Lifecycle Investing - Leveraging when young

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Steve Reading
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Re: Lifecycle Investing - Leveraging when young

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Triple digit golfer wrote: Tue Mar 31, 2020 4:16 pm
Ben Mathew wrote: Tue Mar 31, 2020 4:11 pm
Triple digit golfer wrote: Tue Mar 31, 2020 11:02 am Future contributions: Assume $35k in today's dollars annually for 20 years (just for the math here)
Total is $1.2 million in today's dollars ($500k current plus $700k future contributions)
Make sure you discount future dollars to the present to get the present value of wealth. If the $35K per year future contribution is real dollars adjusted for inflation, you'll still want to discount that to the present using the real discount rate.
The $35k per year would be current contribution rate in current dollars. So no need to discount, correct?
Yes, you still need to discount. If you want to think about it in real dollars (say because your wages will grow with inflation), then you need to discount it to the present using a real yield (as opposed to a nominal yield as mentioned in your thread).

Imagine that TIPs yield 1%. That's a real yield. That means that 35k inflation adjusted in the future is NOT as worthwhile as 35k today. The reason is that I can invest 35k today with such a TIPs and end up with more than 35k inflation-adjusted in that future. So your future savings contributions, if taken at real dollar value, aren't actually as worthwhile as your current savings dollar for dollar.

In this day and age where TIPs yield basically zero (the 20 year TIP literally is at 0%), you can just ignore this step. But it's good to keep in mind in the future should real yields move significantly away from 0%.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

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ChrisBenn wrote: Tue Mar 31, 2020 4:31 pm
Steve Reading wrote: Tue Mar 31, 2020 11:47 am
Triple digit golfer wrote: Tue Mar 31, 2020 11:02 am What size emergency fund do you all you guys have outside of the lifecycle portfolio?
I don't have one. I don't really mentally account my money that way. If I need money, I'll get it from my investments.
Triple digit golfer wrote: Tue Mar 31, 2020 11:02 am Roughly speaking, I have just over 2 years in fixed income/cash and everything else (about 6 years of expenses) in equities. I'm considering contributing all to equities moving forward but keeping that 2 years in fixed income/cash. This will allow me to have a bond/cash cushion in the case of a job loss (one-income family with average corporate job stability) and keep everything else in equities until I hit my dollar goal (40% equities at retirement). Kinda sorta like a lifecycle portfolio, no? Except no leverage; I have no desire to borrow money to invest.
From a mathematical perspective, it is superior to have it all in equities. Yes, maybe that means you sell during downturns. But it's more than made up by avoiding the cash drag.

I think an EF makes sense in two cases: 1) When your current assets are low enough that a market downturn plus lost job would actually mean you can't pay rent, food, etc. 2) And for psychological reasons. I can't tell you how much you need in cash in your EF so you feel ok.
That no ef / all in lifecycle here is the optimal choice because one is optimizing for the final outcome at your retirement target though - with no utility derived from the interim balance prior to retirement, right?

This was one thing that always seemed to be a disconnect between the model/utility function, and "real life" to me; I ascribe some value (in the event of an emergency or opportunity) to the interim value (of my taxable savings at least). That value is probably something like a probability that I could successfully liquidate a ~ fixed amount of my taxable savings at any point in time - and the impact that had on my final outcome.

If it was a percentage of savings that I wanted to liquidate instead of fixed I think that desire would be captured by the risk aversion (what sort of st dev I was willing to accept) -- but since it's fixed it's not.

So to me having a static emergency fund seems like a good compromise to simplify the modeling, allowing me to go all in with lifecycle on the rest of the portfolio. When the amount of the emergency fund is a meaningful percentage of the taxable assets I probably don't want to put the EF at risk by investing it all in equities; and when the equity portion is much greater than the emergency fund then the utility derived, as a percentage, isn't as consequential.

Definitely not saying this is optimal, but it has been a happy medium for me - and I definitely feel it's more optimal than a static allocation or target date fund (not that those are bad, I just buy the lifecycle concept (thanks Steve!), with, I guess, some EF hedging to represent my utility function is not solely defined by the end state)
What I do want to make sure is clear is that A&N's did bring the theory to the test with some real-world limitations (including margin calls). And despite these, every retirement cohort came out ahead. So even if markets drop and you're forced to sell (either because you were leveraged OR because you had no leverage but lost your job and had no EF), you probably will still come out ahead if you keep up with it.

That said, I understand what you mean. Look a lot of these models and simulations are just that. If you derive some comfortableness from having some set-aside safe cash, who is anyone to tell you that you're wrong 0_o And if it makes you swallow the Lifecycle Investing pill with the rest of the portfolio, I think it ends up being productive after all.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

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Triple digit golfer wrote: Tue Mar 31, 2020 4:16 pm
Ben Mathew wrote: Tue Mar 31, 2020 4:11 pm
Triple digit golfer wrote: Tue Mar 31, 2020 11:02 am Future contributions: Assume $35k in today's dollars annually for 20 years (just for the math here)
Total is $1.2 million in today's dollars ($500k current plus $700k future contributions)
Make sure you discount future dollars to the present to get the present value of wealth. If the $35K per year future contribution is real dollars adjusted for inflation, you'll still want to discount that to the present using the real discount rate.
The $35k per year would be current contribution rate in current dollars. So no need to discount, correct?
By "current dollars," if mean "inflation adjusted", then you would still need to discount using the real rate to get the present value.

So $35K 20 years from now, discounted at say a 2.5% real rate would would be $35K/(1+.025)^20= $21K in present value.
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Re: Lifecycle Investing - Leveraging when young

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Ben Mathew wrote: Tue Mar 31, 2020 8:29 pm
Triple digit golfer wrote: Tue Mar 31, 2020 4:16 pm
Ben Mathew wrote: Tue Mar 31, 2020 4:11 pm
Triple digit golfer wrote: Tue Mar 31, 2020 11:02 am Future contributions: Assume $35k in today's dollars annually for 20 years (just for the math here)
Total is $1.2 million in today's dollars ($500k current plus $700k future contributions)
Make sure you discount future dollars to the present to get the present value of wealth. If the $35K per year future contribution is real dollars adjusted for inflation, you'll still want to discount that to the present using the real discount rate.
The $35k per year would be current contribution rate in current dollars. So no need to discount, correct?
By "current dollars," if mean "inflation adjusted", then you would still need to discount using the real rate to get the present value.

So $35K 20 years from now, discounted at say a 2.5% real rate would would be $35K/(1+.025)^20= $21K in present value.
I'm saying I contribute $35k this year and will maintain that rate moving forward. If inflation is 3%, then my contribution will go up to $36,050. If no inflation, it will stay at $35k.
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Re: Lifecycle Investing - Leveraging when young

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Triple digit golfer wrote: Tue Mar 31, 2020 8:32 pm
Ben Mathew wrote: Tue Mar 31, 2020 8:29 pm
Triple digit golfer wrote: Tue Mar 31, 2020 4:16 pm
Ben Mathew wrote: Tue Mar 31, 2020 4:11 pm
Triple digit golfer wrote: Tue Mar 31, 2020 11:02 am Future contributions: Assume $35k in today's dollars annually for 20 years (just for the math here)
Total is $1.2 million in today's dollars ($500k current plus $700k future contributions)
Make sure you discount future dollars to the present to get the present value of wealth. If the $35K per year future contribution is real dollars adjusted for inflation, you'll still want to discount that to the present using the real discount rate.
The $35k per year would be current contribution rate in current dollars. So no need to discount, correct?
By "current dollars," if mean "inflation adjusted", then you would still need to discount using the real rate to get the present value.

So $35K 20 years from now, discounted at say a 2.5% real rate would would be $35K/(1+.025)^20= $21K in present value.
I'm saying I contribute $35k this year and will maintain that rate moving forward. If inflation is 3%, then my contribution will go up to $36,050. If no inflation, it will stay at $35k.
OK, so you are adjusting for inflation only. That is not enough. You would need to calculate the present value by discounting future dollars using the real discount rate.
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Re: Lifecycle Investing - Leveraging when young

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I haven’t read much of this thread, so maybe this has been discussed. And I feel like this is a really dumb question, but I can’t figure it out. How are you calculating the leverage ratio in your OP (copied below)? Shouldn’t it be debt/equity, so for May 2019 it would be 92k/143k = .64 and for April 2019 it would be 301k/123k = 2.45? I’m sure your calc is right and mine is wrong (or at least different), but I can’t figure out how you’re getting yours.

Also, what is the distinction between Debt and Effective Debt?


May 2019
Stock Exposure = 235k
Debt = 92k
Equity in the exposure = 143k
Leverage = 1.64

Aug 2019
Stock Exposure = 251k
Debt = 101k
Equity in the exposure = 150k
Leverage = 1.68

Nov 2019
Stock Exposure = 412k
Effective Debt = 233k
Equity in the exposure = 179k
Leverage = 2.29

April 2020
Stock Exposure = 413k
Effective Debt = 301k
Equity in the exposure = 123k
Leverage = 3.69
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Re: Lifecycle Investing - Leveraging when young

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Gufomel wrote: Wed Apr 01, 2020 7:04 am Thank you. As far as the lifetime wealth calculation (excuse my terminology if that’s not exactly right), would you factor in a mortgage as a negative bond if you intend to have a paid-off house by retirement? I’ve never really been able to wrap my head around the idea of counting a mortgage as a negative bond since it’s separate from my portfolio, but in this framework it seems more intuitive to me. Of course, it would essentially wash out with my future savings calculation because I would be counting principal payment over the life of the mortgage as savings plus retirement contributions as savings. So maybe for that reason it doesn’t matter. But I do think it gives some credence to the idea of after reaching your “equity number”, then attack the mortgage (depending on mortgage rate vs other risk-free rates at the time), then bonds up to your desired retirement AA.

Aside from factoring in a mortgage to the above calculation, do you count a mortgage as debt in your leverage ratio? I have no intention of using leverage for investing beyond a mortgage, but I am interested how/if you factor it in.
Simplest and probably good enough is to calculate all of your future savings contributions, discounted to the present, WITHOUT considering mortgage payments at all. Ex: You make 50k and spend 25k yearly plus 10k in mortgage. So you write out "I am saving 25k every year". So you'll end up with an inflated future savings contribution value, a mortgage debt at X% and some present savings. For purposes of how much equity to buy today, you would just add present savings to future savings and subtract the mortgage debt.

You can count a mortgage in your leverage ratio if you want.
Gufomel wrote: Wed Apr 01, 2020 8:05 am I haven’t read much of this thread, so maybe this has been discussed. And I feel like this is a really dumb question, but I can’t figure it out. How are you calculating the leverage ratio in your OP (copied below)? Shouldn’t it be debt/equity, so for May 2019 it would be 92k/143k = .64 and for April 2019 it would be 301k/123k = 2.45? I’m sure your calc is right and mine is wrong (or at least different), but I can’t figure out how you’re getting yours.
Leverage ratio is just:
(Net worth + Debt)/(Net worth) = Leverage ratio

Effective debt is my way of accounting for derivatives as part of my debt. If a contract gave me 100k of exposure, then I'm counting that as 100k more in debt, 100k more in exposure, and no extra net worth.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

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Steve Reading wrote: Wed Apr 01, 2020 9:32 am
Gufomel wrote: Wed Apr 01, 2020 7:04 am Thank you. As far as the lifetime wealth calculation (excuse my terminology if that’s not exactly right), would you factor in a mortgage as a negative bond if you intend to have a paid-off house by retirement? I’ve never really been able to wrap my head around the idea of counting a mortgage as a negative bond since it’s separate from my portfolio, but in this framework it seems more intuitive to me. Of course, it would essentially wash out with my future savings calculation because I would be counting principal payment over the life of the mortgage as savings plus retirement contributions as savings. So maybe for that reason it doesn’t matter. But I do think it gives some credence to the idea of after reaching your “equity number”, then attack the mortgage (depending on mortgage rate vs other risk-free rates at the time), then bonds up to your desired retirement AA.

Aside from factoring in a mortgage to the above calculation, do you count a mortgage as debt in your leverage ratio? I have no intention of using leverage for investing beyond a mortgage, but I am interested how/if you factor it in.
Simplest and probably good enough is to calculate all of your future savings contributions, discounted to the present, WITHOUT considering mortgage payments at all. Ex: You make 50k and spend 25k yearly plus 10k in mortgage. So you write out "I am saving 25k every year". So you'll end up with an inflated future savings contribution value, a mortgage debt at X% and some present savings. For purposes of how much equity to buy today, you would just add present savings to future savings and subtract the mortgage debt.

You can count a mortgage in your leverage ratio if you want.
Gufomel wrote: Wed Apr 01, 2020 8:05 am I haven’t read much of this thread, so maybe this has been discussed. And I feel like this is a really dumb question, but I can’t figure it out. How are you calculating the leverage ratio in your OP (copied below)? Shouldn’t it be debt/equity, so for May 2019 it would be 92k/143k = .64 and for April 2019 it would be 301k/123k = 2.45? I’m sure your calc is right and mine is wrong (or at least different), but I can’t figure out how you’re getting yours.
Leverage ratio is just:
(Net worth + Debt)/(Net worth) = Leverage ratio

Effective debt is my way of accounting for derivatives as part of my debt. If a contract gave me 100k of exposure, then I'm counting that as 100k more in debt, 100k more in exposure, and no extra net worth.

Regarding the mortgage, overall that mostly makes sense. I just want to make sure I’m clear on what you’re saying. You would effectively be including the mortgage payment in your future savings calculation, correct? And when you mention 10k mortgage in your example above, you would only be counting the principal portion of the payment as savings? I was confused because you said calculate future savings contributions WITHOUT considering mortgage payments, but then seemed to be including mortgage payments as savings in your example.

Thanks for the leverage ratio. Do you include house value and mortgage in calculating debt and net worth (or if that’s not applicable for you would it be included in theory if following this strategy)?
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Re: Lifecycle Investing - Leveraging when young

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Gufomel wrote: Wed Apr 01, 2020 11:00 am Regarding the mortgage, overall that mostly makes sense. I just want to make sure I’m clear on what you’re saying. You would effectively be including the mortgage payment in your future savings calculation, correct? And when you mention 10k mortgage in your example above, you would only be counting the principal portion of the payment as savings? I was confused because you said calculate future savings contributions WITHOUT considering mortgage payments, but then seemed to be including mortgage payments as savings in your example.
An example might be best:
You have 200k in savings, a 300k mortgage, a 500k house (so you have 200k in equity), make 100k a year and spend 50k a year outside of mortgage payments (food, travel, house repairs, etc). You will work for 10 more years.

So you calculate you'd save 100k-50k = 50k a year. Now you know you won't actually save that much because there are mortgage payments to consider but ignore for now. So that's a future savings contribution of about 10*50k = 500k.

You have 200k in savings, 500k in future savings and a 300k mortgage. Your net assets are 200k+500k-300k = 400k for purposes of Lifecycle Investing. Say you want a 60% stock retirement portfolio in retirement. So you'd put 400k*0.6 = 240k in stocks. You only have 200k so just stay 100% stocks.

"But Steve, what about my house equity of 200k?? Isn't that an asset?". No it isn't. If the house were 1M and you had 700k in equity, nothing at all changes above right? Mortgage payments are identical, your cash flow is identical, your final retirement portfolio is identical. Which makes sense because a more expensive house past what you need to live in is effectively money down the drain since it is akin to you having higher rent payments. More house than you need is a consumption, it doesn't provide you any more money or save you any more rent.

Any ways, that's how I see it and have simplified it. Not claiming it's perfect (a mortgage is more like an option in that you have the ability to prepay based on interest rates) but it's probably good enough.
Gufomel wrote: Wed Apr 01, 2020 11:00 am Thanks for the leverage ratio. Do you include house value and mortgage in calculating debt and net worth (or if that’s not applicable for you would it be included in theory if following this strategy)?
It doesn't apply to me right now but I probably would include it to keep everything consistent.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

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Steve Reading wrote: Wed Apr 01, 2020 11:14 am
Gufomel wrote: Wed Apr 01, 2020 11:00 am Regarding the mortgage, overall that mostly makes sense. I just want to make sure I’m clear on what you’re saying. You would effectively be including the mortgage payment in your future savings calculation, correct? And when you mention 10k mortgage in your example above, you would only be counting the principal portion of the payment as savings? I was confused because you said calculate future savings contributions WITHOUT considering mortgage payments, but then seemed to be including mortgage payments as savings in your example.
An example might be best:
You have 200k in savings, a 300k mortgage, a 500k house (so you have 200k in equity), make 100k a year and spend 50k a year outside of mortgage payments (food, travel, house repairs, etc). You will work for 10 more years.

So you calculate you'd save 100k-50k = 50k a year. Now you know you won't actually save that much because there are mortgage payments to consider but ignore for now. So that's a future savings contribution of about 10*50k = 500k.

You have 200k in savings, 500k in future savings and a 300k mortgage. Your net assets are 200k+500k-300k = 400k for purposes of Lifecycle Investing. Say you want a 60% stock retirement portfolio in retirement. So you'd put 400k*0.6 = 240k in stocks. You only have 200k so just stay 100% stocks.

"But Steve, what about my house equity of 200k?? Isn't that an asset?". No it isn't. If the house were 1M and you had 700k in equity, nothing at all changes above right? Mortgage payments are identical, your cash flow is identical, your final retirement portfolio is identical. Which makes sense because a more expensive house past what you need to live in is effectively money down the drain since it is akin to you having higher rent payments. More house than you need is a consumption, it doesn't provide you any more money or save you any more rent.

Any ways, that's how I see it and have simplified it. Not claiming it's perfect (a mortgage is more like an option in that you have the ability to prepay based on interest rates) but it's probably good enough.
Gufomel wrote: Wed Apr 01, 2020 11:00 am Thanks for the leverage ratio. Do you include house value and mortgage in calculating debt and net worth (or if that’s not applicable for you would it be included in theory if following this strategy)?
It doesn't apply to me right now but I probably would include it to keep everything consistent.
Thanks. Yes examples are very helpful. I completely agree with not counting the house equity as an asset for this calculation. Maybe if you expected to significantly downsize in house at retirement then it would make sense to include an amount that you expect to be able to cash out? Idk, that’s not applicable for me so only interesting to me as a theoretical discussion.

I’m a still not completely clear on accounting for the mortgage payments. I know you said “ignore for now”, but then it doesn’t seem to be accounted for in the calculation. I think this results in overstating future savings contributions. In your example, you make $100k and spend $50k per year on non-mortgage expenses. Shouldn’t you count mortgage interest as an expense? Let’s say $5k. The remainder would be savings contribution of $45k which includes mortgage principal. Obviously the portion that’s principal vs interest would need to be adjusted for each future year in the calculation (and maybe that’s why you ignored it for the example), but would be straightforward to calculate with an amortization table.

Regardless of the mechanics of calculating it, the theory would be that the remaining mortgage is counted as a negative in your current asset calculation, and future mortgage principal payments are included in the future savings contribution calculation. Feel free to beat me over the head if that’s not correct.
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Re: Lifecycle Investing - Leveraging when young

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Gufomel wrote: Wed Apr 01, 2020 12:07 pm Thanks. Yes examples are very helpful. I completely agree with not counting the house equity as an asset for this calculation. Maybe if you expected to significantly downsize in house at retirement then it would make sense to include an amount that you expect to be able to cash out? Idk, that’s not applicable for me so only interesting to me as a theoretical discussion.
I don't see why not.

Gufomel wrote: Wed Apr 01, 2020 12:07 pm I’m a still not completely clear on accounting for the mortgage payments. I know you said “ignore for now”, but then it doesn’t seem to be accounted for in the calculation. I think this results in overstating future savings contributions.
It doesn't overstate it because we make the vital step of subtracting those overstated future savings contributions by the mortgage balance, effectively taking it into account.
Gufomel wrote: Wed Apr 01, 2020 12:07 pm Shouldn’t you count mortgage interest as an expense? Let’s say $5k.
Ok here's why you shouldn't:
What we want is to have the present value of all of your assets and debts. Your current savings is easy: it's that value. Your future savings contributions are a little harder. You have to discount every future saving cash flow you plan to put away. So what we need to ask is: What is the present value of your mortgage?

Calculating that takes a little bit of work. It is the sum of all of your future mortgage payments (principal AND interest) discounted to the present. With a negative sign. Here's a key part: If the interest rate you use to discount those future payments to the present is equal to the interest on the mortgage, then the mortgage balance today IS its present value. Mortgage rates nowadays are near enough to regular interest rates that I think it's reasonable to make this simplification.

To be clear, you could instead account for the mortgage payments in your expenses and directly subtract them from your yearly expected savings. So you'd estimate you'd save 50k-25k-10k instead. Then you'd sum all of those future savings contributions, discounted to today. But then do NOT subtract the mortgage balance afterwards. You've taken it into account already.

One reason I don't like that is that your mortgage might be shorter than your accumulation period. The above would make it seem like as long as your savings, you're making mortgage payments. Using the present value of the mortgage, on the other hand, does account for that inconsistency.
Gufomel wrote: Wed Apr 01, 2020 12:07 pm Regardless of the mechanics of calculating it, the theory would be that the remaining mortgage is counted as a negative in your current asset calculation, and future mortgage principal payments are included in the future savings contribution calculation. Feel free to beat me over the head if that’s not correct.
The reality is that it doesn't matter how much of your mortgage payment is principal or interest. All we know is that $X is coming out of your salary monthly and that that will stop in, say, 15 years. That's all you need to quantify the mortgage as an asset and a loan.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

Post by Gufomel »

Steve Reading wrote: Wed Apr 01, 2020 1:26 pm
Gufomel wrote: Wed Apr 01, 2020 12:07 pm Thanks. Yes examples are very helpful. I completely agree with not counting the house equity as an asset for this calculation. Maybe if you expected to significantly downsize in house at retirement then it would make sense to include an amount that you expect to be able to cash out? Idk, that’s not applicable for me so only interesting to me as a theoretical discussion.
I don't see why not.

Gufomel wrote: Wed Apr 01, 2020 12:07 pm I’m a still not completely clear on accounting for the mortgage payments. I know you said “ignore for now”, but then it doesn’t seem to be accounted for in the calculation. I think this results in overstating future savings contributions.
It doesn't overstate it because we make the vital step of subtracting those overstated future savings contributions by the mortgage balance, effectively taking it into account.
Gufomel wrote: Wed Apr 01, 2020 12:07 pm Shouldn’t you count mortgage interest as an expense? Let’s say $5k.
Ok here's why you shouldn't:
What we want is to have the present value of all of your assets and debts. Your current savings is easy: it's that value. Your future savings contributions are a little harder. You have to discount every future saving cash flow you plan to put away. So what we need to ask is: What is the present value of your mortgage?

Calculating that takes a little bit of work. It is the sum of all of your future mortgage payments (principal AND interest) discounted to the present. With a negative sign. Here's a key part: If the interest rate you use to discount those future payments to the present is equal to the interest on the mortgage, then the mortgage balance today IS its present value. Mortgage rates nowadays are near enough to regular interest rates that I think it's reasonable to make this simplification.

To be clear, you could instead account for the mortgage payments in your expenses and directly subtract them from your yearly expected savings. So you'd estimate you'd save 50k-25k-10k instead. Then you'd sum all of those future savings contributions, discounted to today. But then do NOT subtract the mortgage balance afterwards. You've taken it into account already.

One reason I don't like that is that your mortgage might be shorter than your accumulation period. The above would make it seem like as long as your savings, you're making mortgage payments. Using the present value of the mortgage, on the other hand, does account for that inconsistency.
Gufomel wrote: Wed Apr 01, 2020 12:07 pm Regardless of the mechanics of calculating it, the theory would be that the remaining mortgage is counted as a negative in your current asset calculation, and future mortgage principal payments are included in the future savings contribution calculation. Feel free to beat me over the head if that’s not correct.
The reality is that it doesn't matter how much of your mortgage payment is principal or interest. All we know is that $X is coming out of your salary monthly and that that will stop in, say, 15 years. That's all you need to quantify the mortgage as an asset and a loan.
Ok that’s making sense. Thanks for bearing with me. As far as discounting the future mortgage payments, wouldn’t you want to discount it at the risk-free rate? I think you kind of alluded to it that that’s technically what you would want to do. So presumably a nominal treasury rate at a duration around the midpoint of the remaining years left on your mortgage? That’s going to be around 1% currently. Wouldn’t that result in a fairly significantly higher present value compared to using a 3-4% mortgage rate (or in other words using the mortgage balance)? I know you were going for simple explanation here so I understand if you were leaving that out intentionally. Again, just trying to understand the theory.
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

Gufomel wrote: Wed Apr 01, 2020 2:07 pm Ok that’s making sense. Thanks for bearing with me. As far as discounting the future mortgage payments, wouldn’t you want to discount it at the risk-free rate? I think you kind of alluded to it that that’s technically what you would want to do. So presumably a nominal treasury rate at a duration around the midpoint of the remaining years left on your mortgage? That’s going to be around 1% currently. Wouldn’t that result in a fairly significantly higher present value compared to using a 3-4% mortgage rate (or in other words using the mortgage balance)? I know you were going for simple explanation here so I understand if you were leaving that out intentionally. Again, just trying to understand the theory.
Haha you're asking questions where theory breaks down. If the mortgage has a 3-4% interest rate, then that should be the discount rate to use. That's because the mortgage incorporates an element of risk and default that you might end up using. Yes, I'm saying YOU might default on your mortgage, which makes those future payments something less valuable (because you might not make them at all), requiring a higher discount rate. That's why the bank can get away charging that rate and borrowing at the RFR. That's in a perfectly efficient world. If it was known for sure that you wouldn't default, then banks cannot charge anything more than the RFR since other lending institutions would just snatch the business.

I would keep it simple and just use the mortgage balance. If you want to use the RFR to discount those mortgage payments, be my guest. You'll end up with a bigger mortgage balance number that way. I don't think it will change that much.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
Gufomel
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Re: Lifecycle Investing - Leveraging when young

Post by Gufomel »

Steve Reading wrote: Wed Apr 01, 2020 2:25 pm
Gufomel wrote: Wed Apr 01, 2020 2:07 pm Ok that’s making sense. Thanks for bearing with me. As far as discounting the future mortgage payments, wouldn’t you want to discount it at the risk-free rate? I think you kind of alluded to it that that’s technically what you would want to do. So presumably a nominal treasury rate at a duration around the midpoint of the remaining years left on your mortgage? That’s going to be around 1% currently. Wouldn’t that result in a fairly significantly higher present value compared to using a 3-4% mortgage rate (or in other words using the mortgage balance)? I know you were going for simple explanation here so I understand if you were leaving that out intentionally. Again, just trying to understand the theory.
Haha you're asking questions where theory breaks down. If the mortgage has a 3-4% interest rate, then that should be the discount rate to use. That's because the mortgage incorporates an element of risk and default that you might end up using. Yes, I'm saying YOU might default on your mortgage, which makes those future payments something less valuable (because you might not make them at all), requiring a higher discount rate. That's why the bank can get away charging that rate and borrowing at the RFR. That's in a perfectly efficient world. If it was known for sure that you wouldn't default, then banks cannot charge anything more than the RFR since other lending institutions would just snatch the business.

I would keep it simple and just use the mortgage balance. If you want to use the RFR to discount those mortgage payments, be my guest. You'll end up with a bigger mortgage balance number that way. I don't think it will change that much.
Interesting, makes enough sense and simple to account for. Thanks for your thoughts. I may pick your brain at other times. Best of luck on your adventure. I know that by having a mortgage and investing in equities I’m using leverage, but you and others are definitely taking it to another level. A mortgage and discounting my future earnings as current savings is risky enough for me! :D (edit: I know the context that I used “risk” in is regarding shorter-term risk rather than investing lifetime risk).
Gufomel
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Re: Lifecycle Investing - Leveraging when young

Post by Gufomel »

It also finally makes sense to me why the Vanguard lifecycle funds have a significantly higher stock allocation than most typical “age in bonds” or “age minus 10 in bonds” maxims. I think you referenced this in either this thread or another one. Thanks again for your input.
Count of Notre Dame
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Re: Lifecycle Investing - Leveraging when young

Post by Count of Notre Dame »

Let's say I've already read the book and am deciding I want to leverage somehow with a small portion of my future savings, let's call it $2k per month. What is the cheapest way to leverage a diversified portfolio of stocks? I have been comparing opening a 2 to 1 margin account at Interactive Brokers with a current margin account cost below 2% vs. a leveraged ETF. What is the implied interest rate if I were to invest in a leveraged ETF instead? I have some concerns whether the ETF can maintain its leverage. For the margin calls I would be able to borrow from a HELOC to meet them if they are unexpectedly large.
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Steve Reading
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

Count of Notre Dame wrote: Mon Apr 06, 2020 10:26 pm Let's say I've already read the book and am deciding I want to leverage somehow with a small portion of my future savings, let's call it $2k per month. What is the cheapest way to leverage a diversified portfolio of stocks? I have been comparing opening a 2 to 1 margin account at Interactive Brokers with a current margin account cost below 2% vs. a leveraged ETF. What is the implied interest rate if I were to invest in a leveraged ETF instead? I have some concerns whether the ETF can maintain its leverage. For the margin calls I would be able to borrow from a HELOC to meet them if they are unexpectedly large.
The margin loan is most likely a little cheaper and has the advantage that you could leverage a true global portfolio (say VT) instead of just the S&P 500. There are LETFs for international markets but can't speak to their borrowing costs.

Also, I have a preference for rebalancing leverage less often than once a day (say once a month), which you could do with margin.

Also has anyone recently looked at IB's margin rates? 1.05% for accounts with over 100k? Mamma mia that's incredibly competitive.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
ChrisBenn
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Re: Lifecycle Investing - Leveraging when young

Post by ChrisBenn »

Steve Reading wrote: Tue Apr 07, 2020 5:02 pm (...)
Also has anyone recently looked at IB's margin rates? 1.05% for accounts with over 100k? Mamma mia that's incredibly competitive.
Maybe I'm looking at it wrong, but I would feel like I need a model to figure out what a safe margin utilization rate was - taking into a account max drawdown (probably more relevant than volatility), but also modeling IB's risk management practices since from what I understand they can change the max margin allowed at any point -- and it seems like times like this when you would want to utilize it the most is when they would be most likely to require more collateral.

But yeah, those rates are great!
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

ChrisBenn wrote: Tue Apr 07, 2020 5:11 pm
Steve Reading wrote: Tue Apr 07, 2020 5:02 pm (...)
Also has anyone recently looked at IB's margin rates? 1.05% for accounts with over 100k? Mamma mia that's incredibly competitive.
Maybe I'm looking at it wrong, but I would feel like I need a model to figure out what a safe margin utilization rate was - taking into a account max drawdown (probably more relevant than volatility), but also modeling IB's risk management practices since from what I understand they can change the max margin allowed at any point -- and it seems like times like this when you would want to utilize it the most is when they would be most likely to require more collateral.

But yeah, those rates are great!
Well, if you're willing to decrease exposure during market downturns (as per the book), then this doesn't matter as much. Just leverage 2-1 and sell as needed.

Otherwise, you should do what I did with my options: Figure out what % drawdown is needed to cause a margin calls considering that your collateral is also in stocks and will drop by that much. Assume a 25% margin requirement (that's what IB uses). Idk about increasing a margin requirement but i can't see it going up much more than 30 or 35%.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
mr_mac3
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Re: Lifecycle Investing - Leveraging when young

Post by mr_mac3 »

I have just read this thread and the market timer thread (wow what a wild ride that was) and a few others on leveraging when young. I really appreciate these threads and both of you have been super patient with your critics. I find it all very interesting. The next step for me is to get the Ayres and Nalebuff book. I have seen recommendations for the books by Moshe A. Milevsky and Tristan Yates, have you read those and did they add anything beyond what is in the A&N book?

I have a couple questions that I believe haven't come up yet. How are you calculating the implied interest rate on your synthetic long stocks? I am guessing you take the net debit/credit from buying the options and add that with the dividends foregone as your interest payments on the implied borrowed amount of 100*(stock price). (Upon rereading earlier posts I see that this question has already been answered.)

You mentioned that when just buying a long call, the amount of leverage and the value of the implicit protective put are linked, the more leverage you get, the more valuable the protective put.Say I wanted to separate these decisions, for example I wanted 3:1 leverage but didn't want to pay for the implied protective put at that strike price. Couldn't I create a synthetic long stock and then buy a cheap protective put? I am thinking of this for situations like market timer's in 08/09. Given my cashflow I can calculate the maximum rate of decline in the market I could maintain the margin requirements with new cash. I could then just buy protective puts at the strikes and dates that would save me if we exceeded those rates.

I guess my question here is really how would you have handled the situation that if instead of the current rally, we had just continued crashing down to SPY $160? Would you have been ok? What if your income was half of what it is but you still had the same expected lifetime earnings so that you had less cash to throw in but wanted the same exposure? I have no experience with futures or short put margin requirements so I may be way off thinking that your method might respond similar to market timer's. Apologies if this has been discussed in the book, I believe you mentioned they sell off during a downturn.

On rolling LEAP options. You are planning to hold your position to very close to expiration correct? I guess right before the last ex-dividend date. This is because the synthetic long stock has theta=0, correct? So someone who was just using long calls would not have theta=0 and should rollover before time decay becomes a problem, right? How does one find the optimal rollover period? The longer you wait the less times you pay the bid-ask spread, the commission, capital gains tax (if applicable) but the more you start paying in time decay as it is nonlinear. If there isn't a ready answer I might might make that my next project. :)

Finally, why use SPY options? Since your borrowing costs seem to be mostly foregone dividends, would it be better to use your leverage on lower dividend indices that have more expected capital gains? I was looking at say QQQ or IWM. I haven't found a way to find all indices with LEAP options but I wonder if SPY is the best. I guess there is going to be less liquidity but if you are using ATM options to create synthetic long stocks there seems to always be a lot of open interest. It might be harder to just do deep ITM long calls.

(Edit: If I am doing the implied interest calculations right, for synthetic longs created with ATM options I get 1.94% for IWM @ 120 strike, 1.12% for QQQ @ 210 strike and 1.39% for SPY @ 280 strike. This is not as dramatic a difference as I was expecting. It seems the bid/ask spreads are about 11% of the midpoint price for the puts and calls on IWM at 120 strike, that is compared to about 2.2% for SPY at 280 and for QQQ i get a 2.5% spread on the call but an 11.6% spread for the put. I wonder how much these numbers are affected by the current volatility. One would also have to account for the difference in expense ratio SPY 0.09% vs QQQ 0.2% averaged with that of whatever you use to balance out QQQ in the rest of your portfolio (i.e. VTV @ 0.04%). In any case, I wonder if you have an opinion here.)

Sorry to ask so much.
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

mr_mac3 wrote: Fri Apr 24, 2020 12:37 pm I have seen recommendations for the books by Moshe A. Milevsky and Tristan Yates, have you read those and did they add anything beyond what is in the A&N book?
I read "Are you a stock or a bond?". Does a decent job about thinking about your job as an investment (invest it in with education, protect it with disability insurance, etc) but doesn't really discuss any mechanics about leverage. I haven't read anything from Tristan.
mr_mac3 wrote: Fri Apr 24, 2020 12:37 pm Couldn't I create a synthetic long stock and then buy a cheap protective put? I am thinking of this for situations like market timer's in 08/09. Given my cashflow I can calculate the maximum rate of decline in the market I could maintain the margin requirements with new cash. I could then just buy protective puts at the strikes and dates that would save me if we exceeded those rates.
Yeah, you could do that. It's just a long call with a put Bull spread. As long as you know your way around options, I don't see why not.
mr_mac3 wrote: Fri Apr 24, 2020 12:37 pm I guess my question here is really how would you have handled the situation that if instead of the current rally, we had just continued crashing down to SPY $160? Would you have been ok? What if your income was half of what it is but you still had the same expected lifetime earnings so that you had less cash to throw in but wanted the same exposure? I have no experience with futures or short put margin requirements so I may be way off thinking that your method might respond similar to market timer's. Apologies if this has been discussed in the book, I believe you mentioned they sell off during a downturn.
Since the very beginning, I have kept the callable leverage at a point conservative enough (at least in my opinion) that it would take very large market losses to force a liquidation. I could've handled just about SPY 170 before being forced to liquidate. That's a number I felt comfortable with.

Current cash flow did play a small consideration in the above decision but I figured that if a market crash occurred, it could occur very fast any ways so I never relied on my income stabilizing anything short term (a very prescient decision wasn't it?). The biggest buffer against not being forced to sell was to select a conservative amount of initial leverage since the beginning.
mr_mac3 wrote: Fri Apr 24, 2020 12:37 pm Finally, why use SPY options? Since your borrowing costs seem to be mostly foregone dividends, would it be better to use your leverage on lower dividend indices that have more expected capital gains? I was looking at say QQQ or IWM. I haven't found a way to find all indices with LEAP options but I wonder if SPY is the best. I guess there is going to be less liquidity but if you are using ATM options to create synthetic long stocks there seems to always be a lot of open interest. It might be harder to just do deep ITM long calls.
I don't believe the dividend actually matter. If the ETF had no dividend, then the call would be that much more expensive and the puts would be that much cheaper. SPY has the highest interest/liquidity, especially in the longer-term stuff. I'm also not interested in a tech index like the NASDAQ (my job is in tech so, if anything, I should shy away from tech and tilt value, which I do), or any Russell index. I looked at little into options on foreign ETFs but the interest costs were simply higher than SPY so I wasn't interested.
mr_mac3 wrote: Fri Apr 24, 2020 12:37 pm (Edit: If I am doing the implied interest calculations right, for synthetic longs created with ATM options I get 1.94% for IWM @ 120 strike, 1.12% for QQQ @ 210 strike and 1.39% for SPY @ 280 strike. This is not as dramatic a difference as I was expecting. It seems the bid/ask spreads are about 11% of the midpoint price for the puts and calls on IWM at 120 strike, that is compared to about 2.2% for SPY at 280 and for QQQ i get a 2.5% spread on the call but an 11.6% spread for the put. I wonder how much these numbers are affected by the current volatility. One would also have to account for the difference in expense ratio SPY 0.09% vs QQQ 0.2% averaged with that of whatever you use to balance out QQQ in the rest of your portfolio (i.e. VTV @ 0.04%). In any case, I wonder if you have an opinion here.)
I think I looked a little into them but just decided the borrowing cost was too high (I do incorporate spreads into the borrowing cost... I don't use midpoints for anything, I use the ask for the calls and the bid for the puts). Temporal diversification is far more important and effective than asset diversification. I'm not really convinced that VTV or SPY or IWM or QQQ will really matter that much in a portfolio. But I definitely know achieving proper temporal diversification matters a lot. So I picked SPY since it felt like the right choice and didn't think too much more about it.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

Post by UberGrub »

Any updates on this? Markets have gone up quite a bit since the March low!
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

UberGrub wrote: Wed May 27, 2020 2:13 pm Any updates on this? Markets have gone up quite a bit since the March low!
Ah sorry. I don't get notified if you don't quote my posts so I hadn't noticed this.

Things are going well. I estimate markets need to drop about 55% from here to force a liquidation. That's the kind of breathing space that I like to keep and it was certainly welcomed during the March lows. Also, every month I keep saving and buying stocks so I buy myself some downside protection little by little as time goes by. This is a multi-decade, long-term investment strategy after all.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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KEotSK66
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Re: Lifecycle Investing - Leveraging when young

Post by KEotSK66 »

Steve Reading wrote: Fri Mar 01, 2019 12:11 am
I recently came across the research from Prof. Ayres and Nalebuff about lifecycle investing and time diversification. The cliffnotes is that if one thinks about every future year as a potential bet, then it's in your best interest to spread out your bets as uniformly as possible across all those years. This means investing, to the best of your ability, the same dollar amount in stocks every year throughout your life. Since people accumulate money as they age, the implication is to use leverage when young to get closer to that target. That increases short term risk but, paradoxically, lowers long term risk. There are some rules set (such as not borrowing on credit, keeping leverage at 2:1 max, taking into account the nature of your income, etc) but that's the general idea.
I think value averaging would pay off better long term, more shares
"i just got fluctuated out of $1,500", jerry
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Re: Lifecycle Investing - Leveraging when young

Post by Uncorrelated »

KEotSK66 wrote: Sun May 31, 2020 11:39 pm
Steve Reading wrote: Fri Mar 01, 2019 12:11 am
I recently came across the research from Prof. Ayres and Nalebuff about lifecycle investing and time diversification. The cliffnotes is that if one thinks about every future year as a potential bet, then it's in your best interest to spread out your bets as uniformly as possible across all those years. This means investing, to the best of your ability, the same dollar amount in stocks every year throughout your life. Since people accumulate money as they age, the implication is to use leverage when young to get closer to that target. That increases short term risk but, paradoxically, lowers long term risk. There are some rules set (such as not borrowing on credit, keeping leverage at 2:1 max, taking into account the nature of your income, etc) but that's the general idea.
I think value averaging would pay off better long term, more shares
The paper describes the optimal method under some conditions. Don't try to improve it with mental accounting nonsense, it won't result in higher certainty equivalent return.
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Re: Lifecycle Investing - Leveraging when young

Post by KEotSK66 »

Uncorrelated wrote: Mon Jun 01, 2020 3:32 am
KEotSK66 wrote: Sun May 31, 2020 11:39 pm
Steve Reading wrote: Fri Mar 01, 2019 12:11 am
I recently came across the research from Prof. Ayres and Nalebuff about lifecycle investing and time diversification. The cliffnotes is that if one thinks about every future year as a potential bet, then it's in your best interest to spread out your bets as uniformly as possible across all those years. This means investing, to the best of your ability, the same dollar amount in stocks every year throughout your life. Since people accumulate money as they age, the implication is to use leverage when young to get closer to that target. That increases short term risk but, paradoxically, lowers long term risk. There are some rules set (such as not borrowing on credit, keeping leverage at 2:1 max, taking into account the nature of your income, etc) but that's the general idea.
I think value averaging would pay off better long term, more shares
The paper describes the optimal method under some conditions. Don't try to improve it with mental accounting nonsense, it won't result in higher certainty equivalent return.
nonsense ???

buying high won't result in higher return
"i just got fluctuated out of $1,500", jerry
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Re: Lifecycle Investing - Leveraging when young

Post by Uncorrelated »

KEotSK66 wrote: Mon Jun 01, 2020 6:36 am
Uncorrelated wrote: Mon Jun 01, 2020 3:32 am
KEotSK66 wrote: Sun May 31, 2020 11:39 pm
Steve Reading wrote: Fri Mar 01, 2019 12:11 am
I recently came across the research from Prof. Ayres and Nalebuff about lifecycle investing and time diversification. The cliffnotes is that if one thinks about every future year as a potential bet, then it's in your best interest to spread out your bets as uniformly as possible across all those years. This means investing, to the best of your ability, the same dollar amount in stocks every year throughout your life. Since people accumulate money as they age, the implication is to use leverage when young to get closer to that target. That increases short term risk but, paradoxically, lowers long term risk. There are some rules set (such as not borrowing on credit, keeping leverage at 2:1 max, taking into account the nature of your income, etc) but that's the general idea.
I think value averaging would pay off better long term, more shares
The paper describes the optimal method under some conditions. Don't try to improve it with mental accounting nonsense, it won't result in higher certainty equivalent return.
nonsense ???

buying high won't result in higher return
There is no such thing as "buying high" unless you can reliably time the market. Lifecycle investing assumes that you can't do that.

If you believe you can accurately time the markets, you probably shouldn't be using mathematically suboptimal approaches such as dollar cost averaging.
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Re: Lifecycle Investing - Leveraging when young

Post by KEotSK66 »

Uncorrelated wrote: Mon Jun 01, 2020 8:47 am
KEotSK66 wrote: Mon Jun 01, 2020 6:36 am
Uncorrelated wrote: Mon Jun 01, 2020 3:32 am
KEotSK66 wrote: Sun May 31, 2020 11:39 pm
Steve Reading wrote: Fri Mar 01, 2019 12:11 am
I recently came across the research from Prof. Ayres and Nalebuff about lifecycle investing and time diversification. The cliffnotes is that if one thinks about every future year as a potential bet, then it's in your best interest to spread out your bets as uniformly as possible across all those years. This means investing, to the best of your ability, the same dollar amount in stocks every year throughout your life. Since people accumulate money as they age, the implication is to use leverage when young to get closer to that target. That increases short term risk but, paradoxically, lowers long term risk. There are some rules set (such as not borrowing on credit, keeping leverage at 2:1 max, taking into account the nature of your income, etc) but that's the general idea.
I think value averaging would pay off better long term, more shares
The paper describes the optimal method under some conditions. Don't try to improve it with mental accounting nonsense, it won't result in higher certainty equivalent return.
nonsense ???

buying high won't result in higher return
There is no such thing as "buying high" unless you can reliably time the market. Lifecycle investing assumes that you can't do that.

If you believe you can accurately time the markets, you probably shouldn't be using mathematically suboptimal approaches such as dollar cost averaging.
if you can't identify a 10% or 25% or 50% loss in stocks I don't know what to tell
"i just got fluctuated out of $1,500", jerry
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

KEotSK66 wrote: Sun May 31, 2020 11:39 pm
Steve Reading wrote: Fri Mar 01, 2019 12:11 am
I recently came across the research from Prof. Ayres and Nalebuff about lifecycle investing and time diversification. The cliffnotes is that if one thinks about every future year as a potential bet, then it's in your best interest to spread out your bets as uniformly as possible across all those years. This means investing, to the best of your ability, the same dollar amount in stocks every year throughout your life. Since people accumulate money as they age, the implication is to use leverage when young to get closer to that target. That increases short term risk but, paradoxically, lowers long term risk. There are some rules set (such as not borrowing on credit, keeping leverage at 2:1 max, taking into account the nature of your income, etc) but that's the general idea.
I think value averaging would pay off better long term, more shares
Haha I hope not since value averaging is in some ways almost the opposite of what I'm doing.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

Post by Ciel »

I just read the Ayres and Nalebuff book. I find their argument and research compelling. However, the only actionable advice I really got from the book is to go 100% equities. I don't invest taxable but max my tax advantaged space. LEAPS in an IRA is a possibility for leverage, but it seems like it's impossible to get permission from a brokerage to trade options without prior experience doing so (without lying on the application, which is a route I don't want to go down).

The book was still worth the read for me, as it shifted my views on asset allocation. I'll probably end up with a higher percentage in equities as I age as a result of that. In the book they talk about filing a patent for managed lifecycle funds -- I wonder what the main roadblocks they ran into were, as clearly that never made it to market. They do mention how such funds could be interpreted as an ERISA violation if offered as part of a 401k plan, though that would still leave an opportunity for IRAs.

So, I mainly find the book relevant for the very few individuals in their twenties who have plenty to invest in a taxable account (on margin through interactive brokers) after maxing out their tax advantaged space. That's a very small group of individuals.
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Re: Lifecycle Investing - Leveraging when young

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Ciel wrote: Tue Jun 02, 2020 3:32 am I don't invest taxable but max my tax advantaged space. LEAPS in an IRA is a possibility for leverage, but it seems like it's impossible to get permission from a brokerage to trade options without prior experience doing so (without lying on the application, which is a route I don't want to go down).
Oh that's a shame. Getting permission to buy call options is typically level 1 for brokers. Since it carries no margin risk, you can generally obtain it without prior options experience. It's where most of us start. What broker are you using? I wouldn't lie on the application; I got approved for call options years ago and I told them I had zero experience. I used Merrill back then.
Ciel wrote: Tue Jun 02, 2020 3:32 am So, I mainly find the book relevant for the very few individuals in their twenties who have plenty to invest in a taxable account (on margin through interactive brokers) after maxing out their tax advantaged space. That's a very small group of individuals.
I think the book is relevant to many others. Mainly:
- Individuals of any age (20s, 30s, 40s, etc) who are saving enough to fill up their tax-advantaged but not much else. They would use LEAPs in their IRAs as per the book. In fact, this is the demographic they simulate most (I believe each person saves like 5k a year).
- Individuals of any age (20s, 30s, 40s and 50s) who have saved more than their tax-advantaged and also have a taxable account. Those individuals might use LEAPs or margin outside, in the taxable account. You might only need like 15k to buy a LEAP or use margin so it seems accessible to most individuals, especially later in life.
- Individuals later in life (50s, 60s, etc) that still have an income will still use these concepts. They might not need to leverage (or like Ian, they might only need a little leverage). If you take Social Security into account, this is especially relevant. As they show, even starting late has benefits!
- Individuals who have kids. They show some recommendations as to how to save for them to set them up for their lifecycle investing journey.
- Even institutions, endowment funds, etc will want to take heed. They probably already do though.

Just my 2 cents.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

Post by Ciel »

Steve Reading wrote: Tue Jun 02, 2020 8:13 am
Ciel wrote: Tue Jun 02, 2020 3:32 am I don't invest taxable but max my tax advantaged space. LEAPS in an IRA is a possibility for leverage, but it seems like it's impossible to get permission from a brokerage to trade options without prior experience doing so (without lying on the application, which is a route I don't want to go down).
Oh that's a shame. Getting permission to buy call options is typically level 1 for brokers. Since it carries no margin risk, you can generally obtain it without prior options experience. It's where most of us start. What broker are you using? I wouldn't lie on the application; I got approved for call options years ago and I told them I had zero experience. I used Merrill back then.
Ciel wrote: Tue Jun 02, 2020 3:32 am So, I mainly find the book relevant for the very few individuals in their twenties who have plenty to invest in a taxable account (on margin through interactive brokers) after maxing out their tax advantaged space. That's a very small group of individuals.
I think the book is relevant to many others. Mainly:
- Individuals of any age (20s, 30s, 40s, etc) who are saving enough to fill up their tax-advantaged but not much else. They would use LEAPs in their IRAs as per the book. In fact, this is the demographic they simulate most (I believe each person saves like 5k a year).
- Individuals of any age (20s, 30s, 40s and 50s) who have saved more than their tax-advantaged and also have a taxable account. Those individuals might use LEAPs or margin outside, in the taxable account. You might only need like 15k to buy a LEAP or use margin so it seems accessible to most individuals, especially later in life.
- Individuals later in life (50s, 60s, etc) that still have an income will still use these concepts. They might not need to leverage (or like Ian, they might only need a little leverage). If you take Social Security into account, this is especially relevant. As they show, even starting late has benefits!
- Individuals who have kids. They show some recommendations as to how to save for them to set them up for their lifecycle investing journey.
- Even institutions, endowment funds, etc will want to take heed. They probably already do though.

Just my 2 cents.
Mea Culpa. I assumed I would get denied based on what I read on another forum, but lo and behold, Fidelity did approve me today. I'm planning on following the strategy outlined in the book regarding LEAPS.

You're absolutely right, those are all excellent points.
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Re: Lifecycle Investing - Leveraging when young

Post by markfaix »

Steve Reading wrote: Tue Jun 02, 2020 8:13 am
Ciel wrote: Tue Jun 02, 2020 3:32 am I don't invest taxable but max my tax advantaged space. LEAPS in an IRA is a possibility for leverage, but it seems like it's impossible to get permission from a brokerage to trade options without prior experience doing so (without lying on the application, which is a route I don't want to go down).
Oh that's a shame. Getting permission to buy call options is typically level 1 for brokers. Since it carries no margin risk, you can generally obtain it without prior options experience. It's where most of us start. What broker are you using? I wouldn't lie on the application; I got approved for call options years ago and I told them I had zero experience. I used Merrill back then.
Ciel wrote: Tue Jun 02, 2020 3:32 am So, I mainly find the book relevant for the very few individuals in their twenties who have plenty to invest in a taxable account (on margin through interactive brokers) after maxing out their tax advantaged space. That's a very small group of individuals.
I think the book is relevant to many others. Mainly:
- Individuals of any age (20s, 30s, 40s, etc) who are saving enough to fill up their tax-advantaged but not much else. They would use LEAPs in their IRAs as per the book. In fact, this is the demographic they simulate most (I believe each person saves like 5k a year).
- Individuals of any age (20s, 30s, 40s and 50s) who have saved more than their tax-advantaged and also have a taxable account. Those individuals might use LEAPs or margin outside, in the taxable account. You might only need like 15k to buy a LEAP or use margin so it seems accessible to most individuals, especially later in life.
- Individuals later in life (50s, 60s, etc) that still have an income will still use these concepts. They might not need to leverage (or like Ian, they might only need a little leverage). If you take Social Security into account, this is especially relevant. As they show, even starting late has benefits!
- Individuals who have kids. They show some recommendations as to how to save for them to set them up for their lifecycle investing journey.
- Even institutions, endowment funds, etc will want to take heed. They probably already do though.

Just my 2 cents.
I have read the book and this entire thread. I'm nearly 50 years old with 15 years of work left. How I wish I could have read this book and implemented it when I was younger! The idea of time diversification makes complete sense. But better late than never...

A few questions about implementation in my season of life:
1. We own our house outright but will be purchasing a second home, which we plan to sell in 10 years. How would you count the equity being accumulated in the second house toward this asset allocation? I wouldn't count the equity in the first house since we have to live there, but presumably we'll get the equity in the second home back when we sell (minus expenses).

Example:
Current assets 750k
First house 350k (own outright)
Second house 500k (mortgage 300k, equity 200k)
PV of future earnings 450k
PV of future mortgage payments ~70k (I just added up 10 yrs of payments toward principal in the amortization table)
desired ratio 50/50
So total PV of investable assets with this method = 750k + 200k -300k + 450k + 70k ??

2. How did you decide on your Samuelson ratio? I tried the risk calculators in the book and on their website. Got very different numbers, from 40% stock to >70%. I have high willingness to take risk, and a high desire to maximize chances to retire sooner, but my human capital is getting smaller and smaller.
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

markfaix wrote: Wed Jun 03, 2020 2:19 pm A few questions about implementation in my season of life:
1. We own our house outright but will be purchasing a second home, which we plan to sell in 10 years. How would you count the equity being accumulated in the second house toward this asset allocation? I wouldn't count the equity in the first house since we have to live there, but presumably we'll get the equity in the second home back when we sell (minus expenses).

Example:
Current assets 750k
First house 350k (own outright)
Second house 500k (mortgage 300k, equity 200k)
PV of future earnings 450k
PV of future mortgage payments ~70k (I just added up 10 yrs of payments toward principal in the amortization table)
desired ratio 50/50
So total PV of investable assets with this method = 750k + 200k -300k + 450k + 70k ??
In this very page, I answered questions to Gufomel about how I would incorporate a mortgage. A couple of things to note:
1) I think it's reasonable to take your primary house equity into your allocation. I would simply add it, and count it as a bond. The reason is that your primary home is effectively "paying you rent" every month by saving you the rent you'd have to pay otherwise. Unlike a second home that you'd rent out (which is a riskier form of a "bond") your primary home is actually very safe because you know you have to live there! So you know it saves you rent consistently.
2) A second home is a little tougher because it does carry risk. You might sell it for less than you bought it so it's not a riskless investment like a house you buy to retire in. So I would account it, in some stock/bond proportion (say it's 50/50 but feel free to modify based on how risky you believe that endeavor will be). Using your numbers:

I'd say your current net assets are 750k + 350k (house) + 200k (second house equity). Your future contributions are 450k future discounted savings. I don't think there's a need to account for future mortgage payments because those do actually go to equity so it's both an expense (decreasing you future savings) but a form of savings (because they increase your net worth via house equity), canceling out.

That's 1.75M total. You'd want 875k in stock-like investments. The 200k second house I'm counting as, say, 50/50 so it provides 100k in "stocks". Even if you put all of your current savings all in stocks (750k), it's still not enough to hit your target. I wouldn't use leverage since you're so close but I would stay at 100%. And if you accounted for social security (a big bond), then you'd want even more in stocks.

If that feels very risky, the solution is not to give up on this method, or not count your first house or SS as a bond. The solution is to pick a more conservative Samuelson share.
markfaix wrote: Wed Jun 03, 2020 2:19 pm 2. How did you decide on your Samuelson ratio? I tried the risk calculators in the book and on their website. Got very different numbers, from 40% stock to >70%. I have high willingness to take risk, and a high desire to maximize chances to retire sooner, but my human capital is getting smaller and smaller.
Hopefully this post answers that:
viewtopic.php?p=5063345#p5063345

To summarize, I would just pick one instead of trying to determine it with RRAs and expected returns. I'd say that 30% might be about right for most, with maybe up to 50/50 for more aggressive investors. Of course, if you aren't willing to put everything in stocks right now, then 50/50 is clearly a little too aggressive for you personally. I should mention that conventional allocations should be ignored. Many of them implicitly assume retirees have homes and SS. A 50/50 retiree with a house and SS is more like a 20/80 Samuelson share. So it's ok to be quite conservative. If a 20/80 Samuelson share leads to having a 50/50 portfolio, plus house and SS, then that might be about the right level of risk even though 20/80 sounds low (both conventionally and by the book standards).

Once you've picked one, then you can back-calculate your RRA from that (I show that in the post). This lets you do a little market timing and tactical asset allocation in the future in case the Equity Risk Premium looks abnormally large or small.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

Post by markfaix »

Steve Reading wrote: Wed Jun 03, 2020 5:51 pm
markfaix wrote: Wed Jun 03, 2020 2:19 pm A few questions about implementation in my season of life:
1. We own our house outright but will be purchasing a second home, which we plan to sell in 10 years. How would you count the equity being accumulated in the second house toward this asset allocation? I wouldn't count the equity in the first house since we have to live there, but presumably we'll get the equity in the second home back when we sell (minus expenses).

Example:
Current assets 750k
First house 350k (own outright)
Second house 500k (mortgage 300k, equity 200k)
PV of future earnings 450k
PV of future mortgage payments ~70k (I just added up 10 yrs of payments toward principal in the amortization table)
desired ratio 50/50
So total PV of investable assets with this method = 750k + 200k -300k + 450k + 70k ??
In this very page, I answered questions to Gufomel about how I would incorporate a mortgage. A couple of things to note:
1) I think it's reasonable to take your primary house equity into your allocation. I would simply add it, and count it as a bond. The reason is that your primary home is effectively "paying you rent" every month by saving you the rent you'd have to pay otherwise. Unlike a second home that you'd rent out (which is a riskier form of a "bond") your primary home is actually very safe because you know you have to live there! So you know it saves you rent consistently.
2) A second home is a little tougher because it does carry risk. You might sell it for less than you bought it so it's not a riskless investment like a house you buy to retire in. So I would account it, in some stock/bond proportion (say it's 50/50 but feel free to modify based on how risky you believe that endeavor will be). Using your numbers:

I'd say your current net assets are 750k + 350k (house) + 200k (second house equity). Your future contributions are 450k future discounted savings. I don't think there's a need to account for future mortgage payments because those do actually go to equity so it's both an expense (decreasing you future savings) but a form of savings (because they increase your net worth via house equity), canceling out.

Thank you, Steve, for your helpful response! I think I'm on the slow train here, but I'm not sure I follow your point about my first home equity being part of my investment allocation. Yes, the first home equity saves me from paying rent and is therefore bond-like in that respect, but what I save in rent counts toward future investments.

Your point about not accounting for future mortgage payments is a good one since they are both equity increase and expense decreasing future savings.

So I think the total is:
750k (current assets) + 200k (second house equity) - 300k (second house mortgage) + 450k (future discounted earnings) + 200k (Social Security)

What do you think?
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

markfaix wrote: Wed Jun 03, 2020 8:30 pm Thank you, Steve, for your helpful response! I think I'm on the slow train here, but I'm not sure I follow your point about my first home equity being part of my investment allocation. Yes, the first home equity saves me from paying rent and is therefore bond-like in that respect, but what I save in rent counts toward future investments.
Think of it like this: Say you have $1M in a 50/50 allocation and no house. You spend 40k a year (a 4% withdrawal). You spend 20k in rent and 20k in everything else. This scenario has certain risks and rewards.

Now you put down 500k to buy a house. So now you end up with 500k in savings, a 500k house and have 20k in expenses a year. The 20k in expenses will come from the 500k in savings which is still a 4% withdrawal so everything is consistent.

The question we want to know is what allocation should those 500k in savings have such that the scenario before and after are equally risky. They should be equally risky because the look identical otherwise: you have $1M net worth, have 4% withdrawals, live in a house (rented or otherwise), etc.

If you don't count the house at all, then you'd invest the 500k in a 50/50. But this allocation is actually safer than the scenario where you rented. When you rented, all of your expenses would be provided by a 50/50 portfolio. But now, half of your expenses are perfectly met (you live in your house so your living expenses are risklessly met) while half of your expenses are met by a 50/50 portfolio.

Counting the house as your bond allocation would say you invest the full 500k in stocks. I argue that is consistent with your risk taking when renting. Now half of your expenses are risklessly met (housing) as though it came from a 0/100 portfolio and the other half met by a 100/0 portfolio. This is roughly equivalent to ALL of your expenses being met by a 50/50 portfolio.

Another way to think about it is that investing the 500k all in stocks is the only way to maintain an identical exposure to the market (500k invested in stocks), which tells you that you have effectively achieved identical risks before and after the house purchase.
markfaix wrote: Wed Jun 03, 2020 8:30 pm
So I think the total is:
750k (current assets) + 200k (second house equity) - 300k (second house mortgage) + 450k (future discounted earnings) + 200k (Social Security)

What do you think?
The last two terms are fine. Those are future assets. But I disagree with your current assets. Ask yourself "what is my net worth today?". if you had to liquidate everything today, how much would you end up? The answer is "I have 750k in savings, and I have a 500k second house. I also have a 300k debt liability (mortgage). So my net worth is 750k + 500k - 300k. Or simpler, just 750k + 200k (equity of second house)." If you sold the second house, you'd be given 500k, and pay the bank 300k, to end up with your equity (200k). To that you add current savings (750k), future savings (450k + 200k SS). And IMO also your primary house (350k). If you feel uncomfortable with thinking of your primary house as an asset (just an illiquid one), fine, don't add it. But make sure you add the second house properly.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

Post by Infinite Horizon »

Why should one value future earnings using the risk free rate if you're limited by credit constraints? I get that if I could get a 30 year mortgage backed by my future income stream I should value it that way. But if the thing limiting my market exposure is the threat of margin calls, then I can't borrow the capitalized future wages, and I won't be able to contribute them to make up for short term losses and get market exposure back up for many years.

Normally, I discount future income streams based on the expected log wealth growth from the stock market, so why should it be different here? But with current rates that's an enormous difference, like ~0% vs 7%, which would change the net present value of future wages by something like 3x.

I'd really appreciate some insight on this.
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Re: Lifecycle Investing - Leveraging when young

Post by questions49 »

NTropy wrote: Sat Mar 02, 2019 8:56 am I'm a BH lurker who just made an account because actual examples of lifecycle investing seem to be rare.

I read Ayres and Nalebuff a few years ago and found it very persuasive. I spent a solid year looking over the numbers and creating my own simulations to see the impact of leverage on future portfolio values. In general, I (like them) found benefits to risk and return by diversifying across time. Just before implementing the leverage strategy I found markettimer's legendary thread which reinforced the need to approach the topic with caution.

Ayres and Nalebuff suggest limiting leverage to 2x, which means (correct me if I'm wrong) there are three stages to the strategy, based on a target final portfolio value:

Stage 1: 0% to 50% of portfolio target, using 2x leverage
Stage 2: 50% to 100% of portfolio target, with leverage decreasing from 2x to 1x
Stage 3: At 100% of portfolio target, you are delevered

One year ago I took the plunge and purchased LEAPS to move from 100% equity to 200%. I'm early in my career and have a relatively small portfolio size. I buy LEAPS that are 18 months from expiry, at about 75% ITM. To meet my AA I hold LEAPS options on SPY and EFA for US/International exposure, as well as ETFs for those markets plus emerging markets and Canada. One drawback of this method is the need to monitor the leverage as prices change; I track my total equity exposure monthly and buy/sell to stay close to 2x leverage. The first LEAPS I purchased expire later this month so I'll need to roll them over for another 18 months or so when that happens.

My last LEAPS purchase was around 3.2% implied interest, which is much better than what my broker offers in a margin account. In theory it should match the risk-free rate. In the book the authors mentioned futures and leveraged ETFs as other tools to achieve leverage which have been discussed above. I think I'm following Ayers and Nalebuff closer than most, and it looks like you have the same thing in mind. Let me know if you have questions about implementing the portfolio, as I found there are not many places online which discuss the book's strategy.
I take it that you are implementing this strategy in Canada? How have you dealt with currency exchange to be able to buy SPY and EFA in Canada?
Thanks!
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Re: Lifecycle Investing - Leveraging when young

Post by Uncorrelated »

Infinite Horizon wrote: Wed Jun 10, 2020 11:44 am Why should one value future earnings using the risk free rate if you're limited by credit constraints? I get that if I could get a 30 year mortgage backed by my future income stream I should value it that way. But if the thing limiting my market exposure is the threat of margin calls, then I can't borrow the capitalized future wages, and I won't be able to contribute them to make up for short term losses and get market exposure back up for many years.

Normally, I discount future income streams based on the expected log wealth growth from the stock market, so why should it be different here? But with current rates that's an enormous difference, like ~0% vs 7%, which would change the net present value of future wages by something like 3x.

I'd really appreciate some insight on this.
I believe that is related to the solution for merton's portfolio model: https://en.wikipedia.org/wiki/Merton%27 ... io_problem

The right discount rate is not dependent on the expected return in a risky investment, but only on the subjective discount rate and the risk free rate. If you look at some mathematical papers, you might be able to find the exact mathematical derivation.

If you can't borrow at the risk free rate, then Merton's portfolio model still applies and you should still discount at the risk free rate. But you will have to solve it for more than 2 assets at the same time. To my knowledge my analysis here and the analysis on https://www.aacalc.com/about are the only sources that have attempted these calculations.
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Re: Lifecycle Investing - Leveraging when young

Post by Infinite Horizon »

Thanks, I don't fully understand after reading these sources, but I will try to puzzle it out.
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

Uncorrelated wrote: Fri Jun 12, 2020 5:50 am If you can't borrow at the risk free rate, then Merton's portfolio model still applies and you should still discount at the risk free rate. But you will have to solve it for more than 2 assets at the same time. To my knowledge my analysis here and the analysis on https://www.aacalc.com/about are the only sources that have attempted these calculations.
I think if you borrow at higher than the risk-free rate, it is still a 2 asset problem and can be solved by assuming the risk-free rate IS the borrowing rate you have available. There can be no portfolio that has all 3 assets (stocks, cash and borrowing) because borrowing is the exact opposite of cash (and has a higher rate) and hence, there will be another portfolio with strictly better properties where the cash allocation is used to reduce the borrowing allocation. So just solve for the stock ideal % allocation by assuming the RFR is the borrowing rate. This actually adds one more phase to Lifecycle Investing (first leverage, then no leverage but keep buying stocks, then finally add cash). This was covered in the original Ayres paper.

What you linked above is what happens when you introduce bonds, an asset with slightly different properties than cash/-cash (borrowing) because it has duration. In that case, the technically correct solution is a 3 asset problem of course because there very well might be a superior portfolio with stocks and bonds, that is leveraged (it might even have a borrowing rate higher than the bond rate, provided the bonds provide enough diversification to warrant them).

To reiterate: you don't need to solve for 3 assets if you borrow at more, less or equal to cash. You solve it when there are other assets with slightly different properties to cash/-cash/stocks regardless of whether the rate of return on that asset is equal, less or more than the borrowing rate.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

Infinite Horizon wrote: Fri Jun 12, 2020 9:54 am Thanks, I don't fully understand after reading these sources, but I will try to puzzle it out.
And I wouldn't try to understand them that much. I think some of this analysis overcomplicates things. Lifecycle investing has some remarkable diversification benefits. I recommend keeping things simple, reap the benefits from temporal diversification, and don't get bogged down one what is technically the correct, perfect way to think about it.

As for how to discount future wages, you'd discount them at RFR if you weren't credit constrained right? So how about you discount them still at RFR if credit-constrained, but place a leverage cap based on those credit constraints? So borrow only to the extent you feel comfortable with meeting margin calls with salaries. As long as you do that, it is as though the debt was uncallable, mortgage-like debt at that point. So this, and a scenario where you actually do leverage with a mortgage, should have identical allocations to stocks. So you must use the same RFR between them.

And you know what? If that's still feeling wrong and you want to discount at the stock market rate, go ahead and do so. It's not the technically correct way, but again, don't get bogged down here. You will still reap some temporal diversification benefits and will likely end up better off than if you didn't discount them at all and used a target date fund.
Just my 2 cents.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

Post by Infinite Horizon »

Yes, if I could take out a noncallable loan instead of IB portfolio margin I would borrow against my future contribution discounted at that rate and so increase my market exposure by almost 100% (discounting at market returns I would increase exposure by 30%+). As to setting a leverage cap based on my credit constraints, the thing is figuring out what it should be. Ayres and Nalebuff simulate with a 2x cap, but borrowing my future investment contributions would put me well above that, and I don't know how it would work out with higher caps.
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

Infinite Horizon wrote: Mon Jun 15, 2020 5:20 pm Yes, if I could take out a noncallable loan instead of IB portfolio margin I would borrow against my future contribution discounted at that rate and so increase my market exposure by almost 100% (discounting at market returns I would increase exposure by 30%+). As to setting a leverage cap based on my credit constraints, the thing is figuring out what it should be. Ayres and Nalebuff simulate with a 2x cap, but borrowing my future investment contributions would put me well above that, and I don't know how it would work out with higher caps.
Most people would have to go above 2x to borrow all of their future earnings. The solution is, don’t. Borrow up to 2x based on Ayres. As you save more, you will eventually hit your targets with 2x leverage, and then deleverage. This isn’t an all-or-nothing; “either you do borrow all of your future earnings or don’t borrow at all”. Somewhere it between is the best we can do with the tools we have (ex: borrow the future earnings UP TO 2x leverage and then continue accumulating over your life).
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

Post by Infinite Horizon »

I talked this out with an economics person, and they said that if margin constraints bind hard, I should discount with my risk-adjusted leveraged returns (so ~7-9% rather than ~0%). If I go above Kelly leverage I go to near 0 with high probability, and I can't pull out the illiquid assets to reboot early. However, I should be very enthusiastic if I do find the opportunity to borrow against the illiquid assets/capitalized wages, or take an unsecured loan at a reasonable interest rate.
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

Infinite Horizon wrote: Mon Jun 15, 2020 9:06 pm I talked this out with an economics person, and they said that if margin constraints bind hard, I should discount with my risk-adjusted leveraged returns (so ~7-9% rather than ~0%). If I go above Kelly leverage I go to near 0 with high probability, and I can't pull out the illiquid assets to reboot early. However, I should be very enthusiastic if I do find the opportunity to borrow against the illiquid assets/capitalized wages, or take an unsecured loan at a reasonable interest rate.
I don't think that person understands this concept very well. Imagine this scenario:

You have 100k in savings. The present value of future savings, discounted with RFR is 900k. Discounted at 8%, say it's 300k (a factor of 3 like you mentioned). You want a 50/50 stock/bond allocation. So if you follow the Merton model, you'd want to invest 500k in stocks today, or 5:1 leverage. You can't do that due to credit constraints. So you'd follow the Ayres advice and just do 2:1 leverage. So then you say "OK, credit constraints mean 2:1 leverage is the best I can do. And based on this friend of mine, if I'm leveraged constrained, then I need to discount at stock market rate". So then your portfolio is really 100k+400k and you'd need to invest 250k in the market today. Which you still can't do any ways since the most you can do is 2:1 leverage.

So guess what, both of these result in leveraging to the max any ways so discounting at a higher rate in no way addressed your leverage constraints.

A sure payment next year is worth whatever treasury zero coupon bond you need to buy today to pay that in a year, period. Using a higher discount rate reflects the uncertainty of that payment. To the extent your job is safe and you know you will save in the future, one way or another, these payments should be, indisputably, discounted at the RFR. If your job is high risk, then you discount somewhat higher. If it's as risky as the stock market itself (some years you get paid 20% more, some years you have to pay 50% of your wage, etc), then it makes sense to discount with the stock market rate.

The way to address leverage constraints, as I said before, is to put a cap on the leverage you use.

As to your friend, remind him that the Kelly Criterion of the market historically (about 1.5x leverage) only applies in the absence of fund inflows and outflows. If you are planning to contribute to your account, the Kelly Criterion increases significantly, because it is akin to the historical Kelly except every scenario comes with additional payments. So you can leverage more, optimally, if you contribute to an account. Same the other way; if you're in retirement and withdrawing, you can't come anywhere near close to the historical Kelly Criterion of 1.5x leverage without risking ruin.

Remember that every retirement cohort since 1887 in the US, Japan and Britain, would've retired with more money following this strategy? And in the simulations, the cohorts leveraged 2:1, "couldn't pull out illiquid assets", and went past the Kelly Criterion.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

market timer wrote: Sat Mar 02, 2019 12:28 am .
Got a question you might be able to answer.

Currently considering moving to IB and using margin. After-tax, it's the cheapest route for me right now.

Looking to use about 1.4:1 leverage. That could withstand about a 60%+ drop without a margin call. I feel all right with that.
But I am concerned about a flash crash like that of 2010 where some of my positions (say, VBR or FNDE, etc) suddenly drop 90%+ for a couple of minutes and then get back to normal. I mean, IWF traded for a penny during 2010. If IB just liquidates me, that would be a huge problem.

My understanding is the LULD (which does include all of my ETFs right now) should prevent this issue. So it would appear I'm OK after all. I could sign up for portfolio margin to increase my margin requirement cushion as well.

Any thoughts on this and how IB handles this sort of stuff? Am I overthinking it (i.e. LULD basically does solve my problem), or is this an actual problem that basically every IB margin trader has to consider?
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

Some interesting thoughts:
- Because there is a leverage cap in the A&N simulations, leveraging too much is counterproductive. Yes, you come closer to your Samuelson Share today but risk being much farther from it tomorrow after a drop. I think that's why they found leverage greater than 2:1 had more risk.

- Of course, they didn't address whether 2:1 was also too much. So I worked on their data for a bit and found that leverage actually closer to 1.5:1 had even less risk (less terminal wealth variance). So that seems to be the sweet spot. Much less leverage and you don't diversify temporally as much. Much more and you risk a strong market loss setting you back significantly away from your desired exposure and un-diversifying you temporally.

- The IB margin rate looks very attractive right now. I could get a blended rate of 1.2%. That's about as good as the implicit rates I've found on options and futures, but ETFs on margin are much more tax efficient. Not to mention I can get EM and Ex-US exposure, for slightly more diversification.

- I decided to bite the bullet. I moved my account to IB, closed the LEAPs and took out about $175k (1.5:1 leverage). That's enough to withstand about a 55% market decline. Unlike A&N, I am not planning on delevering on market declines. I think I can handle it with contributions. That does mean there's an inconsistency where sometimes I'm at 1.5:1 and some times more. The way I rationalize this is that the market isn't a perfect random walk. It's much less likely to drop 50% after dropping 50% (which Merton's formula assumes is the case). In other words, I think the ERP goes up when prices drop and vice-versa (while Merton assumes a constant ERP). Not develering is effectively a form of market-timing (but contrarian). I'm OK with that.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Lifecycle Investing - Leveraging when young

Post by EfficientInvestor »

Steve Reading wrote: Thu Jun 18, 2020 10:23 am Some interesting thoughts:
- Because there is a leverage cap in the A&N simulations, leveraging too much is counterproductive. Yes, you come closer to your Samuelson Share today but risk being much farther from it tomorrow after a drop. I think that's why they found leverage greater than 2:1 had more risk.

- Of course, they didn't address whether 2:1 was also too much. So I worked on their data for a bit and found that leverage actually closer to 1.5:1 had even less risk (less terminal wealth variance). So that seems to be the sweet spot. Much less leverage and you don't diversify temporally as much. Much more and you risk a strong market loss setting you back significantly away from your desired exposure and un-diversifying you temporally.

- The IB margin rate looks very attractive right now. I could get a blended rate of 1.2%. That's about as good as the implicit rates I've found on options and futures, but ETFs on margin are much more tax efficient. Not to mention I can get EM and Ex-US exposure, for slightly more diversification.

- I decided to bite the bullet. I moved my account to IB, closed the LEAPs and took out about $175k (1.5:1 leverage). That's enough to withstand about a 55% market decline. Unlike A&N, I am not planning on delevering on market declines. I think I can handle it with contributions. That does mean there's an inconsistency where sometimes I'm at 1.5:1 and some times more. The way I rationalize this is that the market isn't a perfect random walk. It's much less likely to drop 50% after dropping 50% (which Merton's formula assumes is the case). In other words, I think the ERP goes up when prices drop and vice-versa (while Merton assumes a constant ERP). Not develering is effectively a form of market-timing (but contrarian). I'm OK with that.
Here are a few thoughts on your thoughts:

- What if you maintain the 2:1 leverage but buy long term put options to protect against a worst case scenario? But the puts 2+ year out in order to get smaller theta decay and roll them once per year. Then, sell just enough covered calls to stay theta neutral.
- The 3-month libor is currently ~0.32%. My calculations that follow show that the implied financing on futures is somewhere around ~0.55% right now. I rolled my June /MES contract forward to September this morning and took in a 11.15 credit (let's just say from 3111.15 to 3100 for easy math). That's a 0.358% discount. If I compound that over 1 year, I get a 1.44% discount by rolling the futures every quarter. The current SEC yield on SPY is 1.99%. The difference between the expected dividend and the discount is the implied financing rate. Therefore, 1.99% - 1.44% = 0.55%. This is a good bit better than 1.2%, but I agree with you about the tax implications. It might be better to stick with the 1.2% if it means you don't have to pay tax on appreciation year to year. But if you can find room in a tax advantaged account to do all of this, the futures would be the way to go.
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Steve Reading
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Re: Lifecycle Investing - Leveraging when young

Post by Steve Reading »

EfficientInvestor wrote: Thu Jun 18, 2020 12:36 pm
Steve Reading wrote: Thu Jun 18, 2020 10:23 am Some interesting thoughts:
- Because there is a leverage cap in the A&N simulations, leveraging too much is counterproductive. Yes, you come closer to your Samuelson Share today but risk being much farther from it tomorrow after a drop. I think that's why they found leverage greater than 2:1 had more risk.

- Of course, they didn't address whether 2:1 was also too much. So I worked on their data for a bit and found that leverage actually closer to 1.5:1 had even less risk (less terminal wealth variance). So that seems to be the sweet spot. Much less leverage and you don't diversify temporally as much. Much more and you risk a strong market loss setting you back significantly away from your desired exposure and un-diversifying you temporally.

- The IB margin rate looks very attractive right now. I could get a blended rate of 1.2%. That's about as good as the implicit rates I've found on options and futures, but ETFs on margin are much more tax efficient. Not to mention I can get EM and Ex-US exposure, for slightly more diversification.

- I decided to bite the bullet. I moved my account to IB, closed the LEAPs and took out about $175k (1.5:1 leverage). That's enough to withstand about a 55% market decline. Unlike A&N, I am not planning on delevering on market declines. I think I can handle it with contributions. That does mean there's an inconsistency where sometimes I'm at 1.5:1 and some times more. The way I rationalize this is that the market isn't a perfect random walk. It's much less likely to drop 50% after dropping 50% (which Merton's formula assumes is the case). In other words, I think the ERP goes up when prices drop and vice-versa (while Merton assumes a constant ERP). Not develering is effectively a form of market-timing (but contrarian). I'm OK with that.
Here are a few thoughts on your thoughts:

- What if you maintain the 2:1 leverage but buy long term put options to protect against a worst case scenario? But the puts 2+ year out in order to get smaller theta decay and roll them once per year. Then, sell just enough covered calls to stay theta neutral.
- The 3-month libor is currently ~0.32%. My calculations that follow show that the implied financing on futures is somewhere around ~0.55% right now. I rolled my June /MES contract forward to September this morning and took in a 11.15 credit (let's just say from 3111.15 to 3100 for easy math). That's a 0.358% discount. If I compound that over 1 year, I get a 1.44% discount by rolling the futures every quarter. The current SEC yield on SPY is 1.99%. The difference between the expected dividend and the discount is the implied financing rate. Therefore, 1.99% - 1.44% = 0.55%. This is a good bit better than 1.2%, but I agree with you about the tax implications. It might be better to stick with the 1.2% if it means you don't have to pay tax on appreciation year to year. But if you can find room in a tax advantaged account to do all of this, the futures would be the way to go.
That's my bad, I definitely misspoke there. Around 1.4% is what I found a week ago when looking at some options. I didn't mean to say that was the case with futures. I just plugged some in my spreadsheet and I see a financing rate of 0.41% so pretty close to what you say.
The 60/40 unfortunately brutalizes me but great catch nonetheless. If I assume stocks go up 6% per year, a 60/40 takes a chunk of almost a third of that in my bracket. It's like paying 0.41% in financing, 1-2% in taxes. Meh.

As for the options strategy, you're talking about establishing a collar right? I gave it a bit of thought actually (it has been talked about before in this forum). I have to think it a little more.

Also, question for you. I do have a Roth. I'd be willing to leverage that using futures. With two E Micros, I could hit 2:1 (thank god for those tiny contracts). What place is good to trade futures in a Roth? Just tell me where, I know you're the guy who has given this a million hours of thought haha.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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