Buy Borrow Die & Risk

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nvrmnd
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Buy Borrow Die & Risk

Post by nvrmnd »

Suppose your investment goal is to maximize the amount of money left to your beneficiaries, one idea that I have become increasingly more appealing to me is the idea of borrowing against (non-IRA) assets instead of selling them, as a way to avoid capital gains tax. Sometimes referred to as the buy-borrow-die strategy. Making use of the step-up in cost basis at death, which effectively forgives all capital gains.

Invariably when this concept comes up there is a comment or two about margin call risk so it's important to agree first off that this strategy only really makes sense if there is a reasonable buffer between the amount of money you will need in retirement and your total assets.

It's not really the margin call risk that gives me pause, but rather that if you plan on doing this any % of fixed income in your portfolio no longer makes any sense at all. It is not sensible to borrow money at a (p+x)% rate while you have fixed income investments paying out at a (p-x)% rate. So this got me thinking about whether fixed income is really that important on the longer time scales, and I have more or less concluded it doesn't make much sense at the 10+ year time frame. The rationale is as follows.

Consider an investment into VTI, and a reasonable risk model for this based on historical trends, the asset should grow an exponential rate (e.g. 9.85% annually) and will have error bars around that number, say at the p95 quantile (i.e. the 5% worst case). A key observations is that even under the most conservative assumptions it's generally assumed that the error does not grow exponentially over time, and certainly not at a faster rate than the mean.

All I'm trying to observe here is that the bottom of the error bar is going up steadily if we plot this over time. With a formula that looks like this: 1.0985^t - c*t^2. For some constant c, which depends on VTI holdings etc. And that c^t functions grow a hell of a lot faster than t^2 functions.

The upshot here is that at some point in the future the worst case for VTI is better than the best case for fixed income. We would have to squabble about precisely when that is, as we debate about how much past variance can predict future variance. But when I sit down and make what I consider to be reasonable assumptions cross over point seems to be 10+ years.

Another way of saying this is that risk only really matters in the short term, when your planning to actually draw down from the portfolio. But I see so many investment channels, forums posts, and so on about using the 80/20 on the 15, 20, or 30 year time frame and I just don't see how that makes any sense. Also, when you throw in rebalancing on deposit into this it's even worse as you end up contributing almost everything to the fixed income channel (Rob Berger has a good video on this).

Appreciate any feedback on these thoughts.
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retired@50
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Re: Buy Borrow Die & Risk

Post by retired@50 »

nvrmnd wrote: Tue Sep 26, 2023 2:02 pm
The upshot here is that at some point in the future the worst case for VTI is better than the best case for fixed income. We would have to squabble about precisely when that is, as we debate about how much past variance can predict future variance. But when I sit down and make what I consider to be reasonable assumptions cross over point seems to be 10+ years.

Appreciate any feedback on these thoughts.
You may need to consider a longer horizon than the 10+ years mentioned above. There is a 17 year stretch where stocks and bonds are nearly equal, and it's from May 1992 to April 2009.

See link: https://www.portfoliovisualizer.com/bac ... ion2_2=100

Regards,
If liberty means anything at all it means the right to tell people what they do not want to hear. -George Orwell
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nvrmnd
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Re: Buy Borrow Die & Risk

Post by nvrmnd »

You may need to consider a longer horizon than the 10+ years mentioned above. There is a 17 year stretch where stocks and bonds are nearly equal, and it's from May 1992 to April 2009.
Thanks for this link, maybe my model is a bit optimistic regarding variance, though.. maybe not.

The model I was using is a mean + variance model, not a historical back testing model, and both are valid and generally agree.

I should also clarify what I mean by best and worst case. We have to acknowledge that one cannot possibly claim that the the worst case for any asset is anything other than falling to $0, because that is always possible. What I instead find interesting is the p95 worst/best case, i.e. where 95% of the cases the asset will be above this value at a given point in time.

That is to say, the particular 17 year period you mention is a cherry-picked datapoint, if you consider all 17 year periods over the last 60 years then > ~98% of the time a diversified ETF out-performs bonds.

For illustrative purposes, numbers I don't have exactly: If you consider 2 year periods 50% cases this is true, 5 year periods 75%, 10 year periods 95%, 20 years 100%...

As your time horizon grows the way in which you think about 60/40, 80/20, etc. really has to change.
randomguy
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Re: Buy Borrow Die & Risk

Post by randomguy »

nvrmnd wrote: Tue Sep 26, 2023 2:02 pm Suppose your investment goal is to maximize the amount of money left to your beneficiaries, one idea that I have become increasingly more appealing to me is the idea of borrowing against (non-IRA) assets instead of selling them, as a way to avoid capital gains tax. Sometimes referred to as the buy-borrow-die strategy. Making use of the step-up in cost basis at death, which effectively forgives all capital gains.

Invariably when this concept comes up there is a comment or two about margin call risk so it's important to agree first off that this strategy only really makes sense if there is a reasonable buffer between the amount of money you will need in retirement and your total assets.
At the expense of having to pay interest. Back when rates where 2%, this wasn't a big deal. But margin rates these days can be 8%+. If you do this scheme for 20+ years, you are going to have a lot of debt to service. 30k/year at 7% for 20 years would be 1.4million dollars of debt . You are hoping your 1 million grows to 6.1m (making 9.5%). But we haven't talked about the money you will need to be borrowing to service that debt. In year 1 it isn't a big deal. In year 20 when you are adding 100k/year to your debt it will add up. The risk is you hit 80 with say 6 million dollars and like 2million in debt. You have done well and have an extra couple million from taking on the risk. The market then drops 50%. With 3 million dollars and 2 million in debt, you get the margin call and whole house of cards comes down. Now this is all quick and dirty math. You would have to put in your assumptions. Maybe your debt level never forces a margin call. The risk is always that the good cases are better but the bad cases are fatal. The long term only matters if you can make it that far.
afan
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Re: Buy Borrow Die & Risk

Post by afan »

As random guy says, this is risky if you start accumulating debt that is substantial compared to your assets.

$2M in debt on a $100M portfolio- no problem. Market drops 70% and you have $2M in debt on a $30M portfolio.

Market drops 70% on a $6M portfolio and you are wiped out.

If you would still be safe from margin call after a 70-80% drop, then borrow away. But just as your margin debt should never approach margin call territory for investing, it should never get there for living expenses.
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama
Rex66
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Re: Buy Borrow Die & Risk

Post by Rex66 »

These work great when you “can control the bank” bc you are a billionaire.

You can force awesome terms for the loan and they are unlikely to mess with you out of fear.

When you don’t like most of us you are just risking for hope of better return but no guarantees. I’d prefer not taking on more risk than 100% equities. One can easily wind up paying more in interest then they would in taxes.
sharukh
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Re: Buy Borrow Die & Risk

Post by sharukh »

I intend to do exactly what you planned. Just add some put options in the portfolio to reduce risk and consider it as the additional cost of interest rate
skeptical
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Re: Buy Borrow Die & Risk

Post by skeptical »

Have you factored in withdrawal rates ?

Lets say you are at a 3% withdrawal rate, kind of conservative, and your asset base will probably grow.
Market drops by 60%, you are now at a 7.5% withdrawal rate. Kind of a deep hole to crawl out of even if stocks continue their 10% annual climb.

I don't have bonds because of their return, and don't compare their return to stocks. I have bonds to reduce portfolio volatility. With a 50/50 portfolio, and a 60% drop in equities, your withdrawal rate is 4.2%, assuming bonds don't change too much.

Also, when markets get volatile, borrowing can become problematic just when you need it the most.

I agree with you during a long accumulation phase, if you can stomach the volatility. Drawdown is different, both numerically and psychologically.
manuvns
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Re: Buy Borrow Die & Risk

Post by manuvns »

borrow when market drops 10% or more then service debt
Thanks!
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nvrmnd
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Re: Buy Borrow Die & Risk

Post by nvrmnd »

At the expense of having to pay interest. Back when rates where 2%, this wasn't a big deal. But margin rates these days can be 8%+
@randomguy -- Yeah the interest payments are painful, I think this is one of the best counter-points to this strategy. Not just that rates are high now, but that these are variable rate loans and therefore there is a major interest rate risk. Also, if rates climb rapidly that can happen right when the equities market begins to drop -- not good.

But just to continue the discussion, because I find it really fascinating, consider this, what I was observing above is that at some time horizon the faster-growing asset will outstrip the slower one and there will be no overlap in the error bars. When it comes to margin interest it's the same observation applies but it just takes longer to get to that 95% certainty point. As instead of the market competing with (fed_rate - x)% fixed income yield it's now competing with (fed_rate + x)% (IBKR is fed_rate+0.75% IIRC). So maybe 15 years?

That basically means that the margin interest is not only going to be paid for but will actually earn more even before you consider the capital gains tax savings, which are huge and really the reason I'm considering this. Again, most likely, 95 times out of 100, or whatever.
I intend to do exactly what you planned. Just add some put options in the portfolio to reduce risk and consider it as the additional cost of interest rate
Yeah, I was doing this too, and you can claim a loss on these hedges as they expire, it's like tax loss harvesting. But then I started being convinced about the time horizon argument and buying LEAP index puts on SPX doesn't make as much sense as simply never going above a high LTV. But maybe late in retirement I would have to start doing this again.
I don't have bonds because of their return, and don't compare their return to stocks. I have bonds to reduce portfolio volatility. With a 50/50 portfolio, and a 60% drop in equities, your withdrawal rate is 4.2%, assuming bonds don't change too much.


I hear this so much, but like here, there is no context on time horizon. A 50/50 portfolio will actually be better than a 100/0 portfolio in 2 years some sensible amount of the time -- say 40% of the time. But what about 50 years? 40 years?
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Watty
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Re: Buy Borrow Die & Risk

Post by Watty »

Two things to consider;

1) The step in cost basis is not engraved in stone and there has been talk of eliminating that. I do not know of any pending legislation to do that right now but because of board rules we cannot discuss possible law changes but the step up in cost basis never really made a lot of sense to me.

2) By using leverage you would be increasing your sequence of returns risk.
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CyclingDuo
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Re: Buy Borrow Die & Risk

Post by CyclingDuo »

nvrmnd wrote: Tue Sep 26, 2023 2:02 pmSuppose your investment goal is to maximize the amount of money left to your beneficiaries, one idea that I have become increasingly more appealing to me is the idea of borrowing against (non-IRA) assets instead of selling them, as a way to avoid capital gains tax. Sometimes referred to as the buy-borrow-die strategy. Making use of the step-up in cost basis at death, which effectively forgives all capital gains.

Appreciate any feedback on these thoughts.
Why not just help teach/coach your beneficiaries to utilize their own human capital to save and invest a solid percentage of their income weekly/monthly/annually?

CyclingDuo
"Save like a pessimist, invest like an optimist." - Morgan Housel | "Pick a bushel, save a peck!" - Grandpa
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nvrmnd
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Re: Buy Borrow Die & Risk

Post by nvrmnd »

2) By using leverage you would be increasing your sequence of returns risk.
The term leverage is usually used in the context of borrowing against investments for the purchase of more investments.

Selling $100k at time `t` and paying $15k in tax v.s. keeping that $100k in VTI and borrowing $100k instead.

This feels different than:

Borrowing $100k to purchase an additional $100k of VTI.
alex_686
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Re: Buy Borrow Die & Risk

Post by alex_686 »

For context, I worked the margin desk during the dot.com boom and bust. I now work in risk management.

I have a very poor opinion of this strategy. You are playing with fire. I have seen lots of different people play this game. Many of them very smart using sophisticated models. I have seen them go down in flames. There are some great stories out there. One is about Long Term Capital Managment who had 2 Nobel winners leading the team.

First, there may be better ways to gain leverage than by margin. Futures and options come to mind. Still playing with fire.

Second, read up on "Volatility Drag".

Simple example. Assume annual 12% returns. Assume a volatility of 18%. Assume your distributions are normal - their not and this is not to your advantage but let us assume this to keep the math simple. So that means you expected returns with a standard deviation will get you returns between -6%/30%.

So here is the critical question. You have average annual returns of 12%. What is your geometric return? I mean, it is not going to be 310% (1.12^10) Well, it is going to be a lot lower than that. You need to subtract the square root of your volatility. That is going to cost you about 4.25% a year. So you are only going to wind up with 210%.

As you increase leverage you increase your average returns. This is good. As you increase leverage you increase the volatility of your returns, which increases you volatility drag. You quickly hit a point where your leveraged geometric return is lower than your unleveraged geometric return.

Now this is kind of a valid strategy if you have a massive ability to take risks and you have serious tax issues. Otherwise it is just not worth it.

The best-case scenario I can think of is to have a modest mortgage on your primary home.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
sc9182
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Re: Buy Borrow Die & Risk

Post by sc9182 »

Or have a 2x levered product such as SSO - with very minute portion of the portfolio— and call it a day.

Nope- we don’t give advice - just writing my thoughts aloud ..
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nvrmnd
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Re: Buy Borrow Die & Risk

Post by nvrmnd »

@alex_686 Thanks for your comment, it's exactly this sort of technical feedback I was after here. Let me try to make a couple counter-arguments, I'm interested in your thoughts on these points.

[A simple argument]
First, there may be better ways to gain leverage than by margin. Futures and options come to mind. Still playing with fire.
Depending on your definition of leverage, borrowing instead of selling could be construed as such. But what I am describing is really quite different than purchasing assets or derivatives to magnify returns. The difference is that the former is so as to avoid capital gains tax, if that was not part of the equation then I would agree with you, leverage itself is not any brilliant strategy going by risk-adjusted returns.

Suppose you have a diversified ETF trading at $100 with a cost-basis of $50, and now you need $4/yr to live for the next 25 years. We expect this ETF to return 9%/yr and that we expect interest rates to land around 6% over this period. Finally, assume a 25% tax rate.

When calculating your favored risk-adjusted returns here you usually end up ahead, because that extra $12.50 you save on taxes is a considerable factor.

[A more complex argument]
In my original post I'm really trying to hit on the point of time horizons as it relates to risk, specifically how the variance of a distribution grows at a slower-than-exponential rate under (afaik) any modeling assumptions widely used today. Specifically, if we were to assume that returns are IID random variables we observe that he variance of the asset value grows linearly over time, implying the standard deviation grows at a \sqrt(time) rate! While the mean grows at an exponential rate, the variance just can't keep up.

I'm not trying to say anything more clever here than the fact that risk needs to be thought of over a time horizon, and that this reasoning applies to both borrowing and the percentage of fixed-income investments in one's portfolio.
afan
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Re: Buy Borrow Die & Risk

Post by afan »

nvrmnd wrote: Tue Sep 26, 2023 10:32 pm ... at some time horizon the faster-growing asset will outstrip the slower one and there will be no overlap in the error bars.
Do not conflate ex ante expected returns with ex post observed. You do not know ex ante which will be the better performing asset.

Stocks are so volatile that the error bars for terminal wealth become huge over decades. Returns to stocks can be lower than Tbills.

The strategy is only safe if a good worst-case estimate, say 90% drop in stocks and high interest rates, say 15% on borrowed money- would leave one far from a margin call.

Say you have $1 billion in marginable assets and you borrow $100,000 each year, index your borrowing to high inflation and let the interest owed accumulate as debt. It would take far more than a lifetime for your debt to get as high as half or 1/3 of assets. That should be enough for even the most nervous broker.

As you climb down from billionaire wealth, you would need to punch in the same figures for negative returns and high interest rates, along what you have and what you actually own and how much you plan to borrow.

The people and companies that alex saw go under were not wiped out because they used leverage, but because they had more debt than they could afford. With enough capital, all of them would have survived. In some cases, the leverage was so great that almost no one could have had enough capital. Those people made big mistakes with other people's money

In some cases, the strategy revolved around massive leverage. The investments they were making would not have paid enough to stay in business without leverage. Those people made big mistakes with other people's money.


If someone hires you to take big risks with their money, pays you a good base salary and huge bonuses when things go well sure, take the offer and leverage to the skies

Do not make this mistake with your own money.
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama
alex_686
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Re: Buy Borrow Die & Risk

Post by alex_686 »

This is being written on a phone, so this may be a bit erratic. Let us start off with 2 quotes.

All models are wrong, some are useful.

The market can stay irrational longer than you can stay liquid.

On that, to you:

“ Specifically, if we were to assume that returns are IID random variables we observe that he variance of the asset value grows linearly over time, implying the standard deviation grows at a \sqrt(time) rate! While the mean grows at an exponential rate, the variance just can't keep up.”

This is wrong. A standard distribution assumes a constant volatility. Volatility varies from period to period, and jumps around. As such you can’t combine periods, such as pre-covid and post covid data.

Well, that’s may argue that I am picking at a narrow technical point and ignoring your general statement. Well, kind of - but it is to make a point. I have seen lots of smart people make the right decisions with a solid plan and still blow themselves up.

You suggest that you have that you have things mapped out to 95%. My experience tells me you are going to face 2 to 4 hard periods over 20 years. (On a side note, my colleague and I had a discussion on CVaR - figuring out had bad things would get if you hit that 5%. He, being a financial engineer l, thought he could come up with a reasonable number. I, with experience, thought it was foolish to come up with a number when a system breaks down in new and novel ways)

Part of this are times like this. Margin rates are what -6ish, 7ish percent? What will be the long term stock return? I can make a case for 7ish percent. If so, then your plan won’t work. And yeah, an inverted yield curve is odd. And it may end shortly- but it has gone on longer than I had thought. And I can see this going for a decade.

Part of this is that people tend to underestimate the risk involved and overestimate their risk tolerances.

So there are going to be times when hard decisions will gave to be made. It takes steady nerves to know when to hold to your plan and when to change course.

If you do this, approach it with humility.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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nvrmnd
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Re: Buy Borrow Die & Risk

Post by nvrmnd »

Well, that’s may argue that I am picking at a narrow technical point and ignoring your general statement.
Haha, yes, that is exactly what I would say. I'm using IID here as an illustration about how the variance of a sum of random variables grows much much slower than an exponential function.

I claim that taking a car is faster than walking because if you take the distance as the crow flies you would save 9 hours, counter-claims about the legitimacy of the crow flies assumption are not wrong, but obviously not interesting either.

Yes, the market is complicated, modeling is hard, the real world is noisy, and black swan events are a real phenomenon. None of this should prevent you from attempting to use mathematics, statics, logical reasoning, and feedback from strangers on the internet to attempt to improve your financial strategy.
comeinvest
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Re: Buy Borrow Die & Risk

Post by comeinvest »

nvrmnd wrote: Tue Sep 26, 2023 2:02 pm Suppose your investment goal is to maximize the amount of money left to your beneficiaries, one idea that I have become increasingly more appealing to me is the idea of borrowing against (non-IRA) assets instead of selling them, as a way to avoid capital gains tax. Sometimes referred to as the buy-borrow-die strategy. Making use of the step-up in cost basis at death, which effectively forgives all capital gains.

Invariably when this concept comes up there is a comment or two about margin call risk so it's important to agree first off that this strategy only really makes sense if there is a reasonable buffer between the amount of money you will need in retirement and your total assets.

It's not really the margin call risk that gives me pause, but rather that if you plan on doing this any % of fixed income in your portfolio no longer makes any sense at all. It is not sensible to borrow money at a (p+x)% rate while you have fixed income investments paying out at a (p-x)% rate. So this got me thinking about whether fixed income is really that important on the longer time scales, and I have more or less concluded it doesn't make much sense at the 10+ year time frame. The rationale is as follows.

Consider an investment into VTI, and a reasonable risk model for this based on historical trends, the asset should grow an exponential rate (e.g. 9.85% annually) and will have error bars around that number, say at the p95 quantile (i.e. the 5% worst case). A key observations is that even under the most conservative assumptions it's generally assumed that the error does not grow exponentially over time, and certainly not at a faster rate than the mean.

All I'm trying to observe here is that the bottom of the error bar is going up steadily if we plot this over time. With a formula that looks like this: 1.0985^t - c*t^2. For some constant c, which depends on VTI holdings etc. And that c^t functions grow a hell of a lot faster than t^2 functions.

The upshot here is that at some point in the future the worst case for VTI is better than the best case for fixed income. We would have to squabble about precisely when that is, as we debate about how much past variance can predict future variance. But when I sit down and make what I consider to be reasonable assumptions cross over point seems to be 10+ years.

Another way of saying this is that risk only really matters in the short term, when your planning to actually draw down from the portfolio. But I see so many investment channels, forums posts, and so on about using the 80/20 on the 15, 20, or 30 year time frame and I just don't see how that makes any sense. Also, when you throw in rebalancing on deposit into this it's even worse as you end up contributing almost everything to the fixed income channel (Rob Berger has a good video on this).

Appreciate any feedback on these thoughts.
I think your thought process is valid. You discovered one of the two free lunches in investing: Time diversification (more on it below), or the longer your investment horizon the higher the short-term drawdown risk you can and should take. The other one is asset diversification (e.g. equities + treasuries). If you go a step further, you have to ask yourself how much leverage is safe. Thinking harder, eventually you might come to the conclusion that the leverage ratio should be age-dependent and decline over time. Also, it is not graved in stone that fixed income doesn't fit into this puzzle - if you borrow short near risk-free rates, and invest long (or better intermediate). You might be interested in reading the mHFEA thread viewtopic.php?t=357281 and the lifecycle thread (diversification over time) viewtopic.php?t=274390 . Those are basically two frameworks that intend to optimize your lifetime risk-adjusted returns. Depending on how they are implemented, they are based on certain tail risk assumptions like markets will recover from drawdowns, no major catastrophic events beyond what the history of the modern financial system saw, and your utility function is only based on the terminal result and not on temporary drawdowns or volatilities.
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nvrmnd
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Re: Buy Borrow Die & Risk

Post by nvrmnd »

Thanks for the links @comeinvest a lot there to process.
sharukh
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Re: Buy Borrow Die & Risk

Post by sharukh »

comeinvest wrote: Fri Sep 29, 2023 5:06 am Depending on how they are implemented, they are based on certain tail risk assumptions like markets will recover from drawdowns, no major catastrophic events beyond what the history of the modern financial system saw, and your utility function is only based on the terminal result and not on temporary drawdowns or volatilities.
Nicely said, you have described the assumption very well.
toddthebod
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Re: Buy Borrow Die & Risk

Post by toddthebod »

nvrmnd wrote: Wed Sep 27, 2023 2:15 pm
2) By using leverage you would be increasing your sequence of returns risk.
The term leverage is usually used in the context of borrowing against investments for the purchase of more investments.

Selling $100k at time `t` and paying $15k in tax v.s. keeping that $100k in VTI and borrowing $100k instead.

This feels different than:

Borrowing $100k to purchase an additional $100k of VTI.
It's worse right? A lot worse, because in the latter case, you have twice as many shares of VTI with the same debt to pay off.

So to me this sounds like taking all the risks inherent in margin investing and greatly amplifying them because you are spending the money instead of purchasing sellable assets.
Backtests without cash flows are meaningless. Returns without dividends are lies.
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nvrmnd
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Re: Buy Borrow Die & Risk

Post by nvrmnd »

toddthebod wrote: Sat Nov 04, 2023 8:51 pm It's worse right? A lot worse, because in the latter case, you have twice as many shares of VTI with the same debt to pay off.

So to me this sounds like taking all the risks inherent in margin investing and greatly amplifying them because you are spending the money instead of purchasing sellable assets.
What I was describing there was not 2 comparable scenarios, but 2 different concepts.

To compare those 2 scenarios you would be doing:
- Borrow $100 and spend it on food/rent
- Borrow $100 and buy VTI, don't eat, sleep outside.

Yes, the latter is better for your NW. But what I'm trying to say here is that borrowing against assets instead of selling them is not the type of behavior that is generally thought of when folks think about "leverage investing" which involves borrowing to purchase more stock.

Of course, however, it can still be referred to as "leverage" because that's a broad term; it's the connotations of that word I am calling out
20cm
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Re: Buy Borrow Die & Risk

Post by 20cm »

nvrmnd wrote: Sun Nov 05, 2023 12:24 am But what I'm trying to say here is that borrowing against assets instead of selling them is not the type of behavior that is generally thought of when folks think about "leverage investing" which involves borrowing to purchase more stock.
Ignoring taxes, what is the difference between these two scenarios:

1) borrow $5000 against portfolio, use it to pay rent and buy food

2) sell $5000 of stock, use it to pay rent and buy food, then borrow $5000 against portfolio, use it to purchase more stock
smectym
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Re: Buy Borrow Die & Risk

Post by smectym »

nvrmnd wrote: Sun Nov 05, 2023 12:24 am
toddthebod wrote: Sat Nov 04, 2023 8:51 pm It's worse right? A lot worse, because in the latter case, you have twice as many shares of VTI with the same debt to pay off.

So to me this sounds like taking all the risks inherent in margin investing and greatly amplifying them because you are spending the money instead of purchasing sellable assets.
What I was describing there was not 2 comparable scenarios, but 2 different concepts.

To compare those 2 scenarios you would be doing:
- Borrow $100 and spend it on food/rent
- Borrow $100 and buy VTI, don't eat, sleep outside.

Yes, the latter is better for your NW. But what I'm trying to say here is that borrowing against assets instead of selling them is not the type of behavior that is generally thought of when folks think about "leverage investing" which involves borrowing to purchase more stock.

Of course, however, it can still be referred to as "leverage" because that's a broad term; it's the connotations of that word I am calling out
Nvrmnd, thanks for posting an interesting thread.

I’m not sure the concept of leverage “as generally thought of” is as narrow as you suppose. The strategy of borrowing against the portfolio to subsidize consumption, vs. selling shares (and incurring [taxable] capital gains) has received a lot of recent publicity…not all of it positive.

Further, your insight that when planning for a longer time horizon it makes sense to onboard more risk, is really something of a hoary platitude on this board.

An interesting question is whether the kind of risk matters. Are we indifferent whether the risk taken involves a more aggressive asset allocation, as opposed to taking on leverage? Is there a “risk parity” formula that can equalize these two sorts of risk? Surely there must be—though perhaps the inputs involve a lot of shaky assumptions.

Further in that vein: 95% confidence level doesn’t do it for me. The surprising creativity of whatever demon generates tail risk has wrong-footed many a gun-slinging VAR-modeling genius.

Bringing it down to actionable: before considering any leverage strategy, I’d argue its essential to first ringfence the capital necessary to guarantee the financial security of you and your loved ones, and as to that capital rule out leverage and invest it conservatively. I won’t invite controversy by defining ‘conservative’ but let’s assume that the fat middle of its distribution curve is roughly 40/60—60/40. Call this ringfenced capital the “Core Assets.”

Strategies dependent for success on (A) leverage, (B) assumptions that set an arbitrary lower bound for financial return expectations over long time periods, and (C) extrapolations of past performance of various asset classes, especially equities, into the future; should only involve capital beyond Core Assets.
8301
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Re: Buy Borrow Die & Risk

Post by 8301 »

Watty wrote: Wed Sep 27, 2023 12:17 am Two things to consider;

1) The step in cost basis is not engraved in stone and there has been talk of eliminating that. I do not know of any pending legislation to do that right now but because of board rules we cannot discuss possible law changes but the step up in cost basis never really made a lot of sense to me.

2) By using leverage you would be increasing your sequence of returns risk.
A sequence of return risk needs 2 conditions met at the same time, deep market drop and withdrawal. If you do not withdraw money from your portfolio, the size of your final portfolio is independent of the sequence of returns. Your accumulated debt will be affected, but this kind of game is only for big boys to play.
toddthebod
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Re: Buy Borrow Die & Risk

Post by toddthebod »

nvrmnd wrote: Sun Nov 05, 2023 12:24 am
toddthebod wrote: Sat Nov 04, 2023 8:51 pm It's worse right? A lot worse, because in the latter case, you have twice as many shares of VTI with the same debt to pay off.

So to me this sounds like taking all the risks inherent in margin investing and greatly amplifying them because you are spending the money instead of purchasing sellable assets.
What I was describing there was not 2 comparable scenarios, but 2 different concepts.

To compare those 2 scenarios you would be doing:
- Borrow $100 and spend it on food/rent
- Borrow $100 and buy VTI, don't eat, sleep outside.

Yes, the latter is better for your NW. But what I'm trying to say here is that borrowing against assets instead of selling them is not the type of behavior that is generally thought of when folks think about "leverage investing" which involves borrowing to purchase more stock.

Of course, however, it can still be referred to as "leverage" because that's a broad term; it's the connotations of that word I am calling out
I understand. And I am countering that by doing so, you are taking all the known risks of margin and amplifying them substantially, because now you have fewer assets to pay the loan back. So my question to you is, are you comfortable borrowing on margin to invest? If not, how can you be comfortable borrowing to spend?
Backtests without cash flows are meaningless. Returns without dividends are lies.
muffins14
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Re: Buy Borrow Die & Risk

Post by muffins14 »

nvrmnd wrote: Tue Sep 26, 2023 2:02 pm

Consider an investment into VTI, and a reasonable risk model for this based on historical trends, the asset should grow an exponential rate (e.g. 9.85% annually) and will have error bars around that number, say at the p95 quantile (i.e. the 5% worst case). A key observations is that even under the most conservative assumptions it's generally assumed that the error does not grow exponentially over time, and certainly not at a faster rate than the mean.

All I'm trying to observe here is that the bottom of the error bar is going up steadily if we plot this over time. With a formula that looks like this: 1.0985^t - c*t^2. For some constant c, which depends on VTI holdings etc. And that c^t functions grow a hell of a lot faster than t^2 functions.

The upshot here is that at some point in the future the worst case for VTI is better than the best case for fixed income.
There are many cases where fixed income has outperformed stocks on a multi-year horizon. If you’re in that time window, then obviously having fixed income has a point.

Also assuming 9.8% returns on average forever is an extremely
Optimistic assumption.
Crom laughs at your Four Winds
8301
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Re: Buy Borrow Die & Risk

Post by 8301 »

20cm wrote: Sun Nov 05, 2023 1:49 am
nvrmnd wrote: Sun Nov 05, 2023 12:24 am But what I'm trying to say here is that borrowing against assets instead of selling them is not the type of behavior that is generally thought of when folks think about "leverage investing" which involves borrowing to purchase more stock.
Ignoring taxes, what is the difference between these two scenarios:

1) borrow $5000 against portfolio, use it to pay rent and buy food

2) sell $5000 of stock, use it to pay rent and buy food, then borrow $5000 against portfolio, use it to purchase more stock
You cannot ignore taxes. Taxes are the key. It is all about capital gains taxes vs. interests on borrowing. Some companies such as Apple borrow while keeping a massive pile of cash offshore to avoid US corporate taxes.
Billionaires also borrow for their lavish living expenses to avoid income taxes. They all sure know what they are doing.
20cm
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Re: Buy Borrow Die & Risk

Post by 20cm »

8301 wrote: Sun Nov 05, 2023 9:14 am You cannot ignore taxes. Taxes are the key.
Yes, obviously taxes are the key. That's the only point of the strategy. What I posted is a mental exercise to understand the (lack of) risk difference.

If the portfolio had zero capital gains or losses then borrowing to spend versus selling to spend and then levering up to get back to the same portfolio value would be equivalent. The OP is tricking themselves with mental accounting into thinking they are taking less risk than borrowing to invest when it's the same risk.

It just comes down to the magnitude of the borrowing. The safety of this strategy depends on having a large enough portfolio to start with that regardless of the sequence of returns you experience your leverage ratio doesn't increase substantially over time.
Last edited by 20cm on Sun Nov 05, 2023 10:16 am, edited 1 time in total.
rv26
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Re: Buy Borrow Die & Risk

Post by rv26 »

I would say if you're think about doing this, connect with a banker at a firm like Morgan Stanley or Schwab about opening a PAL (Pledged Asset Line) or LAL (Liquidity Access Line). The interest rates and terms and can be negotiable. Morgan Stanley was offering 5.5% rate on long term (< 12 months) loans last month.
Topic Author
nvrmnd
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Re: Buy Borrow Die & Risk

Post by nvrmnd »

20cm wrote: Sun Nov 05, 2023 1:49 am Ignoring taxes, what is the difference between these two scenarios:

1) borrow $5000 against portfolio, use it to pay rent and buy food

2) sell $5000 of stock, use it to pay rent and buy food, then borrow $5000 against portfolio, use it to purchase more stock
Yes, this is a good point, borrowing to spend is the same as borrowing to purchase stock. The only difference is the tax savings. My previous comment here doesn't hold water.
Last edited by nvrmnd on Sun Nov 05, 2023 11:31 am, edited 1 time in total.
Topic Author
nvrmnd
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Re: Buy Borrow Die & Risk

Post by nvrmnd »

muffins14 wrote: Sun Nov 05, 2023 8:47 am There are many cases where fixed income has outperformed stocks on a multi-year horizon. If you’re in that time window, then obviously having fixed income has a point.

Also assuming 9.8% returns on average forever is an extremely
Optimistic assumption.
I'm asking for feedback so I appreciate your comments here, but I think you're misunderstanding the points I am trying to make and formulating counter-points to those. Allow me to clarify:

point 1: If you're going to borrow against your portfolio, fixed income makes no sense.
point 2: On average over longer time periods, market growth > interest rates
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nvrmnd
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Re: Buy Borrow Die & Risk

Post by nvrmnd »

rv26 wrote: Sun Nov 05, 2023 10:11 am I would say if you're think about doing this, connect with a banker at a firm like Morgan Stanley or Schwab about opening a PAL (Pledged Asset Line) or LAL (Liquidity Access Line). The interest rates and terms and can be negotiable. Morgan Stanley was offering 5.5% rate on long term (< 12 months) loans last month.
That's a great rate, but a lot of these firms require you to have your account under management, where you're paying a ~1% AUM fee, do you know if that's the case?
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nvrmnd
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Re: Buy Borrow Die & Risk

Post by nvrmnd »

smectym wrote: Sun Nov 05, 2023 2:08 am Further in that vein: 95% confidence level doesn’t do it for me. The surprising creativity of whatever demon generates tail risk has wrong-footed many a gun-slinging VAR-modeling genius.
I mean, speaking of hoary platitudes... Anyway, each investor's appetite for risk is their own business I suppose. If this whole argument did not have the tax savings, I think the points about risk would be more convincing.

That is, if the post was about: "instead of just 100% into stocks, why not go for 130%? Over the long run this leverage is likely to work out, etc.", observations that this strategy is not any better than 100% stocks when a proper risk-adjusted return measure is applied, and some additional comments about tail risk, and so on, would be well taken.

But when it comes to factoring in that immediate loss of 20%-30% of your assets to taxes, trying to win that all back with claims about risk just sound to me like chicken little investing advice.

Very much agree with your comments as they relate to ring-fencing the capital needed to survive, and your helpful articulation of these points.
20cm
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Re: Buy Borrow Die & Risk

Post by 20cm »

nvrmnd wrote: Sun Nov 05, 2023 11:17 am
20cm wrote: Sun Nov 05, 2023 1:49 am Ignoring taxes, what is the difference between these two scenarios:

1) borrow $5000 against portfolio, use it to pay rent and buy food

2) sell $5000 of stock, use it to pay rent and buy food, then borrow $5000 against portfolio, use it to purchase more stock
Yes, this is a good point, borrowing to spend is the same as borrowing to purchase stock. The only difference is the tax savings. My previous comment here doesn't hold water.
Once you've accepted that, the next question you have to answer is whether at your portfolio multiple & allocation does this strategy even do anything for you? At around 65X expenses 100% VTI is already throwing off more dividends than you're spending. Any additional borrowing you do at that level with that portfolio serves strictly to lever up to expand the range of possible outcomes. To get a tax benefit from this strategy you need to either be taking more risk (executing this strategy at some lower portfolio multiple) or be allocated in a way that has minimal distributions such that you would need to be selling appreciated assets in your taxable portfolio in the first place.
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nvrmnd
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Re: Buy Borrow Die & Risk

Post by nvrmnd »

20cm wrote: Sun Nov 05, 2023 12:39 pm Once you've accepted that, the next question you have to answer is whether at your portfolio multiple & allocation does this strategy even do anything for you? At around 65X expenses 100% VTI is already throwing off more dividends than you're spending. Any additional borrowing you do at that level with that portfolio serves strictly to lever up to expand the range of possible outcomes. To get a tax benefit from this strategy you need to either be taking more risk (executing this strategy at some lower portfolio multiple) or be allocated in a way that has minimal distributions such that you would need to be selling appreciated assets in your taxable portfolio in the first place.
By "65X expenses", do you mean that my VTI would be 65x my yearly expense? I think my assumptions on my total portfolio value are lower.. I would hope that I can spend at the 4% of the portfolio value a year (say dividend covers 1% of that) and stay below 50% loan-to-value even after 30 years.
toddthebod
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Re: Buy Borrow Die & Risk

Post by toddthebod »

nvrmnd wrote: Sun Nov 05, 2023 12:47 pm
20cm wrote: Sun Nov 05, 2023 12:39 pm Once you've accepted that, the next question you have to answer is whether at your portfolio multiple & allocation does this strategy even do anything for you? At around 65X expenses 100% VTI is already throwing off more dividends than you're spending. Any additional borrowing you do at that level with that portfolio serves strictly to lever up to expand the range of possible outcomes. To get a tax benefit from this strategy you need to either be taking more risk (executing this strategy at some lower portfolio multiple) or be allocated in a way that has minimal distributions such that you would need to be selling appreciated assets in your taxable portfolio in the first place.
By "65X expenses", do you mean that my VTI would be 65x my yearly expense? I think my assumptions on my total portfolio value are lower.. I would hope that I can spend at the 4% of the portfolio value a year (say dividend covers 1% of that) and stay below 50% loan-to-value even after 30 years.
In that case, consider a dot com or GFC or COVID type crash halfway through your retirement and what will happen. Will there be a margin call? If so, what will you have left after they liquidate your remaining assets?
Backtests without cash flows are meaningless. Returns without dividends are lies.
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nvrmnd
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Re: Buy Borrow Die & Risk

Post by nvrmnd »

toddthebod wrote: Sun Nov 05, 2023 1:01 pm In that case, consider a dot com or GFC or COVID type crash halfway through your retirement and what will happen. Will there be a margin call? If so, what will you have left after they liquidate your remaining assets?
At the halfway mark I would hope to have only, say, a 25% LTV? Maybe 20%, you would want to be careful to adjust your spending to avoid a margin call. But, yeah, I mean if VTI crashes 75% you're kind of screwed, there isn't ever a free lunch.
20cm
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Re: Buy Borrow Die & Risk

Post by 20cm »

nvrmnd wrote: Sun Nov 05, 2023 12:47 pm By "65X expenses", do you mean that my VTI would be 65x my yearly expense? I think my assumptions on my total portfolio value are lower.. I would hope that I can spend at the 4% of the portfolio value a year (say dividend covers 1% of that) and stay below 50% loan-to-value even after 30 years.
Yes, I mean a 100% VTI allocation where the value is 65x your yearly expenses. At a multiple like 25x you're running much more SORR.

If I'm doing the math right with data I pulled off PV:
If you'd started this strategy in 2000 with a 25x starting portfolio allocated to 100% US TSM and inflation adjusting your expenses, you would have been at about 38% margin equity by the end of 2008, assuming your borrow cost was at the money-market rate. Your total portfolio value would have been 14.6x your inflation adjusted expenses of which your equity would have been about 5.6x. For comparison, an investor starting with 65x would have bottomed out above 77% margin equity that year.

If you had managed to diamond-hand and not get margin called through all that, by end of 2022 you would have been at a total portfolio value of 54.8x with 36.9x being your equity. In comparison an unlevered 25x US TSM investor would be at 7.5x, so you would have won by a wide margin (pardon the pun) but not for the tax avoidance reason you entered the strategy with. At the end of 2002 you would have had over 22% more portfolio value than the unlevered investor due to not selling on the way down in the dotcom crash and then at the end of 2008 you would have had 80% more. You would have benefited significantly from entering the ZIRP-era bull party with a much higher total portfolio value.

Interest rates were below 1% for half of the period, tilted very disproportionately to the second half when your loan balances were bigger which would have helped you - though you would have still won (meaning having higher equity than the unlevered investor), though just barely, all the way up to borrowing at MM+5.7%.
afan
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Re: Buy Borrow Die & Risk

Post by afan »

Again, the risk lies in running out of capital.
If you do this, plan to leave a VERY generous margin of error. You need to be sure that your ever-growing debt will never come close a margin call. If you project having debt at 50% of your outstanding loan balance, then you are borrowing far too much money.
If your debt would top out at 20% assuming historically poor market performance, then you should be safe. Remember that brokers can raise margin requirements at any time. When do they make such changes? When the market crashes and investors are failing to meet margin calls.

You need enough capital and light enough borrowing to be safe even if there are terrible market conditions- major losses in stocks and high inflation.
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama
muffins14
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Re: Buy Borrow Die & Risk

Post by muffins14 »

nvrmnd wrote: Sun Nov 05, 2023 11:25 am
muffins14 wrote: Sun Nov 05, 2023 8:47 am There are many cases where fixed income has outperformed stocks on a multi-year horizon. If you’re in that time window, then obviously having fixed income has a point.

Also assuming 9.8% returns on average forever is an extremely
Optimistic assumption.
I'm asking for feedback so I appreciate your comments here, but I think you're misunderstanding the points I am trying to make and formulating counter-points to those. Allow me to clarify:

point 1: If you're going to borrow against your portfolio, fixed income makes no sense.
point 2: On average over longer time periods, market growth > interest rates

On 1) what if you borrow at 3% and earn 4% on fixed income?

On 2) yes it is always better, until it isn’t
Crom laughs at your Four Winds
20cm
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Re: Buy Borrow Die & Risk

Post by 20cm »

muffins14 wrote: Sun Nov 05, 2023 8:45 pm On 1) what if you borrow at 3% and earn 4% on fixed income?
If you've got a line on a broker lending below the risk-free rate, please PM me at you earliest convenience.
muffins14
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Re: Buy Borrow Die & Risk

Post by muffins14 »

20cm wrote: Sun Nov 05, 2023 11:12 pm
muffins14 wrote: Sun Nov 05, 2023 8:45 pm On 1) what if you borrow at 3% and earn 4% on fixed income?
If you've got a line on a broker lending below the risk-free rate, please PM me at you earliest convenience.
Margin interest is tax-deductible, so in some situations that may work out. My margin rate at Fidelity is 6.4%, and you can probably do better at other brokers or via options.
Crom laughs at your Four Winds
rv26
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Re: Buy Borrow Die & Risk

Post by rv26 »

nvrmnd wrote: Sun Nov 05, 2023 11:30 am
rv26 wrote: Sun Nov 05, 2023 10:11 am I would say if you're think about doing this, connect with a banker at a firm like Morgan Stanley or Schwab about opening a PAL (Pledged Asset Line) or LAL (Liquidity Access Line). The interest rates and terms and can be negotiable. Morgan Stanley was offering 5.5% rate on long term (< 12 months) loans last month.
That's a great rate, but a lot of these firms require you to have your account under management, where you're paying a ~1% AUM fee, do you know if that's the case?
I have a Liquidity Access Line with Morgan Stanley. I just needed to open a AAA account and pledge it. The AAA account does have a $125 fee but it can be waived depending on assets.
Journeyman510
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Re: Buy Borrow Die & Risk

Post by Journeyman510 »

What is an AAA account? I use Morgan Stanley too and have found the rate for their pledged asset line to be competitive (certainly not 5.5%). I havent tried negotiated though and only a small portion of my overall portfolio is with Morgan Stanley.

What's the tax treatment of the interest for a pledged asset line?
the_wiki
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Re: Buy Borrow Die & Risk

Post by the_wiki »

These kind of schemes always read to me as people with more than enough never being satisfied and letting greed take them down riskier paths they don’t need to take.

Just like leverage, or options, or hottest stock picking.

Maybe it works out, but do you need it to?
Journeyman510
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Re: Buy Borrow Die & Risk

Post by Journeyman510 »

I'm amused by this characterization of these ideas as schemes and motivated by greed.

I mean this is a site where people sweat the details on expense ratios, agonize over how to save money on razors, won't buy a car that takes premium gas, etc, because these savings can be reinvested in the market to generate more wealth in the long term.

Yet if you try to minimize tax liability it's complicated, time consuming, greed, etc. I mean there is a whole thread on frugality here, where folks talk about saving $15 per year by using loose leaf tea instead of prepackeged tea bags.
ScubaHogg
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Re: Buy Borrow Die & Risk

Post by ScubaHogg »

Journeyman510 wrote: Wed Jan 31, 2024 8:31 pm
Yet if you try to minimize tax liability it's complicated, time consuming, greed, etc. I mean there is a whole thread on frugality here, where folks talk about saving $15 per year by using loose leaf tea instead of prepackeged tea bags.
This made me laugh out loud

Yes, the board has a fair amount of penny wise behavior that characterizes “pound wise” as greedy
There are more things in Heaven and Earth, Horatio, than are dreamt of in your Expected Returns
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