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
"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.
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.