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Old 04-01-2008, 11:55 AM   #21
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Not that I recommend it, but it is possible to have leverage AND asset allocation. One can control 150% of their portfolio value in ETFs that are allocated by asset class.

In such a situation, you'd basically be allocating -50% or more in cash.
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Old 04-01-2008, 05:39 PM   #22
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Originally Posted by ziggy29 View Post
Not that I recommend it, but it is possible to have leverage AND asset allocation. One can control 150% of their portfolio value in ETFs that are allocated by asset class.

In such a situation, you'd basically be allocating -50% or more in cash.
This puts your balls out in the wind. I did this when I was young, when I took allocations from bounds of maybe 80% cash to -20% cash.

It's fine when the market goes up- you stepwise retire your margin debt. As you pay it down, the interest rate goes up but you are decreasing equity exposure as the market goes up. At some point margin will be retired, and you start building cash reserves. A very nice process.

However, coming down the other side is really different. With a cash account where you gradually switch bonds and cash to equities as the target class falls in value, the worst that can happen is that you run out of cash and the market continues down.

But using margin in the process, at some point you will be increasing margin. If the market continues falling, you get very uncomfortable as your -20% cash becomes -25%, - 30%, etc. In the past this often coincided with high and increasing interest rates so just the monthly charges agaisnt your equity start to look scary.

If you are generating a lot of excess cash income from your job or business, no real problem as long as you have the nerves. But if not, you have exposed yourself to a wipeout.

As to your "leverage" a US fixed rate mortgage is taken for granted. I would never leave home without one. Best loan in the world, save perhaps student loans.

Ha
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Old 04-01-2008, 06:20 PM   #23
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I don't think anyone should have 100% equity portfolio, regardless of age.

There is no material difference between a 90/10 vs. 100% equity portfolio over longer timeframes as measured by returns. One does enjoy reduced volatility by doing so however.

Why not? It depends on a lot of things depending on current status.

Accumulation phase.
If your time frame is long enough, equities will (probably) beat FI. If not, you won't accumulate much unless we have severe deflation (and that's another ballgame).

Spending phase.
This depends on your WR. I have an AA that no-one on this board would approve of (50% of NW in former mega-corp ESOP). The difference is when I RE'd a year ago my WR was ~3%. As mega-corp climbed I kept the exposure at ~50% of NW, meaning I sold some and put it in FI. WR has dropped to <2% since mega-corp is on a roll. If my WR was 5% this might be a problem but FireCalc says I should be ok if mega-corp drops to 0 overnight.

If I was to borrow to invest, I'd only put that money where it could do the most good and probably the most harm. I'd never put it where it guarantees a small bit of harm but only a small bit.
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Old 04-01-2008, 06:34 PM   #24
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To answer Nords and Patrick's questions:

My table was the net result of both the cost of capital and the return of investment. The assumptions of the return of 10% was for the efficient portfolio and the cost of capital was 5.5%.

So to use Nord's example of borrowing 50% on 100k (way too much leverage by the way). The return of 150k would be 15k. The cost of 5.5% interest on 50k would be 2.75k. So the total return would be 12.25k or 12.25% (what the table says).

Many people have commented in the thread that additional leverage is risky. I agree. I think only a modest amount (max 30%) is acceptable.

However, I think 100% equity portfolio is risky too. The key question is to ask is moving from a diversified portfolio to a higher percent of equities in order to get higher return more risk or less risky than leverage.

The way I use leverage is through a mortgage -- so no margin calls ever.

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Ok help me understand how this works in a real world scenario

Let say I have $1 million $200K in VEU (total international) $500K VTI, 300K Vanguard Total Bond. So my AA is 70/30 fairly close to the efficient frontier

I take out a $100K Home Equity loan. (I actually did this via Penfed @ 4.99%)

What do I do with the additional $100K?

In my case I did this to try and take advantage of low interest rates and high yields for financial stocks. Sadly I found out financial stocks can continue to drop... (Only 1 dividend though). I knew I was taking more risk, so I am confused how I could do this and decrease risk??
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Old 04-01-2008, 08:54 PM   #25
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This whole thread has got me thinking that at current rates, someone that has a mortgage should never own any long-term government bonds. Given that 10-year treasuries are paying about 3.5%, and most mortgages are around 5-6% (mine is 5.5), I shouldn't own any treasuries.

Instead of buying treasuries, I should be paying down my mortgage. If I owned any treasuries, I should sell them and pay down my mortgage (assuming no extreme tax situation).

Note-- I've never owned any bonds. This just makes me feel a little better about paying ahead on my mortgage instead of adding that to my 100% equities portfolio. It's kinda like buying treasuries that yield 2% more than the real ones.
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Old 04-01-2008, 09:00 PM   #26
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Note-- I've never owned any bonds. This just makes me feel a little better about paying ahead on my mortgage instead of adding that to my 100% equities portfolio. It's kinda like buying treasuries that yield 2% more than the real ones.
True, you gain cash flow. But you lose liquidity. For the past few months I have funded equity and equity-like investments by liquidating TIPS and treasuries.

To me, it is worth it to give up a few hundred bp short term to be better positioned for an investing campaign.

Ha
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Old 04-01-2008, 09:47 PM   #27
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True, you gain cash flow. But you lose liquidity. For the past few months I have funded equity and equity-like investments by liquidating TIPS and treasuries.

To me, it is worth it to give up a few hundred bp short term to be better positioned for an investing campaign.

Ha

There is something to be said for liquidity. I did the same thing HaHa did sold TIPs boughts equities and took out a HEL.

On the other hand, I also agree with Hamlet. I don't see much of a point in having a non-emergency fund money locked up in a bond paying less interest than your loan.

Vanguard GNMA up until this month was yielding between 5-5.5% it is now 4.85% Not worth worrying about paying extra on 4.99% HEL but if it drops below 4%.. I'll considering paying the mortgage.

Similarly I have a Penfed CD @6% which is great but if after it matured in a couple of years it I can't get more than 4.5% no reason to have a multi-year CD instead of a lower mortgage balance.

Now if you are willing to accept more risk you can get 8.8% from Vanguard High Yield of course the NAV of the fund has been dropping steadily...
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Old 04-03-2008, 07:13 PM   #28
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Originally Posted by gryffindor View Post
To answer Nords and Patrick's questions:
My table was the net result of both the cost of capital and the return of investment. The assumptions of the return of 10% was for the efficient portfolio and the cost of capital was 5.5%.
So to use Nord's example of borrowing 50% on 100k (way too much leverage by the way). The return of 150k would be 15k. The cost of 5.5% interest on 50k would be 2.75k. So the total return would be 12.25k or 12.25% (what the table says).
Thanks for clarifying that. Way too much data around here is tortured to produce the desired results.

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Many people have commented in the thread that additional leverage is risky. I agree. I think only a modest amount (max 30%) is acceptable.
However, I think 100% equity portfolio is risky too. The key question is to ask is moving from a diversified portfolio to a higher percent of equities in order to get higher return more risk or less risky than leverage.
The way I use leverage is through a mortgage -- so no margin calls ever.
Ah, sheesh, why didn't you say so in the first place-- still yet another "Should I pay off the mortgage?" thread.

http://www.early-retirement.org/foru...ney-30644.html

Well, a 30-year fixed-interest loan sure beats margin. It also puts both stock-return history and inflation on the investor's side.

The only issue is where to get those righteous interest rates, hopefully without origination fees or points.

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This whole thread has got me thinking that at current rates, someone that has a mortgage should never own any long-term government bonds.
Concur. And something would have to be seriously disrupted in the markets for mortgage interest rates to remain below bond rates.
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Old 04-04-2008, 07:22 PM   #29
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I fear I've done a poor job of communicating some of my concepts -- but since I'm new to the boards I'll work on it.

I think there are a couple of key concepts I was trying to highlight:

1. Asset allocation is # 1 -- if you figure out the best return / volatility portfolio, that by far is your most important decision. I won't talk about that on this post but maybe on a future post (debating whether to since some of it involves hedge funds).

2. Its the portfolio that matters when looking at volatility. Not the individual decisions. So when people start to break apart the decision of what to invest the incremental money and worry about the risk / return of leverage, they're breaking away from the concept of the portfolio reducing volatility. So to answer clifp's question, what you did with the extra 100k -- you invest it equally in the same 70/30 portfolio. Anything else you do (e.g., put the incremental money all in equities) -- moves you to a inferior return / volatility equation. I am all about minimizing volatility.


3. Going towards too much equity creates too much volatility. And for me as an individual investor who knows that he is influenced negatively by quarterly drawdowns, that's a bad thing. I've set a goal not to have more than a negative 10% drawdown within a quarter through these 2 techniques.

4. The mortgage is just one way of getting leverage (probably the best and easiest). But margin would work fine just as long as you keep your leverage ratio low (e.g., 10%- 30%). More than that creates too much risk.
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Old 04-04-2008, 08:03 PM   #30
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So to answer clifp's question, what you did with the extra 100k -- you invest it equally in the same 70/30 portfolio.
OK, so you are saying that you would borrow $30K (for the fixed income portion) @ 8% = $2,400/year and invest it @ say 4% = $1,200/year interest for a net 2,400 - 1200 = $1,200 loss. And this is supposed to improve your overall return. I've got a better idea, just mail me the $1,200 loss (to reduce volatility) and skip the $30K portion of the investment.

Or, alternatively, please explain to me what I'm missing here.
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Old 04-04-2008, 09:46 PM   #31
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The maximum volatility that I can tolerate as a retired person is the amount that would put me on the brink of disaster in the worst forseeable market (whatever that is). Adding any leverage to that point on the efficient frontier will push me over the brink.

I suppose that mortgages are somewhat of a special case in that there are some situations in which you can walk away from them if things go bad. E.g. in California if you are underwater on your property you are not personally for the deficit when the property is foreclosed. But those kinds of "outs" are so rare and morally odious that I would rather not take them.
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Old 04-04-2008, 10:33 PM   #32
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The maximum volatility that I can tolerate as a retired person is the amount that would put me on the brink of disaster in the worst forseeable market (whatever that is).
I think there's two aspects to downward volatility (which is what Griff appears to be loosely defining by the word "risk").

The emotional aspect keeps investors from sleeping at night and inspires them to sell out at the market bottoms. No one is able to exceed their emotional volatility tolerance... but although they might be able to toughen their resistance through education & experience, it can still cause the emotional reaction.

The financial aspect of volatility is only an issue if one has to sell the assets. Another way to deal with that is to avoid selling the assets by keeping enough cash on hand to last through the worst downward volatility that your emotions can tolerate. For us it's two years' expenses in cash that we replenish during up years.

BTW no one has ever complained about upward volatility.
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Old 04-04-2008, 11:56 PM   #33
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The financial aspect of volatility is only an issue if one has to sell the assets. Another way to deal with that is to avoid selling the assets by keeping enough cash on hand to last through the worst downward volatility that your emotions can tolerate. For us it's two years' expenses in cash that we replenish during up years.
I dunno... for me two years of downward volatility is far from the worst that my emotions can tolerate. I envision somewhere around 7-12 years of slow declines or more years of stagflation as the straw that would break me. Two years of cash would do absolutely nothing for me in those scenarios. Making interest payments on leverage drag during a decade of declines would push me over the edge that much quicker. But I've never been much of a risk taker with my finances... I see lots of people who got into more secure positions than myself by taking huge risks and I respect those choices, for the people who are responsible enough to accept the downsides.
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Old 04-05-2008, 06:46 AM   #34
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OK, so you are saying that you would borrow $30K (for the fixed income portion) @ 8% = $2,400/year and invest it @ say 4% = $1,200/year interest for a net 2,400 - 1200 = $1,200 loss. And this is supposed to improve your overall return. I've got a better idea, just mail me the $1,200 loss (to reduce volatility) and skip the $30K portion of the investment.

Or, alternatively, please explain to me what I'm missing here.
I got to say I am with Patrick here. I don't understand how you come out ahead with borrowing $100K investing 70K in equities and 30K in fixed income.

I guess one way to look at the problem is as follows. With relatively low rates I can borrow $100K at 5.5%. I'm comfortable with my current AA of 60/40 to 80/20 (I think it make no sense to do this for less than 50/50 AA). Lets stick with 70/30 for the example. I invest 70K in additional equity. I have had 30K for fixed income.

My choices for fixed income right now are
CDs or treasuries at between 3.5-4% for 1-5 year up to 5% for 10 year. Zero default risk moderate interest rate risk.
TIPs at 1% real no default risk and low interest rate risk.
Mortgage backed security funds @4.75% almost zero default risk moderate interest rate risk.
Junk bond fund at 8% higher principal risk, and higher correlations with equities.
Individual CPI bonds like ISM/OSM at 10% high default risk, lower interest rates.

I can also purchase an different type of bond called paying down my mortgage, with a rate of 5.5% no default risk, and some neat refi options.
I contend that this is almost alway more attractive than any other fixed income option, if the goal is to reduce the volitality of the portfolio.

Now I can be convinced I am wrong, but I think it would require show some simulation of taking mortgage out at the prevailing interest, which result in higher portfolio survivability.
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