Leverage versus Asset Allocation: Which Gets Better Returns with Lower Volatility?

[haha]

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

 

[clifp]

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...

 

[Nords]

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.

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/forums/f47/should-i-pay-off-mortgage-invest-money-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.

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.

 

[gryffindor]

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.

 

[Patrick]

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.

 

[free4now]

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.

 

[Nords]

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.

 

[free4now]

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.

 

[clifp]

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.