Can leverage/options give positive expected value for the long term investor?

[potatoducks]

I was reading WCI's article "In Defense of Bonds".

http://www.mdmag.com/physicians-money-digest/personal-finance/in-defense-of-bonds

 

There he states:

"Young investors are also short-sighted in choosing a 100% equity portfolio. If they are truly risk tolerant and want to maximize their investing returns, why stop at 100%? Because it is a nice round number? It is not difficult to design a portfolio with 110%, 150%, or even more exposure to equities using leverage and/or options."

 

I am truly risk tolerant and want to maximize my expected returns. Currently I invest in lieu of paying back student loans. Don't have a mortgage yet but I'll probably invest instead of paying that off quickly as well. If I lose it all who cares. Is it possible to get more expected value with margin/leverage? I always thought that the interest rates they charge more than outweighs the expected returns of an index fund in a taxable account.

 

Is this false? Or was that a bad argument in the article? I'm sure some consider this foolish but how does the math shake out?

[Complete_newbie]

Think WCI will come here and say his classic line: "You can leverage your whole life to a hilt" if you wanted to.

That being said,

($ you make with leverage)*(1 - tax rate you're at) > Financing cost.

You confident in your abilities? go for it.

Very few REALLY are ok with losing it all. I am max leveraged as a resident my expected returns without leverage are 15-18% (with leverage they are 30+% ) , that money is in RE not stocks.

Zaphod can probably tell you more about leveraged ETFs etc. I am not an expert there and outside my level of competence.

[potatoducks]

I am not at all confident in my abilities. I have no alpha and no desire to do the due diligence required for real estate. I'm only talking about equity (index funds). I probably should have mentioned that in my post. That's why I always thought that further leverage would not give me increased expected value but in the article, it seems that WCI feels differently.

I am very confident in my risk tolerance. Didn't have too much skin in the game in 2000. But I was 100% equity in 2007 and didn't really care much about it.

[WallStreetPhysician]

potatoducks wrote:

I was reading WCI’s article “In Defense of Bonds”.

http://www.mdmag.com/physicians-money-digest/personal-finance/in-defense-of-bonds

 

There he states:

“Young investors are also short-sighted in choosing a 100% equity portfolio. If they are truly risk tolerant and want to maximize their investing returns, why stop at 100%? Because it is a nice round number? It is not difficult to design a portfolio with 110%, 150%, or even more exposure to equities using leverage and/or options.”

 

I am truly risk tolerant and want to maximize my expected returns. Currently I invest in lieu of paying back student loans. Don’t have a mortgage yet but I’ll probably invest instead of paying that off quickly as well. If I lose it all who cares. Is it possible to get more expected value with margin/leverage? I always thought that the interest rates they charge more than outweighs the expected returns of an index fund in a taxable account.

 

Is this false? Or was that a bad argument in the article? I’m sure some consider this foolish but how does the math shake out?

Click to expand...

You can leverage by investing on margin. The interest rates are quite high, though (see https://www.scottrade.com/investment-products/interest-margin-rates.html for an example). Potentially, there would be positive expected value with investing on margin, but there would also be an incredible amount of risk.

Options would not work for what you are trying to do. Remember that options are derivative contracts, and don't have any intrinsic value. They are a zero-sum game.

-WSP

[Zaphod]

WallStreetPhysician wrote:

potatoducks wrote:

I was reading WCI’s article “In Defense of Bonds”.

http://www.mdmag.com/physicians-money-digest/personal-finance/in-defense-of-bonds

 

There he states:

“Young investors are also short-sighted in choosing a 100% equity portfolio. If they are truly risk tolerant and want to maximize their investing returns, why stop at 100%? Because it is a nice round number? It is not difficult to design a portfolio with 110%, 150%, or even more exposure to equities using leverage and/or options.”

 

I am truly risk tolerant and want to maximize my expected returns. Currently I invest in lieu of paying back student loans. Don’t have a mortgage yet but I’ll probably invest instead of paying that off quickly as well. If I lose it all who cares. Is it possible to get more expected value with margin/leverage? I always thought that the interest rates they charge more than outweighs the expected returns of an index fund in a taxable account.

 

Is this false? Or was that a bad argument in the article? I’m sure some consider this foolish but how does the math shake out?

Click to expand…

You can leverage by investing on margin. The interest rates are quite high, though (see https://www.scottrade.com/investment-products/interest-margin-rates.html for an example). Potentially, there would be positive expected value with investing on margin, but there would also be an incredible amount of risk.

Options would not work for what you are trying to do. Remember that options are derivative contracts, and don’t have any intrinsic value. They are a zero-sum game.

-WSP

Click to expand...

Leverage at interactive brokers is around 2% and thus very cheap. If you want to trade on margin, thats the place to do so. If that idea scares you for some reason, you can always trade leveraged index etfs which have ER around 1% which make them about the cheapest leverage you can get your hands on aside from options. These are daily tracked which will introduce some error and make the way it compounds a little bit counter intuitive, but overall tracking error is fairly small and they work well. I would advise highly against anything other than s/p, nasdaq or other such indices. They are just too small and unless you understand the underlyings and mechanics of them you'll probably get taken for a ride.

IMO it takes awhile to understand and utilize options correctly and given their complexity they will be a complete turn off for the majority of people out there, which also makes them a decent source of extra gains. This can be pretty profitable and give you extra income. Something very simple in practice would be like a covered call writing strategy on your index funds you hold. It wont make you rich overnight but could add some smaller % gain to whatever the market gives you. Learning to understand and implement options in general takes a while, so I'd do a lot of reading just to see if you'd be willing to even try that route.

What gives these methods some likely alpha is the intrinsic and often irrational aversion to their use, these and shorting are pretty much the only place left to get an "edge", but of course comes with risk, no free lunches. For example to irrational aversion, you can design two portfolios with equal risk adjusted returns, one with and one without leverage and people will opt for the non leveraged version due to 'fear of leverage". In that instance the portfolios are technically the same and it makes no sense.

If you really want I can point you in the direction of some further learning, basics. Its actually not foolish for young investors and I think the book lifecycle investing by Nalebuff goes over this. They (and others) suggest when young you start out leveraged due to an imbalance between human capital and actual capital to put to work, and you balance it out as time goes on by decreasing your leverage as you get older. The math works out just fine.

[Complete_newbie]

potatoducks wrote:

I am not at all confident in my abilities. I have no alpha and no desire to do the due diligence required for real estate. I’m only talking about equity (index funds). I probably should have mentioned that in my post. That’s why I always thought that further leverage would not give me increased expected value but in the article, it seems that WCI feels differently.

I am very confident in my risk tolerance. Didn’t have too much skin in the game in 2000. But I was 100% equity in 2007 and didn’t really care much about it.

Click to expand...

Expected return is average return. With leverage your returns can be high, but rate is like 8%. If you can beat that and after tax come out ahead you are good, if not then you are screwed. Also you'll lose more than your money since you borrowed it and have to pay that. Given what you are saying, don't think its for you.

[potatoducks]

Wow base rate of 7%. I don't think I can expect to beat that in a post-tax account. Guess 100% equity really is the limit for a lazy investor then.

Regarding options, that's what I also thought with my limited understanding but got a bit confused by the article.

Thanks for the responses.

[Complete_newbie]

Zaphod wrote:

WallStreetPhysician wrote:

potatoducks wrote:

I was reading WCI’s article “In Defense of Bonds”.

http://www.mdmag.com/physicians-money-digest/personal-finance/in-defense-of-bonds

 

There he states:

“Young investors are also short-sighted in choosing a 100% equity portfolio. If they are truly risk tolerant and want to maximize their investing returns, why stop at 100%? Because it is a nice round number? It is not difficult to design a portfolio with 110%, 150%, or even more exposure to equities using leverage and/or options.”

 

I am truly risk tolerant and want to maximize my expected returns. Currently I invest in lieu of paying back student loans. Don’t have a mortgage yet but I’ll probably invest instead of paying that off quickly as well. If I lose it all who cares. Is it possible to get more expected value with margin/leverage? I always thought that the interest rates they charge more than outweighs the expected returns of an index fund in a taxable account.

 

Is this false? Or was that a bad argument in the article? I’m sure some consider this foolish but how does the math shake out?

Click to expand…

You can leverage by investing on margin. The interest rates are quite high, though (see https://www.scottrade.com/investment-products/interest-margin-rates.html for an example). Potentially, there would be positive expected value with investing on margin, but there would also be an incredible amount of risk.

Options would not work for what you are trying to do. Remember that options are derivative contracts, and don’t have any intrinsic value. They are a zero-sum game.

-WSP

Click to expand…

Leverage at interactive brokers is around 2% and thus very cheap. If you want to trade on margin, thats the place to do so. If that idea scares you for some reason, you can always trade leveraged index etfs which have ER around 1% which make them about the cheapest leverage you can get your hands on aside from options. These are daily tracked which will introduce some error and make the way it compounds a little bit counter intuitive, but overall tracking error is fairly small and they work well. I would advise highly against anything other than s/p, nasdaq or other such indices. They are just too small and unless you understand the underlyings and mechanics of them you’ll probably get taken for a ride.

IMO it takes awhile to understand and utilize options correctly and given their complexity they will be a complete turn off for the majority of people out there, which also makes them a decent source of extra gains. This can be pretty profitable and give you extra income. Something very simple in practice would be like a covered call writing strategy on your index funds you hold. It wont make you rich overnight but could add some smaller % gain to whatever the market gives you. Learning to understand and implement options in general takes a while, so I’d do a lot of reading just to see if you’d be willing to even try that route.

What gives these methods some likely alpha is the intrinsic and often irrational aversion to their use, these and shorting are pretty much the only place left to get an “edge”, but of course comes with risk, no free lunches. For example to irrational aversion, you can design two portfolios with equal risk adjusted returns, one with and one without leverage and people will opt for the non leveraged version due to ‘fear of leverage”. In that instance the portfolios are technically the same and it makes no sense.

If you really want I can point you in the direction of some further learning, basics. Its actually not foolish for young investors and I think the book lifecycle investing by Nalebuff goes over this. They (and others) suggest when young you start out leveraged due to an imbalance between human capital and actual capital to put to work, and you balance it out as time goes on by decreasing your leverage as you get older. The math works out just fine.

Click to expand...

Zaphod, actually can you post some resources ? I'd be interested in learning. Thank you.

[Zaphod]

Here is an interesting paper that came out last week on leveraged etfs. I cant find the site with a very elegant description of how volatility drag works. Basically all etfs are leveraged but normal ones are set to 1 and you dont notice that aspect, but all volatility will impact your geometric or realized returns. You do not want leverage on a particularly volatile instrument for instance, and that idea is the whole premise behind risk parity.

Not endorsing any of these strategies but they give some idea of how things work and how to think about stuff. I'll look for that site later.

[Zaphod]

what I meant to attach

https://pensionpartners.com/leverage-for-the-long-run/

Now, dont read something and just start doing it. I'd look at things, think about it and watch it for a while, maybe a year or two. Try a tiny part of your play money if you think you're interested etc...see how you handle it.

[Zaphod]

Here is one on leveraged etfs and volatility drag in general. Its excellent. Once you understand how these things work they will make more sense and you wont be shocked or surprised and will know how to better position ones self to take advantage of the benefits and avoid the negatives.

http://ddnum.com/articles/leveragedETFs.php

This is really an excellent straightforward no nonsense article.

[WallStreetPhysician]

potatoducks wrote:

If you really want I can point you in the direction of some further learning, basics. Its actually not foolish for young investors and I think the book lifecycle investing by Nalebuff goes over this. They (and others) suggest when young you start out leveraged due to an imbalance between human capital and actual capital to put to work, and you balance it out as time goes on by decreasing your leverage as you get older. The math works out just fine.

Click to expand...

No problem, potatoducks, welcome to the forum.

Re: leveraged ETFs. They are designed for short-term traders. It sounded like you wanted to just buy something that will give you double the returns and double the risk, and leveraged ETFs do that for the short-run, but not the long-run.

WCI ran a guest post on leveraged ETFs about 6 months ago: https://www.whitecoatinvestor.com/exploiting-the-inefficiencies-of-leveraged-etfs/

I disagree with the guest poster's strategy, but it illustrates why you can't just get double returns with double the risk in the long-run using leveraged ETFs.

-WSP

[Zaphod]

WallStreetPhysician wrote:

potatoducks wrote:

If you really want I can point you in the direction of some further learning, basics. Its actually not foolish for young investors and I think the book lifecycle investing by Nalebuff goes over this. They (and others) suggest when young you start out leveraged due to an imbalance between human capital and actual capital to put to work, and you balance it out as time goes on by decreasing your leverage as you get older. The math works out just fine. 

Click to expand…

No problem, potatoducks, welcome to the forum.

Re: leveraged ETFs. They are designed for short-term traders. It sounded like you wanted to just buy something that will give you double the returns and double the risk, and leveraged ETFs do that for the short-run, but not the long-run.

WCI ran a guest post on leveraged ETFs about 6 months ago: https://www.whitecoatinvestor.com/exploiting-the-inefficiencies-of-leveraged-etfs/

I disagree with the guest poster’s strategy, but it illustrates why you can’t just get double returns with double the risk in the long-run using leveraged ETFs.

-WSP

Click to expand...

That wasnt a very good article for leveraged etf basics, it was more a beta slippage harvesting strategy which is way too much for everyday folks. As long as you understand whats going on with how these funds work, and their underlyings (super important) they are fine, and I'll say it, even for buy and hold. You do however have to pay attention and I wouldnt recommend that to people as the volatility is too much for most.

Volatility will decrease your actual return compared to whatever stated return you hear, so things like realized volatility of the underlying and path dependency are very important. There are many leveraged funds on underlying assets that dont even trend, and are very volatile normally, which are disaster scenarios for this type of instrument. Oftentimes they even have worse characteristics like the commodities which in addition to the above trade on futures markets and have more built in frictions given the futures term structure which extracts value, holding costs etc....which crushes these instruments. These are nice targets for shorting and harvesting the inefficiencies in leveraged etfs.

The main indices like SP 500 and Nasdaq trend up over time and are relatively non volatile most of the time. These are perfectly fine for 2x/3x funds most of the time. Yes they will be volatile, but they will track very nicely and do a great job even at longer terms. The underlyings are a calculation and have no term structure to overcome, generally trend over time and are relatively non volatile all things considered. Short these at your own risk. There are some aspects to daily releveraging that is beneficial.

For example 2/9/10 (inception date tqqq)

Nasdaq, QQQ=84.56%

3x QQQ, TQQQ=385.5%

1/1/2009-today

SPY=152.3%

3x SPY=836.7%

These dont seem to be trending toward zero due to any kind of bogus simplified math, and in fact seem to be outperforming their stated leverage levels. This is expected given the path dependency and volatility levels over this time. These are the important points when dealing with these issues. I still wouldnt say and buy and hold makes sense as if things take a turn for the worst, you will feel the full brunt of the 3x down initially (and not all markets reward a 3x amount of leverage anyway, 2x has been rewarded over 137 yrs).

These are best used for beta harvesting/mean reversion, as a juicer to overall returns with some small allocation and in bull markets above safe levels. Not particularly hard to implement but more work than most want to do.

[Kamban]

I don't buy bonds or bond funds. Never have.

Just because I take 100 % risk with stocks does not mean that I want to go up further, leverage and borrow money to go 150 or 200% in stocks. I can afford to lose it all in stocks as long as I do not have to borrow additional money.

I use leverage in commercial real estate. But this is done as a group, in multiple properties after studying the market and making sure we have enough cash flow from other properties. The maximum I can expect to lose is 750K on a 250K investment, but more likely it is 250K. So far it has never happened.

What might happen in slower times is that the returns are just enough to pay mortgage, taxes and other expenses and there is not a whole lot to distribute to the investors. But that lasts a year or two before things turn around.

[jfoxcpacfp]

I think there is a different way of looking at risk in the market. The risk of investing without knowing when you will need your money back out of the market. Doing so allows your behavior to sit in the driver's seat instead of the rational plan. If you know you don't need the money you have invested for the next 5 years, pray tell, then what is the risk of a bear market? What will you lose in a correction and why do you need bonds?

Permanent loss in a diversified equity portfolio is always a human achievement of which the market is incapable. It's not what the market is doing that's going to kill you, it's how you react to the market.

Bonds: What are they good for? Part 1

Bonds: What are they good for? Part 2