Should I use margin to buy a balanced fund?

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Rob Bertram
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Should I use margin to buy a balanced fund?

Post by Rob Bertram » Wed Jul 16, 2014 1:17 pm

(Re-posted from a question I asked in a similar thread that had been dormant for 2 months: Should I use my margin to buy bonds?)

Question: What does the Bogleheads community think of buying a balanced fund on margin while early in the accumulation phase?

For purposes of discussion, can we agree to the following constraints:
- Retirement is 30+ years away, and these funds will not be needed for 30+ years
- Use of margin will decrease as assets approach target, think of this as "paying off the home mortgage"
- Investor is already contributing max to 401k and Roth IRA
- Investor and DW have stable jobs and emergency funds for 12 months of expenses
- Investor is in the middle of the 25% tax bracket, 5% state tax, married filing jointly
- Initial investment is $200k cash
- Initial leverage starts at $200k
- Annual cash addition is $12k ($1k/month) -- "monthly mortgage payment"
- Margin account is with a discount broker like Interactive Brokers with margin rate around 1.5% (Fed Overnight Rate + 1.5%)
- Investor will stay the course

Off topic:
- 2x and 3x leveraged ETFs. (UPRO, SSO, etc.) They don't work the same as one would want in a buy-and-hold portfolio.
- Rebalancing (this is done inside the fund)

The wiki on Leverage links us back to a conversation from 2010 titled Ayres and Nalebuff: Young people should buy stocks on margin. The discussion goes on for 400+ posts. Without rehashing the entire conversation, sscritic's comments resonated with my thinking:

sscritic wrote:
G-Money wrote:
sscritic wrote:So what is wrong with a strategy of large risk bets with smaller amounts early and small risk bets with large amounts later?

"Age in bonds" achieves that goal without the possibility of getting completely wiped out.

Thank you.

We agree a common strategy is to start with higher risk (low bonds) early and lower risk (high bonds) late. In fact, many people "leverage" this by borrowing money to buy a house and invest in stocks for retirement at the same time. Assuming you start at age 25, you can save $25,000 a year for 10 years and put nothing into retirement. Then at 35, you buy your house for cash and start your retirement investing, putting 35% into bonds. Most people however, use "negative bonds" so they can start investing for retirement earlier and own a house at the same time. (They also have read the stories about investing from 25 to 35 and stopping gets you more at age 65 than investing from 35 to 65.) By borrowing money, their bond allocation can go from -200% to 65% from age 25 to age 65.

But going "negative" bond is leveraging your stock investments. Unless you pay 100% cash for your home, you borrow money during your investing life. So the question shouldn't be if you should borrow, it is what type of borrowing. What is the best way to borrow so you can invest in stocks while young?
a) credit cards balance
b) home mortgage
c) margin

I think arguments can be made that borrowing against your house is better than using margin, but since a majority of people do borrow at some time in some form during the time they are saving for retirement, you can't really say that no one should borrow ever. Or perhaps you can, but I haven't seen that argument.

Note that the authors did not suggest 2x leverage for 20 years, but declining leverage as you age. When you take a mortgage so you can afford to have that house and save for retirement at the same time, you also have a declining balance as you pay the mortgage off (I am referring here to sane people who don't commit heloc abuse with serial refinancings at higher and higher balances).

So borrow when you are young to invest in stocks and reduce your borrowing as you age and simultaneously increase your bond allocation. Is that really such bad advice? Many people do it and retire comfortably.


Questions:
1) How is this different from using a home mortgage and contributing to a 401k?
2) If someone believes in staying the course with their AA, does anything change when using leverage? For example, does an 80/20 non-leveraged AA turn into 60/40 when leveraged 2x?
3) What stays the same? TLH?
4) If the annualized return of the balanced fund is 8% nominal, what does leveraged 2x nominal return look like? Real return?
5) If the annualized return of the balanced fund is -8% nominal, what does leveraged 2x nominal return look like? Real return?
-=-=-=-=-=-=-=-=- Update -=-=-=-=-=-=-=-=-
After several hundred comments and lively discussion, I decided to try this concept. The current experiment is tracked in this spreadsheet:

https://docs.google.com/spreadsheets/d/ ... sp=sharing
Last edited by Rob Bertram on Mon Apr 13, 2015 8:10 pm, edited 1 time in total.

Snowjob
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Re: Should I use margin to buy a balanced fund?

Post by Snowjob » Wed Jul 16, 2014 1:34 pm

Questions:
1) How is this different from using a home mortgage and contributing to a 401k?
2) If someone believes in staying the course with their AA, does anything change when using leverage? For example, does an 80/20 non-leveraged AA turn into 60/40 when leveraged 2x?
3) What stays the same? TLH?
4) If the annualized return of the balanced fund is 8% nominal, what does leveraged 2x nominal return look like? Real return?
5) If the annualized return of the balanced fund is -8% nominal, what does leveraged 2x nominal return look like? Real return?


1.) Margin rates are adjustable, the loan is callable based on valuation of the collateral. This is inherently more risky.
2.) It turns into 160 / -80
3.) Margin interest is a deduction, if I recall I haven't done my own taxes in 4-5 years so a bit foggy but I believe it is.
4.) 16% minus your cost of funds (~14%)
5.) -16% minus your cost of funds (~18%)

Bottom line, this is a terrible idea to implement on your own, way to much funding risk. Alternatively I would suggest one of the pimco leveraged funds that do essentially the same thing but gain their leverage through swaps or various indexes. This can be had for an expense ration of 2% roughly.

Additionally, you cant lever 2 for one initially, you would have to own the mutual fund for 30 days before you can leverage it, though you do get a bit more room than leveraging individual equity which is nice. I've used interactive brokers for the last 4 years, previously was at Etrade. Margin rates are fantastic, but tread lightly, margin on the way down sucks big time. 2008/9 was terrible!

Why don't you just invest the money normally and use your house as your source of leverage via a fixed mortgage? This would be a much preferred route if the Pimco fund doesn't appeal to you -- or if you have such a desire for risk you could do both. Leverage / other peoples money is the special sauce that really makes the portfolio move, but it cuts both ways -- use it wisely and really try to limit how much is callable.

RunningRad
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Re: Should I use margin to buy a balanced fund?

Post by RunningRad » Wed Jul 16, 2014 4:56 pm

I am not going to read all of the explanation and interrogatory.

It's a terrible idea.
Few decisions in life motivated by greed ever have happy outcomes--Peter Bernstein, The 60/40 Solution

steve_14
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Re: Should I use margin to buy a balanced fund?

Post by steve_14 » Wed Jul 16, 2014 5:02 pm

I'm unclear why you'd need to take this much risk. Can you not save enough for retirement with an unleveraged portfolio?

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fourwedge
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Re: Should I use margin to buy a balanced fund?

Post by fourwedge » Wed Jul 16, 2014 5:17 pm

Don't borrow to invest. Just invest.
Max out your tax sheltered retirement accounts with inexpensive, well diversified, index funds and you will beat 90% of all investors.

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Toons
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Re: Should I use margin to buy a balanced fund?

Post by Toons » Wed Jul 16, 2014 6:10 pm

Summed up in three words:
"Save then invest" :happy
"One does not accumulate but eliminate. It is not daily increase but daily decrease. The height of cultivation always runs to simplicity" –Bruce Lee

Rob Bertram
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram » Wed Jul 16, 2014 6:42 pm

Thanks, Snowjob! I appreciate the information.

And to everyone else, I agree that there is risk in using margin, but I'm trying to identify and to understand that risk. Maybe 2x is too much leverage, but 1.5x is significantly safer? I really don't know the answer, which is why I'm asking.

For those that say "Don't borrow to invest." How do you justify taking a home mortgage and contributing to a 401k?
sscritic wrote:I think arguments can be made that borrowing against your house is better than using margin, but since a majority of people do borrow at some time in some form during the time they are saving for retirement, you can't really say that no one should borrow ever. Or perhaps you can, but I haven't seen that argument.


We have some fairly robust conversations around tilting towards SV, EM, or REITS. Each has its own set of risks. How is borrowing different?

For what it's worth, this question isn't really about me struggling to save for retirement. I've already hit my number. I'll hit double my number in 3 years with my current savings rate. My questions are mostly for knowledge. We have a lot of information on how to minimize taxes, maximize tax-advantage accounts, roth vs traditional, mega roth, backdoor roth, and tilting. There doesn't seem to be much in the ways of borrowing. Assuming that I understand the risks, I might try this method with some excess money.

1) Sure, I agree that margin rates are adjustable. Aren't there adjustable rate mortgages also? People seem fairly comfortable using those. Though, I agree that equity in a house is likely to vary less than that of a balanced fund. That is probably why mortgages often start at 4:1 leverage. I'll go back to what sscritic said, we are much more comfortable with a mortgage. Are margin accounts that much of a mystery?

2) Not all bonds are the same, so I don't think it's as easy as saying 20% TBM + (-100% short term) = -80% TBM. I really don't know the answer to this one. From a volatility perspective relative to the initial cash, 80/20 might behave more like 40/60 leveraged 2x. On the other hand, if my IPS says that I'm comfortable with 80/20 when I have $200k, $400k, and $2M unleveraged, does leverage change anything?

3) Yes, margin interest is a deduction. For example, it can be used to offset dividends from the bond portion of the fund assuming that the bonds are not tax-exempt. It might be allowed to carry over to the next year, but I'm still looking into IRS pubs for this.
What else is possible? If there is a drop, one should be able to TLH, right? Even if there is a margin call, and you are forced to sell some shares, you can still claim the losses on your taxes.

4)
Returns = $400k * 0.08 = $32k
Margin interest = $200k * 0.015 = $3k
Nominal returns on $200k = (32-3)/200 = 14.5%
Let's say inflation is ~3%. Does this mean that the real return is about 11.1% vs ~4.9% for non-leveraged? That's more than 2x real.

5)
Loss = $400k * (-0.08) = -$32k
Margin interest = $200k * 0.015 = $3k
Nominal loss on $200k = (-32-3)/200 = 17.5%

tibbitts
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Re: Should I use margin to buy a balanced fund?

Post by tibbitts » Wed Jul 16, 2014 6:47 pm

Would you be asking this question if the market was still at the lows it hit during the last downturn, and was showing no signs of ever improving?

Rob Bertram
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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram » Wed Jul 16, 2014 7:24 pm

tibbitts wrote:Would you be asking this question if the market was still at the lows it hit during the last downturn, and was showing no signs of ever improving?

Yes.

If I am betting that my AA is appropriate for my risk tolerance, I accept that there will be ups as well as downs. For what it's worth, I've been 100% stocks until I hit my number around 2011/2012. That was during both 2001 and 2008. Now, I'm 80/20. I'll drop to 60/40 when I hit 2x my number.

lee1026
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Re: Should I use margin to buy a balanced fund?

Post by lee1026 » Wed Jul 16, 2014 10:06 pm

Well, how often do you plan on rebalancing? If the answer is never, then consider that if you made the investment in 2007 in 2x leveraged stocks, it would go to zero in the great recession, and you would never recover. If the answer is to rebalance, then you will lose to the same compounding forces that makes funds like SSO underperform.

I am personally 2x leveraged, so I won't say what you are saying is wrong, but you have to do the math far more carefully then what I have seen so far.

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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram » Wed Jul 16, 2014 10:58 pm

lee1026 wrote:Well, how often do you plan on rebalancing? If the answer is never, then consider that if you made the investment in 2007 in 2x leveraged stocks, it would go to zero in the great recession, and you would never recover. If the answer is to rebalance, then you will lose to the same compounding forces that makes funds like SSO underperform.

I am personally 2x leveraged, so I won't say what you are saying is wrong, but you have to do the math far more carefully then what I have seen so far.

Thanks for the feedback!

Well, that's why I'm asking about a balanced fund. There are a lot of reasons:
- It is (ideally) less volatile than stocks, so there will be fewer margin calls.
- It rebalances daily, so it should always be at my desired AA.
- It prevents bad behavior.

lee1026
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Re: Should I use margin to buy a balanced fund?

Post by lee1026 » Wed Jul 16, 2014 11:20 pm

Well, a balanced fund won't rebalance your leverage for you. If you rebalance daily, keep in mind that volatility will eat into your returns big time. Look at how much that cost a fund like TBT or UBT, which hold treasuries, which is probably the least volatile assets in the planet, lose to this effect.

When I did the math, monthly rebalancing into a fund of 33% stocks, 66% bonds that leveraged a ton worked out really well in the past.

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Re: Should I use margin to buy a balanced fund?

Post by cowboysFan » Wed Jul 16, 2014 11:21 pm

Rob Bertram wrote:For those that say "Don't borrow to invest." How do you justify taking a home mortgage and contributing to a 401k?


The average middle class person can't pay cash for a house, but they have to live somewhere and owning probably beats renting in the long run. Should they accelerate their house payments or invest in a 401k? They should always invest at least up to the company match because that's the equivalent of a guaranteed 100% or 50% return on the first day of investment. Beyond that, they should probably still invest in a 401k/ira so that at retirement nearly all their investments are in a tax advantaged accounts. If someone is maxing out their 401k and ira and doesn't want to be 100% stocks, I don't see a lot of benefit for stretching out house payments to buy bonds and certainly wouldn't do so if there was any risk of a margin call.

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Re: Should I use margin to buy a balanced fund?

Post by Khanmots » Wed Jul 16, 2014 11:41 pm

I think market timer's old thread should be required reading for anyone looking to use leverage.

He knew what he was doing. Had a solid plan. Had rightly judged his ability to stay the course... and faithfully executed the plan. Unfortunately he went highly leveraged in 2007 and fate struck. Respect the hell out of him for staying open and honest and keeping updates going on that thread over the years.

That's said what's your contingency plan if 2015 is another 2008 and margin calls force you to sell/lose everything you have invested?

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Re: Should I use margin to buy a balanced fund?

Post by DonCamillo » Wed Jul 16, 2014 11:56 pm

Buying funds on margin seems to have a flavor of seeking a free lunch. That does not seem to be a Boglehead thing to do. Essentially as a young person you are investing your human capital (your future earnings in the form of borrowings) alongside your present earnings. The biggest argument against doing this is probably timing, since you are most likely to do this when recent experience makes this look good. But when it comes to free lunches, I still think TANSTAAFL applies.

I have two PIMCO leveraged muni funds in my portfolio. They total about 1% of of my investments. I inherited them, and never would have bought them myself. They are underperforming all of the rest of my investments, but I enjoy getting a few dollars a day in tax free income, so I keep them. They can pay for a daily Latte for my wife and I until coffee prices go up again. Actually, one of them is the only investment I own with a current value below my basis, and the other is the smallest percentage capital gain I have. I am a little ahead after dividends on both.
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Re: Should I use margin to buy a balanced fund?

Post by lee1026 » Thu Jul 17, 2014 12:56 am

Buying funds on margin seems to have a flavor of seeking a free lunch. That does not seem to be a Boglehead thing to do. Essentially as a young person you are investing your human capital (your future earnings in the form of borrowings) alongside your present earnings. The biggest argument against doing this is probably timing, since you are most likely to do this when recent experience makes this look good. But when it comes to free lunches, I still think TANSTAAFL applies.

There is no free lunch here. I take more risks, and I get more rewards.

That's said what's your contingency plan if 2015 is another 2008 and margin calls force you to sell/lose everything you have invested?

Well, I said I would rebalance to prevent the ratio from getting out of hand (and into margin call area), so I would be selling on the whole way down. (I never said I liked that part of leverage investing) Backtesting said that I would make it though 2007-2008 while losing about 45%, so I should have some left. Of course, the next crisis might be very different from the current one.

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Re: Should I use margin to buy a balanced fund?

Post by ogd » Thu Jul 17, 2014 3:33 am

No matter how you put it, borrowing to invest in bonds, whether separately or the bond portion of a balanced fund, is counterproductive. In fact, leveraging while you hold any bonds at all doesn't make sense. With one hand you are getting paid 1.5% -ish for five year Treasuries, with the other you are paying 1.5% on zero term (floating) money. The term difference is significant and you're getting a bad deal -- note that the market normally demands/pays only 0.1% for zero term money.

The rest -- leveraged credit risk, rebalancing -- only serves to obscure the 1.4% or so of yield difference and couldn't be enough to offset it.

Instead of doing this, you "should" get rid of all your bonds first to cancel out the inefficiency; for example, instead of 2x leveraged 60/40, use 1.2x leveraged 100% stocks; I put "should" in quotes because I don't think anybody should actually be even 100% stocks, let alone 120%. Another example is replacing 1.5x 60/40 with 90/10 which is more reasonable.

Mortgage is a different beast because of the tax advantages and the fact that it's replacing rent -- for example, bonds + mortgage means you can survive long term unemployment without being evicted for far longer than either "no bonds + smaller mortage" or "no bonds + rent".

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Re: Should I use margin to buy a balanced fund?

Post by Valuethinker » Thu Jul 17, 2014 5:48 am

Look this is pretty easy.

If you increase your mortgage and buy stocks, that works out OK if, after tax, your stocks go up pa by more than your mortgage interest

Doing that with bonds right now is fairly foolish. Say after tax your mortgage rate is 3%? You are getting 2.5% *at most* on safe US Treasuries. Negative carry spread => Do Not Do.

If you leverage up via a broker margin account you can get killed. Because margin is Short Term money and this is a Long Term investment strategy.

You not only have to be right, you have to be right in every sub period, to avoid a margin call.

Margin call is what kills you.

Using leveraged ETFs it doesn't matter if you are right in the long run, if you can get wiped out in the short run.

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Re: Should I use margin to buy a balanced fund?

Post by Snowjob » Thu Jul 17, 2014 6:14 am

Rob Bertram wrote:
1) Sure, I agree that margin rates are adjustable. Aren't there adjustable rate mortgages also? People seem fairly comfortable using those. Though, I agree that equity in a house is likely to vary less than that of a balanced fund. That is probably why mortgages often start at 4:1 leverage. I'll go back to what sscritic said, we are much more comfortable with a mortgage. Are margin accounts that much of a mystery?

2) Not all bonds are the same, so I don't think it's as easy as saying 20% TBM + (-100% short term) = -80% TBM. I really don't know the answer to this one. From a volatility perspective relative to the initial cash, 80/20 might behave more like 40/60 leveraged 2x. On the other hand, if my IPS says that I'm comfortable with 80/20 when I have $200k, $400k, and $2M unleveraged, does leverage change anything?

3) Yes, margin interest is a deduction. For example, it can be used to offset dividends from the bond portion of the fund assuming that the bonds are not tax-exempt. It might be allowed to carry over to the next year, but I'm still looking into IRS pubs for this.
What else is possible? If there is a drop, one should be able to TLH, right? Even if there is a margin call, and you are forced to sell some shares, you can still claim the losses on your taxes.

4)
Returns = $400k * 0.08 = $32k
Margin interest = $200k * 0.015 = $3k
Nominal returns on $200k = (32-3)/200 = 14.5%
Let's say inflation is ~3%. Does this mean that the real return is about 11.1% vs ~4.9% for non-leveraged? That's more than 2x real.

5)
Loss = $400k * (-0.08) = -$32k
Margin interest = $200k * 0.015 = $3k
Nominal loss on $200k = (-32-3)/200 = 17.5%


1.) The big issue is its callable more than its an adjustable rate, but a shift in rates is never fun when they are rising. Also as valuethinker noted, the spread on the bond component of your strategy is terrible right now.

2.) Asset perspective its 160 / -80, volatility perspective I think is easier to look at one side of the ledger and say it behaves as 80/20 -- that is what your investing in after all. Just make sure you can cover your debts.

3.) Yes you can TLH, but the idea is not to have out sized losses. Use limited amounts of leverage.

Someone mentioned would you have levered up in 2008/2009. I would say this is precisely when you would like to lever up -- after asset prices have dropped dramatically, not when the market is at an all time high. In either case, your making a big bet that right now is a great time to buy stocks and bonds.

Bottom line is, if you have met your number you probably own property. If really need to lever and you own property take out a fixed mortgage and invest the proceeds. This will firewall you from any sort of balance sheet blow up that comes with lots of margin, and your liability is the monthly payments.

Hope this helps.

P.S. - and yes much higher real returns (and losses) I experienced both sides of this as I started my leverage experiment in the summer of 2008 before the big drop!

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Re: Should I use margin to buy a balanced fund?

Post by ogd » Thu Jul 17, 2014 7:44 am

Valuethinker wrote:Doing that with bonds right now is fairly foolish. Say after tax your mortgage rate is 3%? You are getting 2.5% *at most* on safe US Treasuries. Negative carry spread => Do Not Do.

Yes VT -- except that, like I was pointing out above, with the way mortgages are structured over here Treasuries are actually safer than mortgage prepayments. Think about it. That first month after emergency fund runs out due to extended unemployment and you have to send a mortgage check -- who you gonna call?

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Re: Should I use margin to buy a balanced fund?

Post by Dandy » Thu Jul 17, 2014 8:12 am

Using leverage to buy a balanced fund seems like a really bad idea. You seem determined to do it. Leverage works great until it doesn't then it is usually really, really bad. If you are behind your savings goal -- try saving more/reducing expenses rather than using leverage.

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Re: Should I use margin to buy a balanced fund?

Post by Valuethinker » Thu Jul 17, 2014 8:23 am

ogd wrote:
Valuethinker wrote:Doing that with bonds right now is fairly foolish. Say after tax your mortgage rate is 3%? You are getting 2.5% *at most* on safe US Treasuries. Negative carry spread => Do Not Do.

Yes VT -- except that, like I was pointing out above, with the way mortgages are structured over here Treasuries are actually safer than mortgage prepayments. Think about it. That first month after emergency fund runs out due to extended unemployment and you have to send a mortgage check -- who you gonna call?


Ahhh liquidity.

Which takes me back to my post Lehman post of September 2008, when I suggested that people consider the possibility of lengthy periods of unemployment, and increase their cash reserves accordingly (I suggested 18 months).

So yes, as a liquidity provision strategy it works. My mortgage here is a 'negative mortgage' I can draw it down when I have to (and it is offset against my bank account for interest calculations).

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stemikger
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Re: Should I use margin to buy a balanced fund?

Post by stemikger » Thu Jul 17, 2014 8:30 am

This is a quote from Warren Buffett. "If you're smart, you don't need leverage. If you're dumb, you have no business using it."
Choose Simplicity ~ Stay the Course!! ~ Press on Regardless!!!

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Re: Should I use margin to buy a balanced fund?

Post by Park » Thu Jul 17, 2014 8:33 am

All leverage does is magnify your return, and it magnifies the downside more than the upside, due to the cost of leverage.

Overall, retail investors have a tendency to buy high and sell low. Leverage will magnify this. IMO, an investor should think very seriously before using leverage.

If using margin debt, the possibility of margin calls has been brought up. If leveraging 1.25 times, the possibility of that is small for most retail investors. If leveraging 2 times, the probability goes up considerably. In that case, you have to be willing to rebalance, and that means buying high and selling low. If you don't rebalance voluntarily, the margin call will result in involuntary rebalancing.

Even at a leverage ratio of 1.25, there is still a risk (however small) that this strategy will hurt you. If that risk didn't exist, there would be no increase in expected return.

Rob, I would spend more time learning about leverage before using it. The fact that you have considered borrowing money to buy bonds leads me to that suggestion. If you do use leverage, use a moderate amount and have a backup plan (home LOC etc).

About the Warren Buffet quote, one study estimated his leverage ratio at 1.6 times.

FWIW, I use leverage, and not a small amount.

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Re: Should I use margin to buy a balanced fund?

Post by Valuethinker » Thu Jul 17, 2014 9:01 am

Park wrote:
About the Warren Buffet quote, one study estimated his leverage ratio at 1.6 times.

FWIW, I use leverage, and not a small amount.


Buffett this is complex because of the scale of his insurance operations (effectively borrowing from policyholders).

What he also has is masses of cash (c. $50bn I believe). So he never faces a true 'margin call' because he always has that liquidity on tap.

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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram » Thu Jul 17, 2014 9:46 am

Can we all agree that money is fungible? For example, if I borrow $10 and put it into my bank account, it looks the same as $10 from my pay check. When I buy something for $5 and pay from that bank account, I can't say if that $5 came from my pay check or my loan. All I can say is that the bank account is down to $15 and that I still owe someone $10.

We've already discussed borrowing to buy a home and investing ad nauseam.

But the same applies to margin accounts. Let's say that you keep fixed income (cash, bonds, CDs, whatever) in a regular (unleveraged) account. And you also buy equities on margin in a leveraged account. You have X in fixed income investments, Y in equities, and Z in bond-like debt. X + Y - Z = X + (Y - Z) = (X - Z) + Y. You can say that you are leveraging your stocks, and I can say that you're leveraging your bonds. And we would both be correct. Money is fungible.

If you agree that bonds have a place in your AA, then adding leverage shouldn't change that.

There are two things that I believe strongly:
1) I don't know the future
2) I can't time the market with any success.

If I believe in my AA and that I'll stay the course. It means that I'll invest before, during, and after a crash. And by extension, if I think using leverage is a sound strategy, I would apply it consistently before, during, and after a market event. I am convinced that time in the market is what's important.

From what I'm hearing, call risk is the main problem with leverage. What does that look like for 2x leverage?
Cash = $200k
Loan = $200k
Investment = (Cash + Loan) = $400k
Margin call happens when (Investment - Loan) / Loan <= 25%. Working backwards, the investment needs to drop to $250k or by 37.5%.

What does this look like for 1.5x leverage?
Cash = $200k
Loan = $100k
Investment = (Cash + Loan) = $300k
Margin call happens at $125k or 58% drop.

What do returns look like when the underlying fund produces an 8% return for 1.5x leverage? (I already did the 2x in a previous post.)
Returns = $300k * 0.08 = $24k
Margin interest = $100k * 0.015 = $1.5k
Nominal returns on $200k = (24-1.5)/200 = 11.25%
Let's say inflation is ~3%. Real return is about 8% vs ~4.9% for non-leveraged, which is about 1.6x real.

Homework question: Which balanced funds dropped less than 37% in the past 80 years? Have any dropped by 58%? Wellington is easy to check. The others would need to be approximated by their indexes.

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Re: Should I use margin to buy a balanced fund?

Post by berntson » Thu Jul 17, 2014 10:01 am

It's not every day that you run into an Amazon review from a nobel prize winner. Here's Robert Shiller's Amazon review of the Ayres and Nalebuff book.

Robert Shiller wrote:I have been getting flak for endorsing the Ayres and Nalebuff book (see above on Amazon.com), just as the authors are for writing it. People are thinking it certainly sounds reckless for young people to leverage two to one into stocks. For some young people, it certainly is. Those who do this with their personal savings and are contemplating buying a house soon could lose their down payment, and thus be unable to buy. This factor is increasingly important after the subprime crisis since no-down-payment mortgages are hard to find now. But Ayres and Nalebuff are advocating such aggressive stock market investing only for retirement portfolios. Most young people could survive an annihilation of their retirement savings; they still have plenty of time to rebuild it later and it may generally be a good bet to take just such a risk. This is the basic point that Ayres and Nalebuff make, and it is right. I worry that this book in the wrong hands (of people with a gambling impulse or who are really more precarious in their financial situation) the book could encourage irresponsible investing. At the present time, the stock market looks rather pricey, and I am less optimistic about young people leveraging stock market investments right now. But, as a general, long-haul advice book, for savvy people who can judge 'their situation and not get themselves into a corner, the book is indeed valuable. This is not "Dow 36,000" again, as one reviewer says. This is a book about overcoming standard prejudices about investing, and as such it is an important book.


The emphasis is mine. I think this is a nice, reasoned response to the ideas presented by Ayres and Nalebuff. It probably made sense for a young investor starting out at the bottom of the 2008 crash, with markets at low valuations, to use leverage to buy stocks. It's less clear whether now's the time to start such an aggressive investment strategy.

The authors of the book recommend using LEAPs instead of margin. Why go for margin instead of LEAPs?

I don't feel like I understand leverage well enough to be comfortable leveraging my own portfolio. Margin also adds an extra layer of complexity. So I hold an all-stock portfolio (tilted towards value stocks and small stocks to a lesser degree) as a more simple and conservative alternative. Bernstein suggests something like this in his discussion of Ayres and Nalebuff from his Ages of the Investor book.

Rob Bertram wrote: If you agree that bonds have a place in your AA, then adding leverage shouldn't change that.


It's not about fungibility, it's about risk. Most people who have bonds want to reduce risk (standard deviation, or downward standard deviation, or maximum drawdowns, or whatever). Leverage increases risk. Instead of adding leverage to increase risk, then adding bonds to decrease risk, you could just have less leverage to start with. You get the same thing without the cost of margin and with less complexity.

Leveraging a mixed stock/bond portfolio only makes sense if there is reason to expect the stock/bond mix to have a significantly risk-adjusted returns than an all-stock portfolio. I don't see much reason to believe that, so would rather own more stocks than leverage bonds.

(You may know this already, but the Sharp ratio is basically a way of measuring whether or not you should leverage a portfolio. If X has lower returns than Y but a higher Sharp ratio, that means that it's better to leverage X than to buy Y if there are no margin costs. Since there are margin costs, you need X to have a Sharp ratio that is substantially higher than Y for buying X on margin to make sense. I don't see any good reason to think that balanced funds will have a high enough Sharp ratio compared to stocks going forward. So I don't see the point of buying them on margin.)

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Re: Should I use margin to buy a balanced fund?

Post by HomerJ » Thu Jul 17, 2014 10:32 am

Rob Bertram wrote:Homework question: Which balanced funds dropped less than 37% in the past 80 years? Have any dropped by 58%? Wellington is easy to check. The others would need to be approximated by their indexes.


Homework question #1: What happens if the fund you pick DOES drop more than 37%? Is the extra potential return worth a chance of losing it all?

Homework question #2: Why do brokerages loan you money instead of just following this plan themselves, if it is indeed a sure no-lose plan?

Homework question #3: Have you read this thread yet... viewtopic.php?t=5934

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Re: Should I use margin to buy a balanced fund?

Post by HomerJ » Thu Jul 17, 2014 10:35 am

berntson wrote:It's not every day that you run into an Amazon review from a nobel prize winner. Here's Robert Shiller's Amazon review of the Ayres and Nalebuff book.

Robert Shiller wrote:I have been getting flak for endorsing the Ayres and Nalebuff book (see above on Amazon.com), just as the authors are for writing it. People are thinking it certainly sounds reckless for young people to leverage two to one into stocks. For some young people, it certainly is. Those who do this with their personal savings and are contemplating buying a house soon could lose their down payment, and thus be unable to buy. This factor is increasingly important after the subprime crisis since no-down-payment mortgages are hard to find now. But Ayres and Nalebuff are advocating such aggressive stock market investing only for retirement portfolios. Most young people could survive an annihilation of their retirement savings; they still have plenty of time to rebuild it later and it may generally be a good bet to take just such a risk. This is the basic point that Ayres and Nalebuff make, and it is right. I worry that this book in the wrong hands (of people with a gambling impulse or who are really more precarious in their financial situation) the book could encourage irresponsible investing. At the present time, the stock market looks rather pricey, and I am less optimistic about young people leveraging stock market investments right now. But, as a general, long-haul advice book, for savvy people who can judge 'their situation and not get themselves into a corner, the book is indeed valuable. This is not "Dow 36,000" again, as one reviewer says. This is a book about overcoming standard prejudices about investing, and as such it is an important book.


"Most young people could survive an annihilation of their retirement savings; they still have plenty of time to rebuild it later and it may generally be a good bet to take just such a risk. "

So they are saying there is a chance of losing it all. Annihilation is a strong word. How big a chance I wonder?

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Re: Should I use margin to buy a balanced fund?

Post by technovelist » Thu Jul 17, 2014 10:44 am

I would definitely go for it. In fact, why not go to 3x margin, or whatever your brokerage account will allow?
You'll either make a lot of money or get an invaluable education, so it's win-win!

(Note for the sarcasm-impaired: :oops:)
In theory, theory and practice are identical. In practice, they often differ.

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Re: Should I use margin to buy a balanced fund?

Post by Chan_va » Thu Jul 17, 2014 11:12 am

Using leverage to buy bonds is different from using leverage to buy equities.

In using leverage to buy equities, your nemesis is the margin call in a bear market.
In using leverage to buy bonds, your nemesis is the margin rate and the yield curve, and the fact that you will need to borrow at short term rates and lend at long term rates. Also the fact that to make it worthwhile, you will need to do it at a very large scale.

Using leverage to buy bonds is much harder. If you want to risk up, then do it on the equities side.

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Re: Should I use margin to buy a balanced fund?

Post by ogd » Thu Jul 17, 2014 12:33 pm

Rob Bertram wrote:But the same applies to margin accounts. Let's say that you keep fixed income (cash, bonds, CDs, whatever) in a regular (unleveraged) account. And you also buy equities on margin in a leveraged account. You have X in fixed income investments, Y in equities, and Z in bond-like debt. X + Y - Z = X + (Y - Z) = (X - Z) + Y. You can say that you are leveraging your stocks, and I can say that you're leveraging your bonds. And we would both be correct. Money is fungible.

If you agree that bonds have a place in your AA, then adding leverage shouldn't change that.

You are right about fungibility, which is why I said above that the more general formulation is that it doesn't make sense to use leverage while you have any bonds at all, i.e. even if you don't use the loan directly for bonds. That is, assuming you don't get very good rates for leverage, which you aren't at 1.5% floating. Instead, you should run down the bonds first as you increase risk, before you tap into loan money. The last sentence of the paragraph above doesn't follow.

Rob Bertram wrote:From what I'm hearing, call risk is the main problem with leverage.

This isn't the only problem with your proposition. With less losses, but far more likely to happen, you can have the following situation: you borrow at 1.5% to invest in 5 year Treasuries, rates jump 2% across the board including your margin rate; now you're faced with losing 10% from the differential, either over 5 years or immediately if you back out of the position at a loss. Considering that this was a position with 0% expected return to begin with (margin rate minus Treasury rate), you got yourself some reward-free risk. That 10% loss, btw, will never mend itself unlike the expectations of people leveraging into stocks, who generally think that if they can avoid a margin call they'll eventually get their money back.

You can't make [good] comparisons with investing a mortgage because the two types of loans are not fungible. We're talking long-term fixed rate loans with no margin calls vs the opposite.

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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram » Thu Jul 17, 2014 12:47 pm

berntson wrote:It's not every day that you run into an Amazon review from a nobel prize winner. Here's Robert Shiller's Amazon review of the Ayres and Nalebuff book.

Robert Shiller wrote:...But, as a general, long-haul advice book, for savvy people who can judge 'their situation and not get themselves into a corner, the book is indeed valuable. This is not "Dow 36,000" again, as one reviewer says. This is a book about overcoming standard prejudices about investing, and as such it is an important book.


The emphasis is mine. I think this is a nice, reasoned response to the ideas presented by Ayres and Nalebuff. It probably made sense for a young investor starting out at the bottom of the 2008 crash, with markets at low valuations, to use leverage to buy stocks. It's less clear whether now's the time to start such an aggressive investment strategy.

The authors of the book recommend using LEAPs instead of margin. Why go for margin instead of LEAPs?

I don't feel like I understand leverage well enough to be comfortable leveraging my own portfolio. Margin also adds an extra layer of complexity. So I hold an all-stock portfolio (tilted towards value stocks and small stocks to a lesser degree) as a more simple and conservative alternative. Bernstein suggests something like this in his discussion of Ayres and Nalebuff from his Ages of the Investor book.

Thank you for pointing out Robert Shiller's quote. It sounds exactly like what I am trying to understand.

I don't know much about LEAPs, but I will read up on them. My understanding is that are just long-term options. I originally dismissed them as tools for market prediction/timing which I feel is not a winning strategy. I will see if there is a buy-and-hold approach that works.

berntson wrote:
Rob Bertram wrote: If you agree that bonds have a place in your AA, then adding leverage shouldn't change that.

It's not about fungibility, it's about risk. Most people who have bonds want to reduce risk (standard deviation, or downward standard deviation, or maximum drawdowns, or whatever). Leverage increases risk. Instead of adding leverage to increase risk, then adding bonds to decrease risk, you could just have less leverage to start with. You get the same thing without the cost of margin and with less complexity.

Leveraging a mixed stock/bond portfolio only makes sense if there is reason to expect the stock/bond mix to have a significantly risk-adjusted returns than an all-stock portfolio. I don't see much reason to believe that, so would rather own more stocks than leverage bonds.


So my logic (which may be flawed) is this: Bonds reduce the downward standard deviation which reduces the chance of a margin call. So far, call risk is the only risk that I've heard people mention.
Let's take an example. I say that my AA is 80/20 and I want to use some leverage in the following way:

Normal (unleveraged)
Bonds: $20k

Margin (2x leveraged)
Stocks: $40k
Loan (stocks): $40k
What's my call risk?

Now, change this around:
Normal (unleveraged)
Stocks: $20k

Margin (2x leveraged)
Stocks: $40k
Loan (bonds): $20k
Loan (stocks): $20k
What's my call risk? Leverage is exactly the same.

Combine the two into a balanced fund:
Margin (1.66x leveraged)
Balanced fund: $60k
Loan (balanced fund): $40k
What's my call risk? Leverage is exactly the same.

berntson wrote:(You may know this already, but the Sharp ratio is basically a way of measuring whether or not you should leverage a portfolio. If X has lower returns than Y but a higher Sharp ratio, that means that it's better to leverage X than to buy Y if there are no margin costs. Since there are margin costs, you need X to have a Sharp ratio that is substantially higher than Y for buying X on margin to make sense. I don't see any good reason to think that balanced funds will have a high enough Sharp ratio compared to stocks going forward. So I don't see the point of buying them on margin.)

I think that I intellectually understand the Sharpe ratio. Emotionally, I need to decide how much weight I give to tools that rely on past performance to predict the future. At some point, I decided on an AA which can only be done by looking at the past.

For what it's worth, Wellesley's 5-year Sharpe ratio is 2.20, Wellington's 5-year Sharpe ratio is 1.54, and TSM's 5-year Sharpe ratio is 1.34, and Vanguard's 80/20 LifeStrategy Growth Fund is 1.22.

Five years might be enough, but maybe not. Are 20 or 80 years enough?

edit: Added Sharpe ratio for Wellesley
Last edited by Rob Bertram on Thu Jul 17, 2014 2:01 pm, edited 1 time in total.

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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram » Thu Jul 17, 2014 1:34 pm

HomerJ wrote:
Rob Bertram wrote:Homework question: Which balanced funds dropped less than 37% in the past 80 years? Have any dropped by 58%? Wellington is easy to check. The others would need to be approximated by their indexes.


Homework question #1: What happens if the fund you pick DOES drop more than 37%? Is the extra potential return worth a chance of losing it all?
I agree that the margin call is definitely the most obvious risk. The investor has to add cash and/or sell assets to get above the 25%. Again, the goal of creating this topic was to identify the risk and possible ways to mitigate it.

HomerJ wrote:Homework question #2: Why do brokerages loan you money instead of just following this plan themselves, if it is indeed a sure no-lose plan?
Again, there are definitely risks. Investing has risks. I'm asking the community to help me understand them. And brokerages do what you mentioned. They are called leveraged ETFs, and there are hundreds. I mentioned them in the OP and asked that they stay off topic.
Rob Bertram wrote:Off topic:
- 2x and 3x leveraged ETFs. (UPRO, SSO, etc.) They don't work the same as one would want in a buy-and-hold portfolio.

HomerJ wrote:Homework question #3: Have you read this thread yet... viewtopic.php?t=5934
I have not read it, but I definitely will. Thanks!

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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram » Thu Jul 17, 2014 1:57 pm

Chan_va wrote:Using leverage to buy bonds is different from using leverage to buy equities.

In using leverage to buy equities, your nemesis is the margin call in a bear market.
In using leverage to buy bonds, your nemesis is the margin rate and the yield curve, and the fact that you will need to borrow at short term rates and lend at long term rates. Also the fact that to make it worthwhile, you will need to do it at a very large scale.

Using leverage to buy bonds is much harder. If you want to risk up, then do it on the equities side.

One thing that I see people doing is trying to exclude bonds from a leveraged account by comparing terms and yields. If we believe in an efficient frontier, I don't think we can separate a diversified portfolio into its components and get much meaning by analyzing each part.

Stocks have volatility risk that could force a margin call. Risk adjusted, bonds will never beat the margin rate. However, when you combine the two, stocks have the growth, and bonds have the stabilizing power. It might reduce both of those risk to a known value.

As I've said in almost every post, I don't know the answer to this question. I haven't seen much discussion on margin.

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Re: Should I use margin to buy a balanced fund?

Post by berntson » Thu Jul 17, 2014 2:52 pm

Rob Bertram wrote: So my logic (which may be flawed) is this: Bonds reduce the downward standard deviation which reduces the chance of a margin call.


Say that I have $100,000. I put it all in a margin account and use it, together with $100,000 margin, to put $200,000 in an 80/20 portfolio. I get a margin call once my investments go down 66%. On the other hand, I could put $100,000 in my margin account and use $60,000 to buy a 100/0 portfolio. I would then not get a margin call until my investments went down 88%. Using margin to buy bonds reduces the downside of the portfolio, but also makes it easier to get a margin call (in the sense that smaller losses will lead to a margin call).

I suppose it could be that losing 66% with an 80/20 portfolio is less likely than losing 88% with an all-equity portfolio. That's something you would have to work out.

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Re: Should I use margin to buy a balanced fund?

Post by Chan_va » Thu Jul 17, 2014 3:27 pm

You should note that you are basing all your calculations assuming margin requirements don't change in a downturn. But the opposite is true. During a downturn, your broker can and will raise margin requirements to cover risk. And that will throw off your calculations.

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Re: Should I use margin to buy a balanced fund?

Post by HomerJ » Thu Jul 17, 2014 3:47 pm

Rob Bertram wrote:
HomerJ wrote:Homework question #3: Have you read this thread yet... viewtopic.php?t=5934
I have not read it, but I definitely will. Thanks!


If it's too boring for you, skip forward to page 10 or so (look for Sept 2008-Nov 2008 posting dates), and watch poor MarketTimer go $200k in debt as the market crashes. We read it real time, and it made me sick to my stomach for him (He's doing fine now, due his very large income - which, of course, means he never needed leverage in the first place).

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Re: Should I use margin to buy a balanced fund?

Post by bobbun » Thu Jul 17, 2014 4:08 pm

berntson wrote:
Rob Bertram wrote: So my logic (which may be flawed) is this: Bonds reduce the downward standard deviation which reduces the chance of a margin call.


Say that I have $100,000. I put it all in a margin account and use it, together with $100,000 margin, to put $200,000 in an 80/20 portfolio. I get a margin call once my investments go down 66%. On the other hand, I could put $100,000 in my margin account and use $60,000 to buy a 100/0 portfolio. I would then not get a margin call until my investments went down 88%. Using margin to buy bonds reduces the downside of the portfolio, but also makes it easier to get a margin call (in the sense that smaller losses will lead to a margin call).

I suppose it could be that losing 66% with an 80/20 portfolio is less likely than losing 88% with an all-equity portfolio. That's something you would have to work out.


You're assuming that the margin requirements are the same for equities and bonds. That's going to be true in the case where the poster suggests getting a balanced fund. If instead the poster purchased treasuries for his bond allocation this concern may not apply because his bonds may have a significantly lower margin requirement. Such a portfolio should be less vulnerable to a margin call over all, though I think the risks and costs associated with margin probably still mean that for most people it's not a good idea.

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Re: Should I use margin to buy a balanced fund?

Post by lee1026 » Thu Jul 17, 2014 10:19 pm

Homework question #1: What happens if the fund you pick DOES drop more than 37%? Is the extra potential return worth a chance of losing it all?

Losing 37% in a 2x leveraged fund does not mean losing everything.... it just means that you are being forced to deleverage. You lose 74%, which is very different from everything.

Homework question #2: Why do brokerages loan you money instead of just following this plan themselves, if it is indeed a sure no-lose plan?

Because its a game of risk management. You can easily leverage 100x on margin loans with little-to-no risk, assuming you are good at margin calling people. IB have access to funds near 0.09%, and leveraging that 100x to lend to me at 1.09% gets them about 100% return on equity, which is pretty slick for them.

It's not about fungibility, it's about risk. Most people who have bonds want to reduce risk (standard deviation, or downward standard deviation, or maximum drawdowns, or whatever). Leverage increases risk. Instead of adding leverage to increase risk, then adding bonds to decrease risk, you could just have less leverage to start with. You get the same thing without the cost of margin and with less complexity.

Yes, but leveraging a 50-50 portfolio 2x will have a much lower max drawdown then a 100% stock portfolio, at least in the past. For example, someone that is 100% SPY, 100% TLT would only lose ~35% in 2008-2009 to ~50% for someone who is 100% in stock.

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Re: Should I use margin to buy a balanced fund?

Post by Park » Thu Jul 17, 2014 11:11 pm

IF you are going to borrow to invest, it makes more sense to use that money to buy stocks, as opposed to bonds.

Why?

The cost of borrowing means that your investment paid with borrowed money has a higher hurdle to overcome, compared to investments paid with unborrowed money. Regardless of whether you invest in stocks or bonds, the hurdle will be the same.

If you invest in bonds, the expectation is that the premia from interest rate risk/credit risk will overcome that hurdle. If you invest in stocks, the expectation is that the premia from market risk/small risk/value will overcome that hurdle.

Historically, the premia from the former has been less than the latter, and not by a small amount.

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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram » Fri Jul 18, 2014 9:21 am

Park wrote:IF you are going to borrow to invest, it makes more sense to use that money to buy stocks, as opposed to bonds.

Why?

The cost of borrowing means that your investment paid with borrowed money has a higher hurdle to overcome, compared to investments paid with unborrowed money. Regardless of whether you invest in stocks or bonds, the hurdle will be the same.

If you invest in bonds, the expectation is that the premia from interest rate risk/credit risk will overcome that hurdle. If you invest in stocks, the expectation is that the premia from market risk/small risk/value will overcome that hurdle.

I'm no expert in modern portfolio theory, but I believe the idea is that the risk-adjusted return of a diversified portfolio is greater than that of its individual parts. In other words, adding bonds to a portfolio slightly reduces the return but reduces risk (std dev) more so. Your approach to only analyzing the bond portion of a balanced fund ignores MPT.

Here are three funds that many Bogleheads use. One fund is the total stock market (VTSAX), the other two are balanced funds. Unless otherwise stated, the numbers are the 10-year statistics.

Code: Select all

Fund  Annualized return   Std Dev   Sharpe Ratio    Worst drop in last 75 years (or history of fund if younger)
A     8.50%                9.75     0.72            27.5%
B     8.31%               15.26     0.50            37.1%
C     7.68%                6.12     0.97             9.7%

Questions:
- How much performance is lost to bonds?
- How much is gained by lower volatility?
- Is it possible to calculate the bond % based on the annualized fund return? (MPT says "no".)

Extra credit:
- How much leverage could be used without risking a margin call? (Maybe 2x, 1.6x, 3.5x?)
- What are the expected nominal and real returns at those leverage ratios?

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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram » Fri Jul 18, 2014 11:09 am

I'll be the first to argue that 10 years is too short of a time to draw any meaningful conclusion about the future. Two hundred years might not be enough.

Here's what I get if I consider a 4-sigma drop as the worst case (assuming maint margin stays at 25%):
Leverage: 2.09x, 1.55x, and 2.65x
Nominal returns: 16.4%, 12.1%, 18.14%
Real returns: 12.97%, 8.79%, 14.70%

If you are comfortable with only 3-sigma drop as the worst case (maint margin stays at 25%), then you get:
Leverage: 2.45x, 1.85x, and 3x
Nominal returns: 18.9%, 14.1%, 20.3%
Real returns: 15.46%, 10.78%, 16.83%

Again, this is based on looking at the past 10 years of data which I already said is not significantly useful.

edit: Added values for 3-sigma, also adjusted for admiral shares of each fund.

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Re: Should I use margin to buy a balanced fund?

Post by garlandwhizzer » Fri Jul 18, 2014 1:36 pm

Taking a margin position implies two things. First, that you know the asset you're purchasing is going up in price over your holding period. Second, that you will not have to sell that asset earlier than anticipated to provide for unanticipated expenses during a personal, national, or worldwide economic crisis. Neither of these prerequisites is a certainty. Leverage works both ways, up and down, and massively increases risk as well as reward. The question then boils down to the same old thing: your willingness, ability, and need to take risk. I have in the past used margin buying for equities which was the single worst investing mistake I have ever made in 27 years of investing. Bottom line: the market is unpredictable but your ongoing expenses never disappear. I will never do it again. Un-leveraged portfolios provide plenty in the way of risk/reward tradeoff for my taste.

Garland Whizzer

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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram » Fri Jul 18, 2014 1:41 pm

HomerJ wrote:
Rob Bertram wrote:
HomerJ wrote:Homework question #3: Have you read this thread yet... viewtopic.php?t=5934
I have not read it, but I definitely will. Thanks!


If it's too boring for you, skip forward to page 10 or so (look for Sept 2008-Nov 2008 posting dates), and watch poor MarketTimer go $200k in debt as the market crashes. We read it real time, and it made me sick to my stomach for him (He's doing fine now, due his very large income - which, of course, means he never needed leverage in the first place).

Thank you again for posting the link. I've been reading a couple pages a day.

Is it fair to say that he (Market Timer) was day trading? Here is where he posts his portfolio (which is constantly changing).
market timer wrote:I own C through derivatives.

There have been lots of adjustments lately to have a leaner portfolio, converting almost all equity to S&P futures. It's not even feasible to diversify into small cap value and international, since they only allow 4x leverage. My current portfolio looks something like this (in thousands of $):

225 S&P 500 index
26 Financials ETF
21 Citigroup
16 Bank of America
11 Vanguard Capital Value fund
9 REIT index
8 General Electric
6 Homebuilders ETF

100% wretched. Leveraged about 9x now.

market timer wrote:I'm done with individual stocks. C, BAC, and GE are the fossilized remains of a youthful arrogance, buried under a sediment of loss aversion.


I agree that it is a very good example of how quickly leverage can destroy your entire portfolio. There are a few key differences between his approach and what I am proposing:
1) He was trading individual stocks (C, BAC, GE) and stock index funds (S&P). - I am proposing a balanced approach using a diversified fund
2) He was using options and futures which is tantamount to trying to predict the market. - I am proposing a buy-and-hold approach

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Re: Should I use margin to buy a balanced fund?

Post by Rob Bertram » Fri Jul 18, 2014 1:58 pm

garlandwhizzer wrote:Taking a margin position implies two things. First, that you know the asset you're purchasing is going up in price over your holding period. Second, that you will not have to sell that asset earlier than anticipated to provide for unanticipated expenses during a personal, national, or worldwide economic crisis. Neither of these prerequisites is a certainty. Leverage works both ways, up and down, and massively increases risk as well as reward. The question then boils down to the same old thing: your willingness, ability, and need to take risk. I have in the past used margin buying for equities which was the single worst investing mistake I have ever made in 27 years of investing. Bottom line: the market is unpredictable but your ongoing expenses never disappear. I will never do it again. Un-leveraged portfolios provide plenty in the way of risk/reward tradeoff for my taste.

Garland Whizzer

I totally agree with you that risk tolerance is a personal thing. And, yes, I'm proposing a buy and hold approach for the long term. Also, we individually need to understand our investments. I'm still struggling to understand leverage and how margin accounts work. A couple more days like this, and I think I will understand enough to feel confident in using some amount of leverage.

There have been some good comments and experiences that people have shared. I will probably try it with my "play account". I haven't heard enough quantifiable reasons not to try.

Park
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Re: Should I use margin to buy a balanced fund?

Post by Park » Fri Jul 18, 2014 3:41 pm

Park wrote:IF you are going to borrow to invest, it makes more sense to use that money to buy stocks, as opposed to bonds.

Why?

The cost of borrowing means that your investment paid with borrowed money has a higher hurdle to overcome, compared to investments paid with unborrowed money. Regardless of whether you invest in stocks or bonds, the hurdle will be the same.

If you invest in bonds, the expectation is that the premia from interest rate risk/credit risk will overcome that hurdle. If you invest in stocks, the expectation is that the premia from market risk/small risk/value will overcome that hurdle.

Historically, the premia from the former has been less than the latter, and not by a small amount.


The above doesn't take into account taxes. It's hard to make definitive statements about tax, because tax laws vary across jurisdictions and time.

However, it is not uncommon for the interest charges, due to borrowing money to invest, to be deductible against income. Fixed income is often taxed at the same rate as ordinary income. Dividends may be taxed at the same rate as ordinary income, but sometimes less. Capital gains is sometimes taxed at a lower rates than ordinary income, and can often be deferred.

Assume a scenario where the before tax cost of leverage is greater than the before tax return of the investment made with the borrowed money. But on an aftertax basis in the same scenario, it may be possible for the investment return to be greater than the borrowing cost. This is the tax arbitrage aspect of leverage, and it depends on local tax laws.

Such tax arbitrage is usually more likely with stocks than bonds.

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Chan_va
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Re: Should I use margin to buy a balanced fund?

Post by Chan_va » Fri Jul 18, 2014 4:54 pm

Rob,

Forget about balanced funds vs. stocks and bonds. Here is an argument for why leverage is not a great idea in general. The issue is that you need to consider a sequence of probabilities across time, not one across the whole time period.

Let's simplify the problem. Consider a theoretical asset, which can go up or down every day with a probability P. So, if P > 0.5, then in general you expect your asset to go up, if P <0.5, then in general, you expect it to go down. Let's also assume that the market takes a random walk, where each day's movement is independent of the previous. Like I said, a simple model, but illustrative.

Then, your probability of making money, or inversely of ruin can be modeled using the classic Gambler's Ruin model.

I modeled this in XL and here are some graphs. The graphs show the probability of ruin before you achieve a 50% gain

1. Bull market (lets say P=0.55).

Lets consider a bull market, where it's more likely that your asset will go up rather than down. The graph for your probability for ruin vs. leverage is below. As you can see, your probability for ruin does do up as you increase leverage, but the slope is < 1 for small leverage.

Lessons (caveats - this is a very simple model, so don't focus on the details, just the overall trends)

1. In a bull market, it pays to lever up to a point - For every x% of leverage you take, your probability of ruin rises by less than x.
2. Even in a bull market, there is a point of optimal leverage - 80% in my model based on assumptions, where your risk of ruin rises faster than the increase in leverage.

Image

2. Bear market (lets say P=0.45).

On the other hand, lets consider a bear market. The graph is inverted. For ever x% of leverage, your probability of ruin rises faster than x.


Image

So it pays to lever only

1. If your leverage is low enough to sustain a long bear market
2. If you are very certain that your asset will only go up. Or if you know ahead of time if it's a bull or bear

If #1, then your gains are not worth the hassle, If #2 you have found the mythical mermaid unicorn.

Doesn't matter where your asset is on the efficient frontier.

cowboysFan
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Re: Should I use margin to buy a balanced fund?

Post by cowboysFan » Fri Jul 18, 2014 6:05 pm

Rob Bertram wrote:One thing that I see people doing is trying to exclude bonds from a leveraged account by comparing terms and yields. If we believe in an efficient frontier, I don't think we can separate a diversified portfolio into its components and get much meaning by analyzing each part.


Actually, you can because the bonds and margin cancel each other if they are of the same duration. If you could actually borrow at the fed discount rate, which you can't, and were lending at close to the same duration by buying 1 month t-bills, it should be obvious that a 2x leveraged 50 stocks/50 t-bills portfolio should have identical risk/return characteristics of a 100% stock portfolio before taxes and transaction costs. If you borrow short and lend long, then you're getting paid for taking the risk that interest rates could rise. If you want more exposure to that risk, why not sell TBM and buy 30-year bonds instead?

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market timer
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Re: Should I use margin to buy a balanced fund?

Post by market timer » Fri Jul 18, 2014 9:31 pm

Rob Bertram wrote:Is it fair to say that he (Market Timer) was day trading?
I agree that it is a very good example of how quickly leverage can destroy your entire portfolio. There are a few key differences between his approach and what I am proposing:
1) He was trading individual stocks (C, BAC, GE) and stock index funds (S&P). - I am proposing a balanced approach using a diversified fund
2) He was using options and futures which is tantamount to trying to predict the market. - I am proposing a buy-and-hold approach

My holdings and leverage ratio were changing rapidly during fall 2008, due to leverage requirements. Prior to that, I was not trading often, but had a concentrated position in financials that was the result of having sold out-of-the-money puts on C and BAC in summer 2007. My implementation was not ideal or well thought out--the book by Ayres and Nalebuff explains my pitfalls clearly (individual stock risk, not reducing exposure as the market falls, borrowing using credit cards). Mortgage Your Retirement was my rationalization for doubling down after some early losses on financials in summer 2007.

Your approach is much more likely to be successful; however, keep in mind the behavioral risks that can be brought on from market volatility. Your timing is similar to mine in summer 2007, at an all-time stock market high. Also, not only are stocks at all-time highs, but bonds are near historic lows in yield, which should cause you to lower your expected returns for balanced funds.
Last edited by market timer on Fri Jul 18, 2014 10:32 pm, edited 1 time in total.

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