recommendation. What are the assumptions? How representative are the data? Be aware that utility theory tends to prefer assumptions based on mathematical tractability over realism, and even the architects of modern finance theory have severe reservations about its applicability.

6. This all sounds rather vague. How can I actually implement this strategy?

Each person's financial conditions involve unique risks and opportunity. This is one reason why you should question a one-size-fits-all investment strategy like gradual contributions to an 80/20 or 100/0 asset allocation plan. I suggest starting with your expectations for future market exposure, current assets, and availability of credit. As a young investor on the Boglehead site, your conservative estimates for your average market exposure over your investment career likely exceed your current assets and availability of credit. If you want to be extremely conservative, how much do you expect to have invested in the stock market in 2-3 years under your current asset allocation plan? You should make it a goal to achieve that level of exposure in the near future using various credit lines and options. For some, this is as simple as reducing cash/bonds and increasing equities.

7. You suggest 100% equities. Is this on the Efficient Frontier?

I believe the Efficient Frontier can only be known in hindsight. If you have a strong belief that an allocation such as 80/20 is on the Efficient Frontier, you can construct a leveraged version of this by varying your leverage. Consider the equity exposure of a hypothetical 80/20 portfolio and base your equity exposure on some multiple of the equity exposure in this portfolio. A critical difference between my analysis and what's often described as being on the Efficient Frontier is that I incorporate future cash flows.
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Interesting but I think not

Postby grok87 » Sun Sep 16, 2007 2:18 pm

Market timer,
First I think some kudos are in order for bringing an interesting topic for discussion and thought.

But I would strongly advise against implementing your suggestion for most people. Most people are leveraged enough already with the purchase of a house (as the subprime crisis demonstrated I think).

I think your proposal comes down to monetizing future income before you earn it. What if you are laid off? What if you are permanently disabled and cannot work? Then this extra debt will sink you like a stone.

I think the old adage that you should have your age in bonds (many people now do age-10 in bonds, perhaps implicitly reflecting increased longevity) basically reflects the point you are perhaps making- that when you are old you have less future earnings and hence need to be more in bonds.

Anyway, just my two cents...
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Postby EmergDoc » Sun Sep 16, 2007 2:44 pm

Most people factor in their future working/income potential into their asset allocation when they consider their ability to take risk.

I think the main problem with your plan is costs (which we all know sink investment returns.) If you are servicing debt at 8% and only making 9%, you're not going to get very far.

Besides, consider how much money would go to servicing the debt. If I were to retire today, I'd want $2 Million. A 30 year $2 Million debt at the going rate, let's say 7%, would cost $13K per month. I can't come up with $13K per month, but I shouldn't have any problem at all hitting $2 Million in real dollars in 30 years.
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Re: Interesting but I think not

Postby market timer » Sun Sep 16, 2007 2:51 pm

grok87 wrote:
I think your proposal comes down to monetizing future income before you earn it.


This is exactly the point. Even conservative assumptions on future income can lead to large improvements in risk-return.

grok87 wrote:
I think the old adage that you should have your age in bonds . . . basically reflects the point you are perhaps making.


This is true as well. It is a rule of thumb, similar to the rule of 72. It works well as an approximation, but perhaps can be improved at the extremes. In particular, the rule of thumb breaks down for young investors, who will not take on nearly enough risk without a leveraged portfolio.

The amount of leverage might appear staggering for early investors. Many start with a negative net worth, so it isn't even clear how the allocation percentages should be expressed. But our capacity for risk, especially if single, is perhaps highest in these early years. Why should we squander this potential to bear risk on--at most--100% equity allocations? Rather, we should consider risk in dollar (not percentage) terms, and seek exposure--at a minimum--up to the amount that we can conservatively expect to average over our lifetimes.
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Postby market timer » Sun Sep 16, 2007 2:57 pm

EmergDoc wrote:
I think the main problem with your plan is costs (which we all know sink investment returns.) If you are servicing debt at 8% and only making 9%, you're not going to get very far.



Yes, it is clear that costs are an important consideration. As the cost of borrowing increases above the risk-free rate, one should reduce borrowing from the theoretical optimal level. Fortunately, LEAPS allow investors to achieve leverage at extremely competitive interest rates.

If you estimate a $2 million nest egg in 30 years, you would first need to calculate the average equity exposure you'll need over time to achieve this nest egg. Clearly, this amount will be less than $2 million, plus you have your currest savings, so you wouldn't need to borrow the full sum.
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Postby EmergDoc » Sun Sep 16, 2007 3:09 pm

Maybe I'm not understanding exactly what you're advocating. Can you dumb it down a bit for me using a concrete example.
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Postby market timer » Sun Sep 16, 2007 3:09 pm

EmergDoc wrote:I can't come up with $13K per month, but I shouldn't have any problem at all hitting $2 Million in real dollars in 30 years.


This is a cash flow problem. It is solved by effectively issuing zero coupon debt. Buying a LEAP is a way to implement this solution, since you are not required to make any interest payments.
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Postby market timer » Sun Sep 16, 2007 3:23 pm

EmergDoc wrote:Maybe I'm not understanding exactly what you're advocating. Can you dumb it down a bit for me using a concrete example.


No problem. Suppose you've recently graduated from med school, earned your first $10,000, and have no debt. What percentage should you invest in stocks? I'm saying that this decision should be based on how much you plan to invest over your lifetime. The goal should be to average your future exposure to equities. As a doctor, you can expect to accumulate several million dollars, and can conservatively expect to average several hundred thousand dollars of equity exposure each year. Therefore, you should borrow as much as you can at competitive interest rates to increase your equity exposure to several hundred thousand dollars. From an asset allocation perspective, this might result in 2000%/-1900% stocks/bonds, which might seem bizarre to some, but actually decreases risk over time. Your next $10K can be used to pay off debt.
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?

Postby TimDex » Sun Sep 16, 2007 3:33 pm

Hasn't this been already tried..??

I think it was called hedge funds, aka leveraged quant deals that blew up in everybody's face.

Leverage always looks good when you make just one initial assumption about future returns.

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Postby Easy Rhino » Sun Sep 16, 2007 3:33 pm

I also think I'm missing something. The main concern would be the cost of the debt for the leverage. It seems unrealistic to assume that Joe Average is going to be able to invest in any asset class that will have a reasonable change of exceeding the cost of whatever large amount of debt he could reasonably tap. It's just a problem of practicality.

If the debt was 0%, inflation rate, or risk-free-return rate, then it would seem more of a no brainer.
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Re: ?

Postby market timer » Sun Sep 16, 2007 3:37 pm

TimDex wrote:Hasn't this been already tried..??

I think it was called hedge funds, aka leveraged quant deals that blew up in everybody's face.

Leverage always looks good when you make just one initial assumption about future returns.

Tim


This is a problem of a margin call resulting in forced liquidation. There are many ways to achieve leverage, and not all expose the investor to the risk of forced liquidation. Buying LEAPS, for example, does not expose one to the risk of margin calls.
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Postby EmergDoc » Sun Sep 16, 2007 3:40 pm

Interesting concept. I believe it carries an assumption that risky assets will outperform risk-less instruments over my investing horizon, no? I'm not sure I'm willing to risk everything on that assumption.

The other issue is that a LEAP is an option. As I understand them, options are usually a negative-sum game. Fine for hedging with a smal portion of the portfolio, but not for the entire portfolio. I think the problem again comes down to costs eroding the return.
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Postby market timer » Sun Sep 16, 2007 3:43 pm

Easy Rhino wrote:If the debt was 0%, inflation rate, or risk-free-return rate, then it would seem more of a no brainer.


Most people have an aversion to borrowing, so they do not closely monitor their credit options. Moreover, the options market allows borrowing at interest rates that are close to the risk-free rate. I think borrowing is a critical aspect to investing, and have been able to achieve significant equity exposure without any savings.
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Postby market timer » Sun Sep 16, 2007 3:46 pm

EmergDoc wrote:Interesting concept. I believe it carries an assumption that risky assets will outperform risk-less instruments over my investing horizon, no? I'm not sure I'm willing to risk everything on that assumption.


No, the reason for leverage is to smooth risk taking over time. It requires no assumptions on the realized returns. Essentially, the logic boils down to it being better to risk $1 today and $1 tomorrow than it is to risk $2 tomorrow.

The other issue is that a LEAP is an option. As I understand them, options are usually a negative-sum game. Fine for hedging with a smal portion of the portfolio, but not for the entire portfolio. I think the problem again comes down to costs eroding the return.


By arbitrage, a deeply in the money LEAP has nearly the same payoff as if you'd bought the underlying security and sold a bond (i.e., bought the security at a very low, tax-deductible margin rate).
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Postby watchnerd » Sun Sep 16, 2007 3:51 pm

This might not be foolhardy if you are in an occupation that has virtually no chance of layoff and a steady income stream.

I, however, work in high tech startups, which are volatile. The income stream is also variable, depending upon if one has a good 'exit' or not.

There is no way I would make myself an indentured servant, or slave, to a huge debt note via such a structure. And I don't think I would sleep well at night with such a large obligation hanging over my head.
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Postby EmergDoc » Sun Sep 16, 2007 3:59 pm

How is this different than what the 2X S&P 500 funds are trying to do (rather unsuccessfully, I might add.)
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Postby market timer » Sun Sep 16, 2007 4:26 pm

watchnerd,

I don't know your exact circumstances (age, net worth, etc.), but I could imagine someone in tech startups benefitting from my plan. Imagine someone who has just graduated with an engineering degree from Stanford, and who decides to accept a startup job in Silicon Valley. This person has zero net worth but access to $100K in credit at 5% interest or less through various sources. How much should this person invest? The likelihood that a Stanford engineer will average equity investments over $100K in his lifetime seems extremely high, so I would suggest investing all $100K.
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Postby market timer » Sun Sep 16, 2007 4:33 pm

EmergDoc wrote:How is this different than what the 2X S&P 500 funds are trying to do (rather unsuccessfully, I might add.)


2x S&P 500 funds use a constant rate of leverage. This implies that they will buy stocks as the market rises and sell them as the market falls. When the market is volatile without direction, the 2x funds lose money due to this unsuccessful momentum trading.

The leverage I suggest is not constant. In fact, as the market rises, to maintain constant equity exposure, you are required to sell. As the market falls, you are required to buy more. LEAPS, as one method to obtain leverage, will act like an investment purchased on margin (without the risk of margin call). Therefore, your leverage increases as the market falls and decreases as the market rises for any particular LEAP.
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Going broke..

Postby craigr » Sun Sep 16, 2007 4:40 pm

Whenever you hear stories about people going completely broke with their investments it usually involves investing with borrowed money and/or leveraging. One of the fastest ways to lose everything you've saved is to invest with borrowed money.
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Re: Going broke..

Postby market timer » Sun Sep 16, 2007 4:48 pm

craigr wrote:Whenever you hear stories about people going completely broke with their investments it usually involves investing with borrowed money and/or leverage.


Your comment is relevant in that it typifies the innate distrust most people have of debt and leverage. For people unwilling to educate themselves about the risks in investing with borrowed money, perhaps it is best that they stick to commonly prescribed rules of thumb.

What I find ironic is that my suggested strategy is actually less risky than alternatives being defended, yet people focus on the use of leverage as somehow implying an unacceptable risk.
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Re: Going broke..

Postby craigr » Sun Sep 16, 2007 5:23 pm

market timer wrote:What I find ironic is that my suggested strategy is actually less risky than alternatives being defended, yet people focus on the use of leverage as somehow implying an unacceptable risk.


Using borrowed money to invest is not less risky. Borrowed money used for investing in any form always amplifies your risks. You take on the risk of the stock market and the risk you can't pay back the loan. The most likely scenario is that both show up at the same time: The stock market dives, you lose your job and can't service the loan and have to sell your depressed shares to keep up on the payments. I'm sure there are many other unforeseen risks hidden as well.

Also you are making assumptions of future stock market performance as part of the plan. However history has shown that equity performance is not predictable nor guaranteed.

I think what you are proposing is interesting, but using borrowed money for investing always involves significant risks even if they aren't readily apparent.

Just my opinion...
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Re: Going broke..

Postby market timer » Sun Sep 16, 2007 5:46 pm

craigr wrote:Using borrowed money to invest is not less risky. Borrowed money used for investing in any form always amplifies your risks. You take on the risk of the stock market and the risk you can't pay back the loan. The most likely scenario is that both show up at the same time: The stock market dives, you lose your job and can't service the loan and have to sell your depressed shares to keep up on the payments.


Just as modern portfolio theory shows you can reduce portfolio risk by adding riskier assets (such as emerging markets), so too am I showing that you can reduce portfolio risk (over time) by adding exposure/risk (via leverage) early and subtracting exposure/risk later. This philosophy really is consistent with having a diversified portfolio, only I'm suggesting intertertemporal diversification. Clearly, the correlation between the S&P's returns today and tomorrow is less than 1. Longer term, if market returns exhibit mean reversion, as some evidence suggests, the intertemporal diversification benefits will be large.

As I've said, one can benefit from this strategy even with conservative expectations over future income. I think the people who would benefit most from my strategy are young and have large investments in human capital. How much equity exposure can a newly minted MD conservatively expect to average over his life? Even in a very bad lifetime scenario, $200K seems absurdly low, yet that is still far more equity exposure than any med student I know.

Also you are making assumptions of future stock market performance as part of the plan. However history has shown that equity performance is not predictable nor guaranteed.



This is a similar point to what EmergDoc mentioned. In fact, I'm not assuming that equity returns will exceed the risk-free return. The argument is that one should try to keep equity exposure constant in real dollars over one's lifetime. There is a "free lunch" for intertemporal diversification, where you effectively take on risk today that you would have taken on anyhow tomorrow.
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Postby watchnerd » Sun Sep 16, 2007 5:53 pm

market timer wrote:watchnerd,

I don't know your exact circumstances (age, net worth, etc.), but I could imagine someone in tech startups benefitting from my plan. Imagine someone who has just graduated with an engineering degree from Stanford, and who decides to accept a startup job in Silicon Valley. This person has zero net worth but access to $100K in credit at 5% interest or less through various sources. How much should this person invest? The likelihood that a Stanford engineer will average equity investments over $100K in his lifetime seems extremely high, so I would suggest investing all $100K.


Well, I'm 37 and have a degree from Stanford, so I fit the scenario, or at least did when I was younger.

Why would someone working tech startups follow this at all when a) working in tech startups carries enough risk already and b) the rewards can be much greater from stock options?

I prefer to take my risks on the 'career side' of my port. I've done far better with stock options and startup liquidity events than I would have ever done investing $100k into the market [Note: I do invest in the market, but mainly for retirement purposes, which I've never tapped]. And I've felt capable of taking on risky startup jobs because I have 0 debt and a very large emergency fund.

P.S. This is very hypothetical: At age 22, nobody would have lent me $100k of unsecured credit, Stanford degree or not. Heck, I didn't get my first car loan until I was 29. Plenty of Ivy League grads choose other paths in life than being financially successful.
Last edited by watchnerd on Sun Sep 16, 2007 7:03 pm, edited 3 times in total.
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Postby watchnerd » Sun Sep 16, 2007 6:03 pm

Another point is psychological:

At age 22 I was a terrible investor. I bought individual stocks and traded too often. In all likelihood, I would have made terrible choices and wasted a good chunk of the money. Earning my nest egg slowly, and losing some along the way, has been far better, in the long run, than if someone had made a large sum available.

Additionally, I didn't know what career I wanted when I was 22, and I'm glad I didn't have some $100k loan forcing me to pick something lucrative fast, rather than finding my own way to what I enjoy. I can't put a price on enjoying my work.
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Postby stratton » Sun Sep 16, 2007 6:05 pm

This sounds like Bridgewater's All Weather Portfolio where they try to lever up certain assets and deleverage others so they have a smooth volatility level. See Engineering Targeted Returns and Risks. See Chart 1 and the paragraphs following it on page 2.

Paul
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Postby stebul » Sun Sep 16, 2007 6:09 pm

market timer,

I think you have made a good theoretical argument, but I'm not sure how to turn it into something practical? Most 30 year olds can't walk out and get an unsecured credit line for $100-250K. Tapping into HELOC's isn't going to work for many people these days. You can't margin an IRA or 401K, which is where most young people have their investments. One year, zero interest offers on credit card advances won't cut it.
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Postby market timer » Sun Sep 16, 2007 6:23 pm

watchnerd,

My aim is to show that people fail to diversify optimally intertemporally. You are taking on more risk now in dollar terms than you were 15, 10, and probably 5 years ago. The correlations between these returns are likely rather low, so the onus is on you to explain why you didn't diversify over time. You would have had the same expected return with less risk. Most consider this a winning proposition.

But then you bring liquidity into the mix. Perhaps you are randomly presented with outstanding investment opportunities. To get your attention, these would have to have better risk-return profiles than those offered by stocks. Without question, this is good news, as you can sell stocks or borrow more, invest in the new investment opportunity, and have a higher expected returns. I am not suggesting that you buy illiquid securities.

You seem to create a false dichotomy between diversifying intertemporal risk in your portfolio and taking on risky jobs. If you truly would be unwilling to take a startup job with $100K in debt, then we would need to consider how much debt you could bear. My guess is that you were not being realistic in comparing the relative size of $100K to your future income stream.
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Postby market timer » Sun Sep 16, 2007 6:31 pm

stebul wrote:I think you have made a good theoretical argument, but I'm not sure how to turn it into something practical? Most 30 year olds can't walk out and get an unsecured credit line for $100-250K.


It doesn't take the full credit line to get started. Someone could borrow $20K, invest it in LEAPS leveraged 5:1, and have $100K equity exposure at a competitive interest rate. There are many potential sources of credit, such as student loans, HELOC, or even family members.

Also, regarding retirement accounts, it is possible to buy options in an IRA.
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Postby larryswedroe » Sun Sep 16, 2007 6:41 pm

market timer-dont have time to read the whole thread but one should take their labor capital into account when deciding on their asset allocation. Of course one should consider how it correlates with the economic cycle risks of stocks, and even greater economic cycle risks of size and value. This is point I have made often.
The more stable the job (less correlated with equity type risks) the more ability one has to take risk, and vice versa.
Also the longer the period of expected employment the more one can take risks.
But labor capital also has risks--like disability, death, etc. And those risks must be taken into account (via an well-thought-out risk management/insurance plan)
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Postby market timer » Sun Sep 16, 2007 6:44 pm

stratton wrote:This sounds like Bridgewater's All Weather Portfolio where they try to lever up certain assets and deleverage others so they have a smooth volatility level. See Engineering Targeted Returns and Risks. See Chart 1 and the paragraphs following it on page 2.

Paul


That is an interesting paper, Paul. It is similar to what I propose in that we both suggest employing a certain amount of leverage. If his paper is correct, then 100% equities is not on the efficient frontier. Ideally, my suggestion would be implemented with a portfolio taken from the efficient frontier, with overall portfolio leverage based on lifetime expected risk exposure and individual asset class leverage based on something like Bridgewater's suggestions.
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Postby watchnerd » Sun Sep 16, 2007 6:53 pm

market timer wrote:watchnerd,

My aim is to show that people fail to diversify optimally intertemporally. You are taking on more risk now in dollar terms than you were 15, 10, and probably 5 years ago. The correlations between these returns are likely rather low, so the onus is on you to explain why you didn't diversify over time. You would have had the same expected return with less risk. Most consider this a winning proposition.

But then you bring liquidity into the mix. Perhaps you are randomly presented with outstanding investment opportunities. To get your attention, these would have to have better risk-return profiles than those offered by stocks. Without question, this is good news, as you can sell stocks or borrow more, invest in the new investment opportunity, and have a higher expected returns. I am not suggesting that you buy illiquid securities.

You seem to create a false dichotomy between diversifying intertemporal risk in your portfolio and taking on risky jobs. If you truly would be unwilling to take a startup job with $100K in debt, then we would need to consider how much debt you could bear. My guess is that you were not being realistic in comparing the relative size of $100K to your future income stream.


market timer,

And you, in turn, are failing to realize that no creditor exists who would be willing to give a $100k unsecured line of credit to a 22 year old, or even a 37 year old with a good credit score, zero debt and very healthy six figure income....at least not at 5% interest.

I think it's safe to assume the average person, when career uncertainties, possible divorces, accidents, children, family emergencies, etc, are factored in, has about the same risk as a mid-grade junk bond. Call it BB. Possibly worse, but we'll be generous.

Searching through E*Trade's Bond Center for BB 20 year bonds, I get yields from 7.76% - 8.9%. Assuming the stock market yields 10% over the next 20 years (and many experts are saying one should expect less, given 'price to perfection' PEs), that's only 1.1%-2.24% return above the interest payment.

To put it into cash flow terms, let's assume I actually could get an unsecured loan today (splitting the difference on the BB rating) 8.33% for 20 years on $100,000. The monthly payments on that would be $857.09.

Now, that's $857.09 after taxes. In the 33% bracket, that's $1139 before taxes. Oh, and the investment returns have to get taxed, too.

Of course, instead, I could contribute the entire $1139 to a 401k and invest the entire proceeds tax free. And it can compound without taxes, too, over the years. And get risk-free 'free money' matching from my employer, too.

So if such a thing were to be available you'd need to compare the time value of money, assuming a lump sum at 8.33% over 20 plus years, including tax costs, vs. the usual tax-sheltered route with matching..

I eagerly await the calculations, but I suspect the lack of 5% funding damages the concept.
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Postby watchnerd » Sun Sep 16, 2007 6:58 pm

By the way, as an additional point, someone who had followed this scheme with a decade of investment returns from the 1930s or the 1970s would have been in a world of hurt given the poor stock market returns of those eras.

And if you had borrowed money at 1970s interest rates, even doubly so.
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Postby market timer » Sun Sep 16, 2007 7:02 pm

Larry,

Human capital is an important component of one's asset allocation. I agree that correlations between human capital and market risk should be analyzed in the context of one's investments.
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Postby market timer » Sun Sep 16, 2007 7:14 pm

watchnerd,

You bring up two points:

(1) There are limits to credit.
(2) Poor market performance is bad.

Regarding (1), I would not recommend borrowing at 8%. Fortunately, there are many borrowing options for people at lower rates: student loans, HELOCs, family, credit cards, etc. These credit lines can be levered through LEAPS at near risk-free, tax-deductible interest rates, thanks to arbitrage pricing. The amount that anyone borrows should clearly depend on the cost of borrowing.

Regarding (2), crashes are impossible to predict. This is one reason why I find it compelling to seek constant equity exposure over time. The flip-side to your hypothetical involves the unfortunate group who retires around or just after the 1973-74 bear market. It would have been far better for them to take more risk during the 50s and 60s, resulting in less exposure during the 70s. Unfortunately, we don't know ahead of time whether the market will tank when we are accumulating or when we are nearing distribution phase, so why not equate risk to the extent possible?
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Postby Dale_G » Sun Sep 16, 2007 7:35 pm

market timer wrote:

I mean keep the same expected return with less risk.


Ah, the classic free lunch. Maybe there is a Nobel prize hidden here.

May I suggest a modest improvement? The parents of a newborn sell a zero coupon bond maturing in 65 years and invest the proceeds in a diversified basket of equities. At age 65 the now mature child sells a small fraction of the equities to pay off the bond.

The result: wealth with zero effort, truly a free lunch.

All the parents have to do is to find some one to buy the zero coupon bond at a cheap enough rate.

BTW market timer, is your dissertation posted online. I might like to peruse it.

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Postby watchnerd » Sun Sep 16, 2007 7:43 pm

Dale_G wrote:
All the parents have to do is to find some one to buy the zero coupon bond at a cheap enough rate.


Oh, that's easy. We group them together and we take the children from high-achiever demographics and lump them in with the riskier kids from the bad side of the tracks.

We then have the whole mess given a nice 'weighted average' credit rating, slice it into tranches, and sell the resulting slices. We'll call it "LDO", Lifetime Debt Obligations and sell it to hedge funds, investment banks, and German money market funds. :wink:
Last edited by watchnerd on Sun Sep 16, 2007 7:44 pm, edited 1 time in total.
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Postby Ariel » Sun Sep 16, 2007 7:43 pm

market timer

I agree with others that this is an interesting thread. However, having investigated and traded in LEAP calls (sold against long stock positions), I question that they offer the inexpensive leverage you seem to suggest.

Having modeled, in a different context, the risk reward profile of stocks + cash versus LEAP calls + cash (with same equity exposure), I have been shocked, in fact, to see how expensive long-term index calls are under a dsitribution of market scenarios that capture the uncertainty yet promise of future returns.

So, rather than all this vague talk, I would like to see real-time quoted ask prices on one or ideally more LEAP equity-index call options that are highly liquid, the corresponding index quote and underlying dividend yield of the corresponding market, the range of index outcomes and the probailities you assign to them, and the resulting expected returns and deviations (given your probabilities).

I think you will have a very hard time beating a 40% stock, 60% cash portfolio with a probability distribution of future returns that most here could accept as reasonable. By "beating", you should have both higher expected return and lower uncertainty. (I, for one, would suggest your probability distribution should have historical variability coupled with lower expected future resturns given various considerations including low dividend yield at present and historical importance of yield to total returns.) And don't forget the lost dividends, and don't foregt the lost interest on the part of the cash that's invested in the LEAP calls! And use the ask price of the option, not the bid, although for simplicity you can ignore other trading costs. I'd suggest using the Vanguard Prime Money Market Fund rate, now 5.17% on a compounded basis, as the "safe" cash return, which I suggest you keep constant for simplicity sake.

I look forward to your analysis!
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Postby market timer » Sun Sep 16, 2007 7:44 pm

Dale_G wrote:market timer wrote:

I mean keep the same expected return with less risk.


Ah, the classic free lunch. Maybe there is a Nobel prize hidden here.


Was the work of Markowitz any more insightful?

May I suggest a modest improvement? The parents of a newborn sell a zero coupon bond maturing in 65 years and invest the proceeds in a diversified basket of equities. At age 65 the now mature child sells a small fraction of the equities to pay off the bond.


Ideally, the parents would lend the money directly (tax free?) from the cash portion of their portfolio, secured by their ability to rewrite their will.

BTW market timer, is your dissertation posted online. I might like to peruse it.


Not yet, unfortunately I have another two years of work. My dissertation is not related to any of this.
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Postby LH » Sun Sep 16, 2007 8:24 pm

market timer wrote:watchnerd,

I don't know your exact circumstances (age, net worth, etc.), but I could imagine someone in tech startups benefitting from my plan. Imagine someone who has just graduated with an engineering degree from Stanford, and who decides to accept a startup job in Silicon Valley. This person has zero net worth but access to $100K in credit at 5% interest or less through various sources. How much should this person invest? The likelihood that a Stanford engineer will average equity investments over $100K in his lifetime seems extremely high, so I would suggest investing all $100K.


I like these option topics.

So you buy 100K worth of 2 year leaps options tied to the sp500 with borrowed money at 5 percent(five seems cheap), and right after you buy them, the market tanks for 4 years straight.

Your 100K worth of LEAPS is then worth zero? you have a -100K(minus your interest costs as well) worth and no assets?

Sounds very risky. Is Bankruptcy how one funds the downside?
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Mathematically mostly correct, but practical problems

Postby grabiner » Sun Sep 16, 2007 9:07 pm

market timer wrote:How many of us try to maintain constant equity exposure? Note that this naturally leads to a decreasing fraction of wealth in equities if we have positive savings. This conclusion provides a simple solution to the retirement investment decision: one should borrow as a lump sum enough money to fund retirement in expectation as early as possible, then spend the working years servicing this debt and eventually saving the remainder in cash/bonds once the debt is paid.


This is mathematically mostly correct. If you are accumulating money starting at age 25, and want to optimize your portfolio at age 65, maintaining constant equity risk over all 40 years is the mathematically optimal way to do this.

The mathematical problem is that the future portfolio is uncertain for most investors. A government worker with civil service protection, or a tenured teacher or professor, with disability insurance, has a predictable future income stream. Almost any other investor has some investment risk in his future income stream; if a recession occurs, his future income is likely to fall along with his portfolio value.

However, there are multiple problems in practice. The first is that you cannot hold an optimal equity risk for much of your career; there is a limit to how much you can borrow on margin. And even if you can borrow at this limit now (or leverage implicitly, as by buying options), the market may prevent you from doing it in the future; if you have $600K in stock and $300K in margin debt, and the stock market loses 1/3 of your value, you will have a net worth of only $100K and will not be allowed to get back to $600K in stock in order to take advantage of the stock market's long-term gains.

In addition, you cannot borrow at the same rate as you can lend. The difference in returns between 90% and 100% stock is thus greater than the difference in returns between 100% and 110% stock; this may limit the mathematically optimal portfolio to 100% stock at all times. (Rather than going to 110% stock, many investors on this board have chosen to invest in riskier stock such as small-cap and emerging markets.)

Finally, there is the risk tolerance of individual investors, both psychological and practical. Few young investors are even prepared to stick with a 100% stock portfolio in a bear market, never mind a leveraged portfolio. And even if they would be willing to take the risk, they may not have the ability. An investor who was 200% stock at the 1973 peak would go bankrupt in 1974 if he didn't hit a margin call first.

What is left from the strategy is part of standard investment advice: young investors should have more stock than older investors, because they have less risk in their investments. If you are 80% stock but you have only saved half your retirement portfolio, a 25% decline will cost you only 10% of your retirement income. If you are 40% stock and are about to retire, a 25% decline will cost you the same 10%.
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Postby market timer » Sun Sep 16, 2007 9:51 pm

Ariel,

Consider the December 2008 SPY call with a 75 strike. The call premium is exactly $75 at the ask, and SPY currently trades at 148.90, so this option provides very nearly 2:1 leverage.

I'm going to compare the cost of buying this option and putting $73.90 into cash with buying SPY directly. The option will be held until it is exercised the day before SPY goes ex-div in mid December 2008. There will be an interest rate that makes an investor indifferent between these alternatives, which is the effective interest rate for the LEAP.

How much more does the SPY holder receive vs. the call holder? First, there are dividends, which can be invested in cash from the time they are paid until options expiration. There will be five such quarterly dividends paid, and I estimate their value in mid December 2008 will be approximately $3.43 per share. There is also the time premium on the call option. This is $1.10, found by subtracting the cost of SPY from the option premium + strike price. Therefore, the difference is $4.53 per share, which must be earned in the $73.90 cash account for the investor to be indifferent.

What interest rate does this imply? Given a 1.25-year period, the interest rate on $73.90 that yields $4.53 is approximatly 4.9%. Moreover, this interest is effectively tax-deductible, since it has reduced long term cap gains vs. the alternative.
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Re: Mathematically mostly correct, but practical problems

Postby LH » Sun Sep 16, 2007 9:58 pm

grabiner wrote: If you are 80% stock but you have only saved half your retirement portfolio, a 25% decline will cost you only 10% of your retirement income. If you are 40% stock and are about to retire, a 25% decline will cost you the same 10%.


Ah, I knew that on a general level, but I have never read that spelled out with a percentage example before in terms of savings percentage related to stock/bond percentage over time(that I recollect at least), nor really thought about it explicitly.

Thanks grabiner,

LH
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Postby market timer » Sun Sep 16, 2007 9:59 pm

LH,

Your post does a good job of explaining why this strategy is counterintuitive. To someone with a net worth of $10K, losing $50K may seem ridiculously risky. That same person in 10, 20, or 30 years will likely lose $50K without even breaking a sweat, as his portfolio approaches seven figures. Why do we view risk in percentage and not absolute terms? Assuming we can avoid the risk of margin calls, it seems reasonable to view risk appropriately, which is in terms of lifetime wealth.
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Postby Dale_G » Sun Sep 16, 2007 10:04 pm

Thank you for being honest market timer. Your first post implied that you held a PhD degree:

This surprises me because my PhD is in economics,
, but it is now clear that you are two years away from this goal.

As you are well aware, success in the academic world depends on peer review. While this site is not necessarily comprised of academics, we can be brutal when reviewing new(?) concepts. Take the criticisms to heart, your peers may be even more brutal.

Best of luck to you.

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Postby Ariel » Sun Sep 16, 2007 10:10 pm

You've still not accounted for the interest you won't earn on that deep in the money call, that you would earn in cash. Again, I invite you to really work this out deeply, comparing it to a 40:60 or 50:50 SPY/cash combo.

Simply saying you'll earn the cost of the call in the cash position won't work, because then in a flat market for SPY you've made nothing with cash interest only covering lost dividends and time premium, while all in SPY you get the dividends and in 50:50 you get mix of dividends and cash interest. As I said, you will find it very hard to make that leverage work for you across a combination of up, down and flat market probabilities with historical volatility.

Note that your two-fold leverage also means that a 20% drop in SPY (150 to 120) will translate into a 40% drop in your deep-in-money call (75 to 45). Very little downside protection for those deep-in-the money calls, and you're still paying the costs! That's why most prefer near the money calls -- but then those cost a lot, lot more!
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Postby market timer » Sun Sep 16, 2007 10:12 pm

grabiner,

All good points on the implementation of this strategy. As I said before, making an analogy the rule of 72, common advice about asset allocation appears to work well for most demographics but fail at the extremes, particularly for younger investors.

If nothing else, I think at least moderate leverage should be considered prudent for this group. I gave an example above where 2:1 leverage can be obtained for 4.9% tax-deductible interest. The exact amount of leverage will depend on many other factors, including access to long term credit and career security.
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Postby market timer » Sun Sep 16, 2007 10:17 pm

Ariel wrote:You've still not accounted for the interest you won't earn on that deep in the money call, that you would earn in cash.


I'm comparing two options, both of which cost $148.90:

(1) Buy SPY for $148.90
(2) Pay $75 for the call, put $73.90 in cash

Option (1) returns $4.53 more after 1.25 years vs. the call alone. Therefore, we are only indifferent when the cash returns $4.53.

I don't think I've forgotten anything.
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Postby LH » Sun Sep 16, 2007 10:19 pm

market timer wrote:LH,

Your post does a good job of explaining why this strategy is counterintuitive. To someone with a net worth of $10K, losing $50K may seem ridiculously risky. That same person in 10, 20, or 30 years will likely lose $50K without even breaking a sweat, as his portfolio approaches seven figures. Why do we view risk in percentage and not absolute terms? Assuming we can avoid the risk of margin calls, it seems reasonable to view risk appropriately, which is in terms of lifetime wealth.


I can see your point in theory.

You seems to beg the practical question of blow up risk though, "counterintuitive" implies its a good way to go, just does not seem that way on initial approach.

I assume someone magically agreed to give a young man with no assets 100K to invest in leap options at 5 percent(interesting assumption to put it mildly but ok I will roll with it). That young man still has gotta PAY the interest though, and you have zero assets except income. In the best case the market does well AND the young man does not get fired, get ill, or whatever. In the worse case, the market falls for 2 years, your options are underwater and your 100K expires worthless. Your debt interest payments on that 100K will never expire sans bankruptcy. Your blowup risk is huge.

This is not "counterintuitive", its simple fact unless you can show otherwise.
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Postby EmergDoc » Sun Sep 16, 2007 10:21 pm

market timer wrote:LH,

Why do we view risk in percentage and not absolute terms?


While I agree with your reasoning, I'm still not convinced by your methods. Perhaps if I understood LEAPS better.

It is unlikely I would be able to use this method as one of the foundations of my investment plan is that if I can't explain it to my wife, I'm not allowed to invest in it.
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Interesting

Postby grok87 » Sun Sep 16, 2007 10:24 pm

The Leaps idea is an interesting one- I'll give it some thought. But in general I think non-professional investors should avoid options. I think it's much easier to get ripped off by the proessionals buying and selling options. Investing in low cost index funds (particularly @ Vanguard) is the way to go.

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