Should I use margin to buy a balanced fund?

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

Post by market timer » Mon May 11, 2015 10:02 pm

Rob Bertram wrote:According to Portfolio Visualizer, it's about 14.54% drawdown of the notional portfolio during 1973-4, or 3.18% after adjusting for monthly contributions. I don't have daily or monthly data to know if there are larger intra-year drops.
Yes, the 1x portfolio is down 14.54% over those two years. However, the borrowing costs would also reduce returns on the leveraged portfolio. Eyeballing the rate history for short term Treasuries, I think your borrowing costs would have been around 7.5%/year over this period, or 15.6% in all over two years. Therefore, a hypothetical $100K investment in a $700K portfolio would have a return of roughly 7 x (-14.54%) - 6 x (15.6%) = -102% - 94% = -196%, i.e., the $100K would become negative $96K. The monthly contributions would need to be fairly large to avoid margin calls in that scenario.

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

Post by Rob Bertram » Tue May 12, 2015 7:50 am

Correct. Borrowing costs plus max drop of the notional portfolio set the upper limit for leverage. So when borrowing costs are 0.5% and max drop is 14.5%, I can lever at most 100%/(14.5 +0.5%) = 6.67x. Monthly contributions would avoid a margin call. If borrowing costs were 7.5%, I could go as high as 100/(14.5+7.5) = 4.5x. Ideally, I would be closer to 5.5x for roughly an 80% max loss.

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

Post by lack_ey » Tue May 12, 2015 11:27 am

1973-4 stock drawdown wasn't far from the calendar year boundaries. The drop started in January 1973 and continued until September 1974, with October positive, and the rest of the year negative again (but not offsetting October).

Have you looked at markets outside the US? I'm pretty sure some have had worse worst-case balanced portfolio drawdowns, even in the modern era. (but maybe that was inflation adjusted and not nominal...)

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

Post by Rob Bertram » Tue May 12, 2015 12:19 pm

We have looked at things like global equity and bond returns, but I haven't spent much time researching specific countries. I'll look into finding some foreign market data.

On a side note, increasing interest rates are a good thing for a long-term buy-and-hold portfolio. Sure, there is a drop in the price of the bonds, but the expected return of the portfolio is now higher. I haven't hit a rebalancing band yet, but part of me is excited to see what will happen.

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

Post by Tanelorn » Tue May 12, 2015 6:36 pm

Rob Bertram wrote:On a side note, increasing interest rates are a good thing for a long-term buy-and-hold portfolio. Sure, there is a drop in the price of the bonds, but the expected return of the portfolio is now higher. I haven't hit a rebalancing band yet, but part of me is excited to see what will happen.
But if your floating rate margin costs increase, are you sure that higher rates are a net positive for you?

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

Post by Rob Bertram » Tue May 12, 2015 7:17 pm

It depends. Short- and long-term yields don't always move in sync. Increasing long-term yields with static short-term borrowing costs is definitely a good thing. If they move together, it's neutral. If the short term rates increase while long-term drop, I'm in for some interesting times.

On the short-term side, I will keep some cash in a high-yield savings account and CDs that are equal to or higher than my borrowing costs. (Right now, only savings account, but CDs will probably happen soon.) I'm not sure how long that will last, but roughly half my cash will be indifferent to short-term interest rate changes.

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

Post by lack_ey » Tue May 12, 2015 7:55 pm

I was wondering about that too. What's the plan if the yield curve flattens or inverts? These episodes can last for a year or more sometimes and are definitely not always followed by all the rates dropping (unlike 2000 and 2006).

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

Post by Rob Bertram » Tue May 12, 2015 9:42 pm

The blanket answer is to stay the course, rebalance as necessary. The asset allocation and leverage ratio might not be optimal for the short-term market conditions, but it probably won't be terrible, either.

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

Post by Spec7re » Tue May 12, 2015 10:36 pm

Rob

Have you evaluated you exposure to interest rates. How much of a rate increase would it take for you to see a 50% loss.

When I came up with the 10x 10/90 portfolio using the 2 yr futures, my target max loss was 33%, which is similar to the 1x 80/20 portfolio I hold in other accounts.

From backtesting, the 10x 10/90 using the 2 yr future has never lost more than 25%. But with rates so low, I really need to understand what I'm up against.

Currently, looking at the 2 yr rate and the slope of the curve at two years, I can determine the amount of rate increase over the next year that I can absorb without losing money.

-Current 2 yr rates is 0.61% which can absorb a rate increase of 0.61/2 = 0.305%
-Current slope of the yield curve near the 2 year is about 0.375%.

So in total, the 2 yr future can handle a 0.68% rate increase over the next year without losing money.

So how much additional rate increase can I handle before I begin to hit my risk tolerance? Ignoring potential stock gains/losses, at 10x, a 3.3% drop will cause my portfolio to drop 33%. An additional rate increase of 1.65% would cause this to happen.

So, in total, a 0.68% rate increase would cause the 2 yr to return nothing, and an additional 1.65% increase cause losses approaching my risk tolerance. 0.61 + 0.68 + 1.65 = 2.94%. If the 2 yr rate rises to 2.94% over the next year, I will be near the maximum drop I expect from this portfolio. This analysis is somewhat conservative because as rates rise, the ability of the bonds to absorb future rate increases will also rise.

Currently, with the longer term bonds at 7x leverage, I don't think it would take much of a rate increase to hit you for 50%.

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

Post by Spec7re » Tue May 12, 2015 10:56 pm

I really think commodities or gold probably have a place in this type of portfolio. If you examine the years when both bonds and equities are down, commodities and gold are usually up.

I have a hard time imagining scenarios where we see a 3%+ rise in interest rates that also coincide with 30%+ losses in equities. In my understanding ease rise due to unexpected inflation, loss of credit, or increase economic activity.

High unexpected inflation seems to be the most likely candidate, which is why I add commodities to my allocation. It's also why I think this type of portfolio works well with leveraged real estate (best inflation hedge).

Loss in faith in the credit of the U.S. Government along with a global economic downturn could be another cause.

If money is flowing out of global markets and out of US treasuries, where is it going? Alternative assets? Food, guns, and ammo? Maybe this is an argument for holding Dev/EM bonds.

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

Post by lee1026 » Tue May 12, 2015 11:54 pm

1994? Stocks and bonds were both down from what I remember.

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

Post by lack_ey » Wed May 13, 2015 12:42 am

lee1026 wrote:1994? Stocks and bonds were both down from what I remember.
Stocks were basically flat in 1994. (S&P 500 slightly up, the rest slightly down) Intrayear, looks like single digit losses. 10-year T-Note returned -8.04%, though.

In 1969, S&P 500 and the 10-year T-Note returned -8.24% and -5.01%.
In 1931 *ahem*, S&P 500 (backfilled approximate data) and the 10-year T-Note returned -43.84% and -2.56%.
I don't quite have the exact numbers intrayear, but the first nine months of 1974 saw stocks return worse than -35% and the 10-year T-note yield rise from 9.39% to 12.06% (not that much a loss when the yield is that high; it ended at 11.80% for net positive return on the year) while inflation was about 7.5%.

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

Post by Maynard F. Speer » Wed May 13, 2015 12:56 am

Spec7re wrote:I really think commodities or gold probably have a place in this type of portfolio. If you examine the years when both bonds and equities are down, commodities and gold are usually up.

I have a hard time imagining scenarios where we see a 3%+ rise in interest rates that also coincide with 30%+ losses in equities. In my understanding ease rise due to unexpected inflation, loss of credit, or increase economic activity.

High unexpected inflation seems to be the most likely candidate, which is why I add commodities to my allocation. It's also why I think this type of portfolio works well with leveraged real estate (best inflation hedge).

Loss in faith in the credit of the U.S. Government along with a global economic downturn could be another cause.

If money is flowing out of global markets and out of US treasuries, where is it going? Alternative assets? Food, guns, and ammo? Maybe this is an argument for holding Dev/EM bonds.
"Cash is king" has been thrown around a lot this year, with some very large funds holding 40-60% cash (but that can include currency plays), and also alternatives, like hedge funds, are being seen as relative safe havens ..

With gold and commodities, it can be a rocky ride - personally I'm protecting my portfolio by holding more in hedge funds this year, and they've mostly been climbing or at least holding value as stocks and bonds have slid

Good research paper on optimal hedge fund allocation .. A study cited recommends 20% improves almost any portfolio - interestingly 20% is what the Yale endowment holds
http://www.lyxor.com/fileadmin/_fileup/ ... nt/20/#/4/
"Economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions." - John Maynard Keynes

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

Post by Day9 » Wed May 13, 2015 3:25 am

I've found that commodities have negative correlation with duration risk (one does well in inflation the other in deflation) so they may fit well in your treasury bond-heavy portfolios. Here are some great threads from the Collective thoughts sticky including some great debate between Swedroe and Ferri and some backtesting.

commodity prices add a non-financial event risk hedge
1974-75 backtest
other examples
risk of collateralized commodities futures

Here are AFA's recommendations on commodity funds and ETFs
I'm just a fan of the person I got my user name from

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

Post by Rob Bertram » Wed May 13, 2015 8:46 am

Wow, that's more than a debate between Swedroe and Ferri. It's a cat fight.

I'm not sure about commodities in general. In the best case, commodities keep up with inflation and are uncorrelated with the other assets in my portfolio (stocks + treasuries). Worst case, they don't keep up with inflation, add extra volatility, and are correlated with my other assets. The major problem with commodities is that they don't have an expected real return. Gold might be different. I understand that some jump to gold when the markets go sideways. And then they jump out when things calm down.

Instead of building a portfolio that performs well in a black swan event and poorly otherwise, I'd rather have a portfolio that survives a black swan and performs well when markets are normal. There are many roads to Dublin, so I'm sure that commodities work in many peoples portfolio. I don't know if they have a place in mine, though.

I haven't looked at hedge funds in depth.

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

Post by lack_ey » Wed May 13, 2015 9:52 am

But when you have leverage, you need to be more worried about left tail events, right? That's what causes margin calls and unraveling on the way down. It's not necessarily just black swans, anyway.

For what it's worth, if you add more asset classes then you really are drifting more towards leveraged risk parity ideas. A lot of the risk parity proponents do advocate using commodities (though in small quantities, and perhaps not just long-only exposure). The idea is to have multiple return drivers so hopefully not everything is kicking you in the face simultaneously.

From what I gather, hedge funds are apparently much less expensive and accessible for retail investors in say the UK than the US. That said, some strategies are available in mutual funds and ETFs (market neutral, merger/acquisitions arbitrage, managed futures, etc.), though priced at costs more like 1% ER. And the mutual funds tend to have high minimums, and these fields may be overmined and/or possibly not well executed by cheaper funds available to us plebeians.

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

Post by Spec7re » Wed May 13, 2015 10:35 am

I'm on the Swedroe side of the that argument.

A collateralized commodity futures fund should have positive expected return due to the bonds they hold as collateral. But currently with rates so low that doesn't add up to much.

Some commodities seem to have a positive expected roll return. For example, someone may sell cattle at a lower price in the future than the current spot price, allowing them to hedge supply/demand risk. So in that case you receive a sort of risk premium. However, other commodities have high holding cost. Example, oil futures price is currently higher than the spot price. Some of that is holding cost, and some is probably speculation on future oil prices. I'm no expert, but I think there is evidence that certain rolling/rebalancing strategies can create positive expected return in commodities without relying on the underlying bond collateral.

Recent performance of commodities is horrible, so it is pretty hard to sell yourself on their benefits.


My goal is to create the portfolio with the lowest risk adjusted returns and leverage it to my risk tolerance, so I'm open to any alternative investments that can help achieve this goal. I haven't done much research on hedge funds, currencies, market neutral funds, or emerging market debt, but I would be open to adding some of these If I could be convinced that they increase risk adjusted returns.

I am a fan of risk parity type portfolios.

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

Post by Johno » Wed May 13, 2015 11:10 am

Spec7re wrote:I'm on the Swedroe side of the that argument.

A collateralized commodity futures fund should have positive expected return due to the bonds they hold as collateral. But currently with rates so low that doesn't add up to much.

Some commodities seem to have a positive expected roll return. For example, someone may sell cattle at a lower price in the future than the current spot price, allowing them to hedge supply/demand risk. So in that case you receive a sort of risk premium. However, other commodities have high holding cost. Example, oil futures price is currently higher than the spot price. Some of that is holding cost, and some is probably speculation on future oil prices. I'm no expert, but I think there is evidence that certain rolling/rebalancing strategies can create positive expected return in commodities without relying on the underlying bond collateral.
One (well at least one) of the commodity (futures) ETF's selects according to some algorithm to minimize roll cost, USCI. You can compare its return to GCC which just invests equally via futures in 17 commodities. Over 5 yrs (longest graph on Google Finance including both) USCI has done a little better, both are cumulative losers in that period again not surprising given the general trend in commodities lately. If you back tested further you might get an answer of more 'statistical significance' but with more implicit reliance on the future being the same as the more distant past, the usual dilemma.

The key problem with these funds relative to the closest alternative, which is to go long the commodity futures yourself, is the poor return they get on the cash compared to what you could get, even on pure cash (in FDIC bank account, v t-bill like investments they make, big difference, before even including their expense ratio). And in terms of 'risk parity' you could also reasonably invest at least part of the cash in longer duration or credit risk fixed income investments. Of course DIY has its own disadvantages, firstly that replicating a very broad commodity portfolio would require a minimum notional size in the several $100k's at least. Also some of the contracts these funds invest in aren't easily available in most liquid form through retail-oriented brokers (for example IB makes you do metals on NYMEX and liquidity there is too low for most contracts for the bid offer cost of constantly rolling to make any sense). For other contracts though you mightn't pay any more bid-offer than USCI or GCC do.

But I say that's the closest alternative because it is. Often these funds are written off based on 'roll cost' as if that's some artificial barrier you could easily get around if not 'a sucker'. But it's not. Some 'roll cost', potentially a lot or even all, represents real costs you are avoiding by investing in the futures rather than physical; you can't expect but for those costs to be reflected in the futures price (this is pretty strictly true for financial futures, though a less ironclad relationship for commodities futures, and differs also between perishable and non-perishable commodities). So for example the alternative is not to own say oil and store it for free, as seems implicit in some off handed criticisms of commodity funds.

Anyway, the suboptimal use of cash (better part of 1%) and ~.8% management fees of these funds is significant in context of argument whether they make sense assuming a long term raw commodity return of CPI, or probably any raw expected return one could reasonably argue IMO.

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

Post by Rob Bertram » Wed May 13, 2015 12:20 pm

lack_ey wrote:But when you have leverage, you need to be more worried about left tail events, right? That's what causes margin calls and unraveling on the way down. It's not necessarily just black swans, anyway.
Correct. Definitely worry about left-tail events and try to quantify a worst case. Though, there's a line somewhere between building a leveraged balanced portfolio of stocks and bonds that has a reasonable chance of surviving a left-tail event and building a portfolio that primarily handles left-tail events. Instead of adjusting the portfolio to the left-tail event, I impose a ceiling on my target leverage.
lack_ey wrote:For what it's worth, if you add more asset classes then you really are drifting more towards leveraged risk parity ideas. A lot of the risk parity proponents do advocate using commodities (though in small quantities, and perhaps not just long-only exposure). The idea is to have multiple return drivers so hopefully not everything is kicking you in the face simultaneously.
I'm not sure that I understand risk parity enough to go down that path. I get that the premise is similar to mine -- that a portfolio of diverse assets can have an optimal risk-adjusted return that can then be leveraged to taste. The multiple return drivers might be my my biggest understanding gap. If I understand it correctly, risk parity looks for risky assets that are uncorrelated or negatively correlated. Return is nice but not necessary. The volatility and negative correlation is what supposedly adds the return. Correlation changes so much that I don't see how a risk parity portfolio would do well long term without constantly changing the AA.

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

Post by Beliavsky » Wed May 13, 2015 12:25 pm

Anyway, the suboptimal use of cash (better part of 1%) and ~.8% management fees of these funds is significant in context of argument whether they make sense assuming a long term raw commodity return of CPI, or probably any raw expected return one could reasonably argue IMO.
Johno's discussion of commodity index fund and direct futures investment is informative as usual. It would be a hassle for an investor to try to replicate the Goldman Sachs Commodity Index, which trades 24 commodities. Energy in general and oil in particular has a large weight in commodity indices. One could buy oil futures with tenor of 1 year and roll annually to get commodity exposure without much hassle or transaction cost.

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

Post by Rob Bertram » Wed May 13, 2015 12:47 pm

Beliavsky wrote:Johno's discussion of commodity index fund and direct futures investment is informative as usual.
I definitely agree! We get some fabulous discussions here. They are thought provoking and open my mind to a different perspective.

I really appreciate everyone's contributions to the discussions. I should probably say it more often as I know how much effort it takes to communicate a new and complicated idea to the group.

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

Post by lack_ey » Wed May 13, 2015 1:29 pm

Rob Bertram wrote:
lack_ey wrote:For what it's worth, if you add more asset classes then you really are drifting more towards leveraged risk parity ideas. A lot of the risk parity proponents do advocate using commodities (though in small quantities, and perhaps not just long-only exposure). The idea is to have multiple return drivers so hopefully not everything is kicking you in the face simultaneously.
I'm not sure that I understand risk parity enough to go down that path. I get that the premise is similar to mine -- that a portfolio of diverse assets can have an optimal risk-adjusted return that can then be leveraged to taste. The multiple return drivers might be my my biggest understanding gap. If I understand it correctly, risk parity looks for risky assets that are uncorrelated or negatively correlated. Return is nice but not necessary. The volatility and negative correlation is what supposedly adds the return. Correlation changes so much that I don't see how a risk parity portfolio would do well long term without constantly changing the AA.
I don't think there's any one definition, and the idea of there being "parity" is more marketing spin than a strict requirement. The hope is that the different assets have positive returns, not just low correlations, I don't think that is necessary.

One implementation would be to have an allocation that targets each of the following: market risk (just go long enough stocks to get that), value (long value stocks, short growth stocks to get "pure" value without market exposure, plus enough leverage), small (same as for value), term (leveraged Treasuries, probably, and/or just go to longer durations), credit (leveraged credit with term risk shorted out). Other factors or risk sources may be more popular in practice, and you can always use different things. One might get factor/style exposure across multiple asset classes. The idea is to be closer to equal risk from each category rather than equal dollar allocation to each. This could just be getting the standard deviation from each category equal.

The original allocation of 40% stocks, 30% long Treasuries, 30% intermediate Treasuries is kind of close to risk parity with just stock market beta and bond term risk (though the risk allocation of 40% stocks is slightly higher than those Treasuries), but that's just two sources of return. The problem is again getting access to these things as an individual investor without lots of money, plus the real possibility that the models have missed something important and/or the allocation is going to blow up on you as a result of something not yet in the historical record.

I think AQR has a bunch of papers if you search their site (I don't think Bridgewater and others like to publish as much), and SSRN is probably full of them.
https://www.aqr.com/cliffs-perspective/ ... ight-lever
https://www.aqr.com/library/journal-art ... with-style
https://www.aqr.com/library
http://www.ssrn.com/en/

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

Post by lee1026 » Wed May 13, 2015 3:51 pm

I don't think there's any one definition, and the idea of there being "parity" is more marketing spin than a strict requirement. The hope is that the different assets have positive returns, not just low correlations, I don't think that is necessary.
Negative correlations can make for for negative returns - for example, a hypothetical investment that have a -0.9 correlation with the S&P 500, beta of -2, and expected returns of -2% would be pretty appealing, despite the fact that it loses money like crazy.

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

Post by rmelvey » Wed May 13, 2015 5:09 pm

I have contemplated a leveraged risk parity strategy as well. I am exploring using options express as a broker because you can buy stocks, bonds, and futures through them (which is great because you can use your stocks and bonds as the collateral).

I am going to start paper trading a strategy that is 50% US equities (VTI), 50% 30 year treasury (TLT) and 50% exposure to gold through futures. Basically a cashless Permanent Portfolio at 1.5 leverage. It's great because you are getting very cheap leverage through the futures. :mrgreen: :dollar

What's great about this strategy is the gold has micro futures contracts that represent only 10 oz of gold (which is roughly $12,000) right now. So, you could implement this strategy using $24K of capital (12K of stocks 12K of bonds as collateral for your gold contract)!

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

Post by Rob Bertram » Wed May 13, 2015 5:36 pm

Is there any reason why you are going with OptionsHouse? If you fill up on ETFs and buy a gold future, then you might have to take a margin loan if the futures drop. It looks like OptionsHouse charges 6.25% + FFR which is highway robbery in this period of low interest. InteractiveBrokers charges 1.5% + FFR.

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

Post by rmelvey » Wed May 13, 2015 5:46 pm

I have never traded futures so I am still trying to figure out all of the pitfalls. It was my understanding that as long as I have enough collateral to cover the margin requirements I would be fine. Even if gold went to zero in that scenario as long as (hypothetically) my other assets stayed flat I am more than covered right? Because I would have 12K of gold exposure and $24k of assets.

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

Post by Rob Bertram » Wed May 13, 2015 6:01 pm

That is close. If your contract drops by $500 over the day, then $500 gets subtracted from your account and delivered to the person who sold you the contract. If you run out of cash, I would imagine that they automatically give you a margin loan before they start liquidating your assets.

On the flip side, if your contract goes up by $500, then money gets deposited into your account.

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

Post by lack_ey » Wed May 13, 2015 6:22 pm

Rob Bertram wrote:That is close. If your contract drops by $500 over the day, then $500 gets subtracted from your account and delivered to the person who sold you the contract. If you run out of cash, I would imagine that they automatically give you a margin loan before they start liquidating your assets. [emphasis added]

On the flip side, if your contract goes up by $500, then money gets deposited into your account.
You better confirm that for my passing curiosity for your own sake.

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

Post by Rob Bertram » Wed May 13, 2015 6:48 pm

That is fair. Interactive Brokers automatically switches to a margin loan. OptionsHouse could be different. They don't say how they handle the situation on their margin page, but they might give more detail when you open the margin account.

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

Post by rmelvey » Wed May 13, 2015 7:49 pm

Hmm good point I hadn't thought about daily cash settlement. I guess the best way would be futures contracts for all three positions so I always had enough cash.

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

Post by lee1026 » Wed May 13, 2015 9:39 pm

There are major tax benefits to using ETFs for stocks vs futures - the ability to defer taxes on capital gains is quite valuable and should not be thrown away lightly.

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

Post by comeinvest » Thu May 14, 2015 1:26 am

rmelvey wrote:I have contemplated a leveraged risk parity strategy as well. I am exploring using options express as a broker because you can buy stocks, bonds, and futures through them (which is great because you can use your stocks and bonds as the collateral).

I am going to start paper trading a strategy that is 50% US equities (VTI), 50% 30 year treasury (TLT) and 50% exposure to gold through futures. Basically a cashless Permanent Portfolio at 1.5 leverage. It's great because you are getting very cheap leverage through the futures. :mrgreen: :dollar

What's great about this strategy is the gold has micro futures contracts that represent only 10 oz of gold (which is roughly $12,000) right now. So, you could implement this strategy using $24K of capital (12K of stocks 12K of bonds as collateral for your gold contract)!
"because you can use your stocks and bonds as the collateral" - can you confirm that it works that way, or are you just guessing? I'm curious because I'm trying to find out the exact same thing. After doing some reading, it is my understanding that futures accounts are governed by rules, regulations, insurance, and regulating agencies completely different from those of equity and options accounts. Therefore, futures accounts are in most cases separate from equities and options trading accounts. The very few brokers that offer "combined" accounts provide a common interface or maybe automatic cash management/transfer between the futures and equities portions, but effectively they are two separate underlying accounts. IB has a "universal" account. I just came off IB online customer service, and was informed that collateral for futures positions are deducted from cash (or from broker's margin at borrowing margin rates, if available), and deposited into the futures margin subaccount without earning interest for the duration of the contract. So in essence, at IB, equities and bonds can NOT be used as collateral - only cash. I conclude that you have to add the opportunity cost of the (non-interest bearing cash) performance bond, or at least the margin rates charged on the amount deducted from cash and used as performance bond, to the effective cost of leverage using futures. To add confusion to the situation, I got the exact opposite answer from ToS (TD Ameritrade) - they said they can use marginable equities as collateral for futures positions, thus essentially adding the margin requirements of the equities (and bonds) and the deposit margin requirement of the futures positions to a combined margin requirement of the account. I do not know if the customer representative was right or just guessed. I also don't know if the "combined accounts" are handled differently by different brokers. I would be glad if someone could clarify the technicalities around futures margin in combination with marginable equity positions. It would make a noticeable difference to the effective financing cost of portfolio leverage using futures.

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Maynard F. Speer
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Re: Should I use margin to buy a balanced fund?

Post by Maynard F. Speer » Thu May 14, 2015 2:12 am

Rob Bertram wrote:Wow, that's more than a debate between Swedroe and Ferri. It's a cat fight.

I'm not sure about commodities in general. In the best case, commodities keep up with inflation and are uncorrelated with the other assets in my portfolio (stocks + treasuries). Worst case, they don't keep up with inflation, add extra volatility, and are correlated with my other assets. The major problem with commodities is that they don't have an expected real return. Gold might be different. I understand that some jump to gold when the markets go sideways. And then they jump out when things calm down.

Instead of building a portfolio that performs well in a black swan event and poorly otherwise, I'd rather have a portfolio that survives a black swan and performs well when markets are normal. There are many roads to Dublin, so I'm sure that commodities work in many peoples portfolio. I don't know if they have a place in mine, though.

I haven't looked at hedge funds in depth.
Have you read The Ivy Portfolio?

Image

Endowment portfolios are essentially built around this concept of growth through minimising losses - preserving capital in black swan events - but can also target quite high returns ... It's one of the most readable and interesting books on investing I've read, and although I don't follow it as gospel, it changed the way I look at asset allocation .. It's also got a chapter on hedge funds

I think Harvard uses Commodities but Yale doesn't .. I don't hold any directly - they've had quite a rocky ride for a while, so I prefer to have a section of my portfolio in more active, multi-asset hedge-style funds where better resourced managers than me can make decisions on things like gold and energy (and futures and options to insure against losses)

EDIT:

Alternatively there are All-Weather portfolios .. A simple, conservative asset allocation designed to hold up through most market conditions

Image

Image

Image

http://www.ipe.com/risk-parity-achievin ... ullarticle
"Economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions." - John Maynard Keynes

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

Post by Tanelorn » Thu May 14, 2015 5:58 am

comeinvest wrote:"because you can use your stocks and bonds as the collateral" - can you confirm that it works that way, or are you just guessing? I'm curious because I'm trying to find out the exact same thing. After doing some reading, it is my understanding that futures accounts are governed by rules, regulations, insurance, and regulating agencies completely different from those of equity and options accounts. Therefore, futures accounts are in most cases separate from equities and options trading accounts. The very few brokers that offer "combined" accounts provide a common interface or maybe automatic cash management/transfer between the futures and equities portions, but effectively they are two separate underlying accounts. IB has a "universal" account. I just came off IB online customer service, and was informed that collateral for futures positions are deducted from cash (or from broker's margin at borrowing margin rates, if available), and deposited into the futures margin subaccount without earning interest for the duration of the contract. So in essence, at IB, equities and bonds can NOT be used as collateral - only cash. I conclude that you have to add the opportunity cost of the (non-interest bearing cash) performance bond, or at least the margin rates charged on the amount deducted from cash and used as performance bond, to the effective cost of leverage using futures. To add confusion to the situation, I got the exact opposite answer from ToS (TD Ameritrade) - they said they can use marginable equities as collateral for futures positions, thus essentially adding the margin requirements of the equities (and bonds) and the deposit margin requirement of the futures positions to a combined margin requirement of the account. I do not know if the customer representative was right or just guessed. I also don't know if the "combined accounts" are handled differently by different brokers. I would be glad if someone could clarify the technicalities around futures margin in combination with marginable equity positions. It would make a noticeable difference to the effective financing cost of portfolio leverage using futures.
I don't know specifically about IB vs ToS, but there is an issue and most brokers aren't set up to margin futures vs stocks. Some can, but don't assume so without confirming it a couple times.

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

Post by rmelvey » Thu May 14, 2015 6:53 am

Comeinvest,

After more research I don't think it works the way I had hoped. I think I would need to use futures for all three positions which is unfortunately much less tax efficient.

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

Post by Rob Bertram » Thu May 14, 2015 7:14 am

comeinvest wrote:"because you can use your stocks and bonds as the collateral" - can you confirm that it works that way, or are you just guessing? I'm curious because I'm trying to find out the exact same thing.
I can tell you how IB does it. They do have different sub accounts for securities and futures. If the futures account needs more money to settle, it pulls from the securities account.

Right now, my securities account is about -9k cash while futures is +17k cash for a net +8k cash. I am not accruing any interest on the -9k.

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

Post by Rob Bertram » Thu May 14, 2015 7:37 am

rmelvey wrote:Comeinvest,

After more research I don't think it works the way I had hoped. I think I would need to use futures for all three positions which is unfortunately much less tax efficient.
Futures are treated as 60% long-term/40% short-term gain/loss. It's a bad deal for stocks as most of the gains are from appreciation and can be taken as long-term if held as ETFs. Bonds are mostly gains from dividends which are considered ordinary income (not cap gains!), so futures are often a better tax deal. (If I remember correctly, interest from treasuries are exempt from state and local taxes but treasury futures are not.)

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

Post by rmelvey » Thu May 14, 2015 8:03 am

Hi rob thanks for the expedited education/wisdom I really appreciate it. Are you saying that you didn't have to pay interest on the borrowed cash used to settle the futures because you had collateral in the form of stocks/bonds?

Or is the money borrowed in the securities account not accruing interest because you have the cash in the futures account?

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"No Margin for Error"

Post by Taylor Larimore » Thu May 14, 2015 8:20 am

Bogleheads:

Before borrowing to invest, it is a good idea to read this warning by the Financial Industry Regulatory Authority:

No Margin For Error

Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

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

Post by Rob Bertram » Thu May 14, 2015 9:08 am

rmelvey wrote:Hi rob thanks for the expedited education/wisdom I really appreciate it. Are you saying that you didn't have to pay interest on the borrowed cash used to settle the futures because you had collateral in the form of stocks/bonds?

Or is the money borrowed in the securities account not accruing interest because you have the cash in the futures account?
It is more the latter but some of the first. Futures accounts can't go negative, but the securities account can. So the collateral in stocks/bonds allowed me to take a margin loan and transfer that cash into the futures account. I am net cash positive, so I'm not paying any interest on that margin loan. At least, that's what I am seeing. I have been cash negative in my securities account for about two weeks. If I were accruing interest, it should be about $9k *1.6%/250 = $0.58/day. It is not showing up on my statement, and I just checked it this morning.

IB is doing all of this automatically. As far as I can tell, I don't have any way to transfer money between sub-accounts besides buying and selling assets.

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

Post by comeinvest » Thu May 14, 2015 1:12 pm

Rob Bertram wrote:
rmelvey wrote:Comeinvest,

After more research I don't think it works the way I had hoped. I think I would need to use futures for all three positions which is unfortunately much less tax efficient.
Futures are treated as 60% long-term/40% short-term gain/loss. It's a bad deal for stocks as most of the gains are from appreciation and can be taken as long-term if held as ETFs. Bonds are mostly gains from dividends which are considered ordinary income (not cap gains!), so futures are often a better tax deal. (If I remember correctly, interest from treasuries are exempt from state and local taxes but treasury futures are not.)
You can still try to use futures on whatever asset class within your overall portfolio that is most tax efficient (for using futures), and/or that has the most liquid futures market. Because of the low futures margin deposits, in many cases you could achieve your desired overall leverage by using futures only on the most efficient (for futures purposes) asset class. In retirement accounts, that would often be the S&P500 index portion (use ES future). For retirement accounts, the competitive advantage of futures vs. alternative leverage methods is bigger than for taxable accounts; I think this has been mentioned earlier in this thread. For taxable accounts, at least my models indicate that the advantages of e.g. margin borrowing at IB with tax loss harvesting and tax deferral on capital gains probably outweigh the advantages of futures on a risk adjusted expected return basis.

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

Post by lee1026 » Thu May 14, 2015 2:19 pm

It is more the latter but some of the first. Futures accounts can't go negative, but the securities account can. So the collateral in stocks/bonds allowed me to take a margin loan and transfer that cash into the futures account. I am net cash positive, so I'm not paying any interest on that margin loan. At least, that's what I am seeing. I have been cash negative in my securities account for about two weeks. If I were accruing interest, it should be about $9k *1.6%/250 = $0.58/day. It is not showing up on my statement, and I just checked it this morning.
This gives me an idea on avoiding margin interest - sell a big stack of ITM futures options, buy the underlying futures. The ITM future options will get cash into your (futures) account immediately. You won't have to pay anything upfront for the underlying futures. But if the cash in your futures account count against your margin interest, then it is basically free margin interest.

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

Post by comeinvest » Thu May 14, 2015 2:39 pm

lee1026 wrote:
It is more the latter but some of the first. Futures accounts can't go negative, but the securities account can. So the collateral in stocks/bonds allowed me to take a margin loan and transfer that cash into the futures account. I am net cash positive, so I'm not paying any interest on that margin loan. At least, that's what I am seeing. I have been cash negative in my securities account for about two weeks. If I were accruing interest, it should be about $9k *1.6%/250 = $0.58/day. It is not showing up on my statement, and I just checked it this morning.
This gives me an idea on avoiding margin interest - sell a big stack of ITM futures options, buy the underlying futures. The ITM future options will get cash into your (futures) account immediately. You won't have to pay anything upfront for the underlying futures. But if the cash in your futures account count against your margin interest, then it is basically free margin interest.
I never traded futures, and just learning the details, but I can guarantee you that you forgot to account for some implied or hidden financing cost somewhere in your logic.

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

Post by comeinvest » Thu May 14, 2015 3:20 pm

Rob Bertram wrote:
rmelvey wrote:Hi rob thanks for the expedited education/wisdom I really appreciate it. Are you saying that you didn't have to pay interest on the borrowed cash used to settle the futures because you had collateral in the form of stocks/bonds?

Or is the money borrowed in the securities account not accruing interest because you have the cash in the futures account?
It is more the latter but some of the first. Futures accounts can't go negative, but the securities account can. So the collateral in stocks/bonds allowed me to take a margin loan and transfer that cash into the futures account. I am net cash positive, so I'm not paying any interest on that margin loan. At least, that's what I am seeing. I have been cash negative in my securities account for about two weeks. If I were accruing interest, it should be about $9k *1.6%/250 = $0.58/day. It is not showing up on my statement, and I just checked it this morning.

IB is doing all of this automatically. As far as I can tell, I don't have any way to transfer money between sub-accounts besides buying and selling assets.
Thanks for giving us the data points regarding the accounting at IB. If you are indeed not paying interest on your margin loan, it would mean that IB is basically netting the cash balances of the futures and securities accounts, including the cash used as performance bond in the futures account. If that is the case, then contrary to my prior concern that I mentioned in my prior post, there would indeed be no additional financing cost in form of margin borrowing cost of the cash collateral for the futures positions, at least not in the scenario where marginable equities are available in a combined equities+futures account.
To confirm this theory, I'm curious what the statement would look like if you had a negative total cash balance. Would the negative cash in the securities account be split into two parts, i.e. netted with the positive cash in the futures account, and margin debit interest only be paid on the net amount? Does the *total* cash balance show on your statement, or did you just calculate it yourself? I would assume the portion of any cash balance that interest is charged on should show on the statement.
Another interesting question would be if a total positive cash balance (including the cash in the futures account) earns interest in higher interest rate environments.
Also, if this theory is correct, the movement of cash from the securities to the futures subaccount would have no economic meaning. If this transfer of cash between subaccounts is neutral with respect to interest, i.e. if interest is only charged on the total netted balance, then one could say that effectively the equities serve as collateral for the futures position. The futures margin collateral amount is deducted from the "Cash available (for trading)", and margin requirements of the futures and equities accounts are effectively combined, and the end result would be the same as what ToS (TD Ameritrade) explained to me - at least for taxable accounts.
Not so for retirement accounts. IB explained to me that futures collateral can only be in the form of cash. In an IRA, there is no borrowing from the broker, and consequently futures positions would require a positive total cash balance in the amount of the futures margin. Given the high futures margin requirements of IRAs at IB, in my understanding this would mean a significant increase in effective cost of leverage using futures - even though cash balances of the futures and securities account were netted for debit interest purposes, cash in the securities account alone can not go negative even when total cash is positive, so the futures collateral would be sitting idling with no interest, adding to the cost of leverage.
The ToS representative, on the other hand, given the exact same scenario, explained that I would need zero cash to initiate a futures position in an IRA if I have enough marginable equities in the account.
Which one is right? While it is thinkable that the two brokers use completely different accounting, I don't think it's likely. I have a strong feeling that at least one of the two representatives is wrong. I would prefer to know the rules and leverage cost before committing to a strategy, rather than doing some sort of trial and error with moving targets :)

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

Post by Rob Bertram » Fri May 15, 2015 4:14 pm

Maynard F. Speer wrote:Have you read The Ivy Portfolio?

Endowment portfolios are essentially built around this concept of growth through minimising losses - preserving capital in black swan events - but can also target quite high returns ... It's one of the most readable and interesting books on investing I've read, and although I don't follow it as gospel, it changed the way I look at asset allocation .. It's also got a chapter on hedge funds

I think Harvard uses Commodities but Yale doesn't .. I don't hold any directly - they've had quite a rocky ride for a while, so I prefer to have a section of my portfolio in more active, multi-asset hedge-style funds where better resourced managers than me can make decisions on things like gold and energy (and futures and options to insure against losses)

EDIT:

Alternatively there are All-Weather portfolios .. A simple, conservative asset allocation designed to hold up through most market conditions
I have not read The Ivy Portfolio, but I will. I reserved a copy at the library.

Do you have any books that you'd recommend on hedge funds?

I have heard of the all-weather portfolio but dismissed it due to the different risky tilts (commodities, EM bonds). I will definitely take another look in order to understand it. I used the numbers from the pie chart and plugged them into Portfolio Visualizer. It does not have EM bonds, so I put the 14.58% into global bonds instead. It's not a perfect match, but it's a reasonable approximation.

Image

Here are the results. (Portfolio Visualizer link) The 40/60 portfolio that I'm using is the blue line (Portfolio #1). The red line is the all-weather portfolio (Portfolio #2). The yellow line is the US stock market as a frame of reference.

Image

I would love to see how the portfolios compared in the 1970s. Though, I'm not sure if EM bond funds existed back then. I know that my treasury-heavy portfolio dropped about 14.5% from 1973-4.

The nice thing about bonds (and having a portfolio that is 60% bonds) is that they have a positively skewed standard deviation. For that reason standard deviation might not be as good of a metric as something like max drawdown.

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

Post by market timer » Thu Jun 04, 2015 1:26 am

Rob Bertram wrote:For those watching the spreadsheets, I updated the new one. I backfilled data to April 14th when I switched to futures and got the portfolio back into balance. It still only has 2 weeks of data, but it's better than only 1 week. https://docs.google.com/spreadsheets/d/ ... sp=sharing
How are you updating this spreadsheet? Do you manually input share prices daily or have some program that automates it?

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

Post by Rob Bertram » Thu Jun 04, 2015 7:18 am

I manually update them. For a time, I tried using the Google finance macros, but that fails more often than I like for historic data. I have been considering automating the maintenance of the spreadsheets, but it's not a high priority yet.

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

Post by privatefarmer » Thu Jun 04, 2015 6:12 pm

I have been trying to keep up on this thread but it has gotten very technical and has lost me...

HOWEVER, I am currently using interactive brokers/leverage to invest 100% in equities w/ a strong value/small tilt. I am 31 yrs old, hope to accumulate for another 30+ years.

I understand the power of leverage and the risks, I am only about 25% leveraged right now so that I am not at a legitimate risk of a margin call in a bad market.

I am wondering if those who have kept up on this thread could summarize :

1) if you are using leverage, what is your asset allocation, risk tolerance, and time frame for investing?

2) how much leverage are you using

3) has anyone found the "sweet spot" w/ IB portfolio margin that will maximize the amount of leverage one can have w/o decreasing equities to too small of a percentage of assets (I understand that if you have more fixed income you can have more leverage w/ portfolio margin but obviously you are then reducing your expected CAGR)

I have not hit the 110k yet to have PM but hope to get there soon. Any help is greatly appreciated. Thanks!

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

Post by lack_ey » Thu Jun 04, 2015 8:07 pm

Just be clear you understand that even without margin calls, more leverage does not mean more returns. Too much is actually worse. An allocation that must be concerned about margin calls may already be more risky than is actually helpful.

If you happened to enter the market in 2000 and invested in the US stock market through the end of 2012, you would have turned $10,000 into $13,128. That's a kind of rough 13 years but at least in the green. If you were 125% stocks and -25% cash, with the borrowing cost being 50 bp over T-bills (never mind 150 bp), you would have turned $10,000 into $12,191. More risk and a couple plunges below $5,000 later, you end up with less reward. That's without the small value tilt but shouldn't be that much different with it.

Now, 125% stocks and -25% cash is going to return more under more favorable market conditions, but don't count on it, and don't count on more margin being necessarily better for absolute returns. Obviously you're throwing risk-adjusted returns out the window.

And don't count on holdings other than stocks to be flat (much less up) at the same time equities are down.

However, do note that all scenarios are much more manageable and profitable if making regular contributions throughout and not lump summing at the beginning.

edit: the above is using monthly returns and rebalancing margin levels to get 125% stock, -25% cash. I think keeping a constant AA is a fairer representation and closer to how risk might be managed in real time. Otherwise, you have higher leverage when drawdowns occur, which is usually when markets are even more volatile anyway. Not volatility/AA adjusting is not realistic. One of these days you run into a bad enough market and need to make some kind of systematic change or have it forced upon you.

In any case, the borrowing cost changes over time (and was higher over much of the period) and is generally higher than it is now.

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

Post by privatefarmer » Thu Jun 04, 2015 11:11 pm

lack_ey wrote:
edit: the above is using monthly returns and rebalancing margin levels to get 125% stock, -25% cash. I think keeping a constant AA is a fairer representation and closer to how risk might be managed in real time. Otherwise, you have higher leverage when drawdowns occur, which is usually when markets are even more volatile anyway. Not volatility/AA adjusting is not realistic. One of these days you run into a bad enough market and need to make some kind of systematic change or have it forced upon you.
I am prepared for up to a 70% draw down in the markets (I also have included a years worth of salary/contributions during the draw down in my calculation) which is how I have determined that ~25% leverage is my current max to avoid a margin call. I would not want to ever sell, particularly in a draw down; I understand that when a draw down occurs my margin loan will be a larger percentage of my total portfolio. But that's okay, that's why I am only 25% leveraged to start with so that the odds of a margin call are minuscule.

I am more concerned about borrowing costs rising. Has anyone calculated at what point borrowing costs outweigh potential future profits? at 1.6% cost I am fairly confident I can make money w/ margin but I figure if it approaches 5% then I should just pay off my margin loan and walk away. What is the general consensus (assuming 100% equities, unless there is a more profitable way using a mix of equities and fixed income).

Again, I am 31 yrs old, have hopefully 30+ yrs to accumulate, am not concerned w/ volatility but am concerned w/ avoiding a margin call.

Thanks all!

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