Author Topic: Index funds: Too good to be true?  (Read 5823 times)

beekeeper

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Index funds: Too good to be true?
« on: February 16, 2014, 03:26:02 AM »
I have been very impressed by MMM's analysis of Index Funds in "Dude, where's my 7% investment return?" but I have a couple of questions before I take the step of buying my first shares.

First, I'm able to borrow money against my house for 2% interest fixed over 10 years. (I live outside the US and this is the standard interest rate deal in my local currency.) If Index Funds will almost certainly perform much better over this time frame, why would I not leverage my house to borrow money to buy them? (Or more alternatively, why is the bank willing to lend me money at 2%-over-10-years instead of investing their money in Index Funds?)

Second, the analysis looks at 1950-2011. Is this cherry-picking data to support the hypothesis? I think the analysis of "worst <n> year period" would look much worse if the dates had been (say) 1900-2011. Is it really safe to predict the next 60 years based on only the previous 60?
« Last Edit: February 17, 2014, 01:10:25 AM by beekeeper »

warfreak2

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Re: Index funds: Too good to be true?
« Reply #1 on: February 16, 2014, 04:52:55 AM »
If the stock market crashes then the bank could lose almost everything. If you default on your mortgage, the bank still has your house. A lower interest rate represents a lower rate of risk.

The bank almost certainly does invest in the stock market too, just not with all of their money.

medinaj2160

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Re: Index funds: Too good to be true?
« Reply #2 on: February 16, 2014, 07:47:43 AM »
Can you really borrow money at 2% fixed for 10 years? Through which entity?

My house is almost paid off.... I would consider borrowing to invest on other things if I could borrow money at such a low interest.

TreeTired

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Re: Index funds: Too good to be true?
« Reply #3 on: February 16, 2014, 08:14:36 AM »
With 10 yr US Treasuries yielding 2.75% it seems unlikely that a bank - even a stupid bank - would lend at 2% fixed for 10 yrs.   More likely a 2% variable rate, or a teaser rate of some kind.

huadpe

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Re: Index funds: Too good to be true?
« Reply #4 on: February 16, 2014, 10:21:33 AM »
I am seeing current 10 year fixed mortgages at 3.25%  But let's say you're still interested at that rate.

First, it is absolutely possible to lose money over a 10 year period in the stock market.  If, for example, you'd invested on Jan 1, 1929, you'd still be down about 50% before dividends over that period, and about 25% after dividends.

Second, you have to make mortgage payments.  Your leverage therefore is declining every year.  So you can't just take the amount of the mortgage*(expected return - rate)*number of years.  You'll likely be only getting about half your mortgage amount for 10 years.

Third, fixed rate mortgages are self-amortizing, which means you're paying a lot more interest than principal in the early years of the mortgage than in the later years.  So if you need to end the deal for any reason, say, moving, you can end up having paid a MUCH higher effective rate, quite possibly above 7-8%. 

Fourth, you are moving assets from a bankruptcy-protected status to an unprotected status.  While it's of course quite unlikely, if you get sued for many millions of dollars and lose (say a car accident or slip and fall), you get to keep your house and whatever equity is in it.  You don't get to keep your investment accounts.

I think that the structure of a self-amortizing mortgage makes this much less appealing than it looks at first blush, and I wouldn't do it.

Frankies Girl

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Re: Index funds: Too good to be true?
« Reply #5 on: February 16, 2014, 11:59:34 AM »
Sounds like you're proposing investing on margin, which is crazypants talk.
http://www.investopedia.com/terms/m/margin.asp

You don't invest money you don't actually have, and you certainly don't invest money borrowed from a needed source - like your house - unless you're prepared to lose it in the short term.

The stock market does trend upwards, but that doesn't mean that short term, it won't drop and lose money. That's why all of the basic investment advise says to invest money you don't have a short term need for - if you're saving for a house downpayment for instance as you're looking at buying a house in the next 3 years, it would NOT be smart to risk that money as the market could be down right when you need to pull it out.

medinaj2160

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Re: Index funds: Too good to be true?
« Reply #6 on: February 16, 2014, 05:20:01 PM »
Sounds like you're proposing investing on margin, which is crazypants talk.
http://www.investopedia.com/terms/m/margin.asp

You don't invest money you don't actually have, and you certainly don't invest money borrowed from a needed source - like your house - unless you're prepared to lose it in the short term.

The stock market does trend upwards, but that doesn't mean that short term, it won't drop and lose money. That's why all of the basic investment advise says to invest money you don't have a short term need for - if you're saving for a house downpayment for instance as you're looking at buying a house in the next 3 years, it would NOT be smart to risk that money as the market could be down right when you need to pull it out.

Are you serious? Corporations borrow money all time for investing. Also I imagine whatever interest he ends up paying will be tax deductible.

Just borrow an amount that doesn't put you in a really difficult situation. There is always stuff that you can sell or money you can use on emergencies.

Frankies Girl

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Re: Index funds: Too good to be true?
« Reply #7 on: February 16, 2014, 05:44:31 PM »
Sounds like you're proposing investing on margin, which is crazypants talk.
http://www.investopedia.com/terms/m/margin.asp

You don't invest money you don't actually have, and you certainly don't invest money borrowed from a needed source - like your house - unless you're prepared to lose it in the short term.

The stock market does trend upwards, but that doesn't mean that short term, it won't drop and lose money. That's why all of the basic investment advise says to invest money you don't have a short term need for - if you're saving for a house downpayment for instance as you're looking at buying a house in the next 3 years, it would NOT be smart to risk that money as the market could be down right when you need to pull it out.

Are you serious? Corporations borrow money all time for investing. Also I imagine whatever interest he ends up paying will be tax deductible.

Just borrow an amount that doesn't put you in a really difficult situation. There is always stuff that you can sell or money you can use on emergencies.

Why would I not be serious? Investing on a margin is VERY risky, and considering that we're talking a person essentially putting up their house that they could end up losing if they're not planning out very carefully the amounts they can afford to lose in the short term, I don't see why you'd think that was a joke.

Investing in 100% stocks is considered risky as well, so going hard into a total stock market fund and additionally putting up money you really can't afford to lose (or wait for years to recover) isn't going to be a fun situation.

Comparing a person putting up their house as collateral (which is basically what this would be) to a huge corporation that has sellable assets - not quite the same thing. Investing on a margin amplifies risk. A regular joe shouldn't take on that sort of risk without being VERY sure what they're getting into.


CanuckExpat

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Re: Index funds: Too good to be true?
« Reply #8 on: February 16, 2014, 09:47:21 PM »
Borrowing to invest in the stock market sounds like a good idea, but as a small investor with limited access to capital and credit, you have to be very careful about what might happen in a down market. There is a good example with a very honest poster here: http://www.bogleheads.org/forum/viewtopic.php?t=5934

Summary:
Quote
Econ grad student applies Mortgage Your Retirement theory at the top of the last bull market, starting around 2x leverage, loses $210K of borrowed money, and is forced is to sell what's left of his portfolio at S&P 821 in November 2008.

beltim

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Re: Index funds: Too good to be true?
« Reply #9 on: February 16, 2014, 11:53:56 PM »
Sounds like you're proposing investing on margin, which is crazypants talk.
http://www.investopedia.com/terms/m/margin.asp

You don't invest money you don't actually have, and you certainly don't invest money borrowed from a needed source - like your house - unless you're prepared to lose it in the short term.

The stock market does trend upwards, but that doesn't mean that short term, it won't drop and lose money. That's why all of the basic investment advise says to invest money you don't have a short term need for - if you're saving for a house downpayment for instance as you're looking at buying a house in the next 3 years, it would NOT be smart to risk that money as the market could be down right when you need to pull it out.

Are you serious? Corporations borrow money all time for investing. Also I imagine whatever interest he ends up paying will be tax deductible.

Just borrow an amount that doesn't put you in a really difficult situation. There is always stuff that you can sell or money you can use on emergencies.

Why would I not be serious? Investing on a margin is VERY risky, and considering that we're talking a person essentially putting up their house that they could end up losing if they're not planning out very carefully the amounts they can afford to lose in the short term, I don't see why you'd think that was a joke.

Investing in 100% stocks is considered risky as well, so going hard into a total stock market fund and additionally putting up money you really can't afford to lose (or wait for years to recover) isn't going to be a fun situation.

Comparing a person putting up their house as collateral (which is basically what this would be) to a huge corporation that has sellable assets - not quite the same thing. Investing on a margin amplifies risk. A regular joe shouldn't take on that sort of risk without being VERY sure what they're getting into.

This only makes sense if you wouldnt invest until you had completely paid off your mortgage. I don't think you'd recommend that (practically no one does) so what's different about this situation?

I agree that the comparison to a business isn't great, but I also wonder if you're serious.

beekeeper

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Re: Index funds: Too good to be true?
« Reply #10 on: February 17, 2014, 01:12:44 AM »
If the stock market crashes then the bank could lose almost everything. If you default on your mortgage, the bank still has your house. A lower interest rate represents a lower rate of risk.

This sounds exactly right to me. But I think the implication of the bank accepting a 2% return over 10 years, without inflation protection, suggests that the bank sees equities as much more risky than many bloggers do, including MMM. And that helps me see why people recommend only keeping (say) 1/3 of assets in equities.

Sacadoh

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Re: Index funds: Too good to be true?
« Reply #11 on: February 18, 2014, 05:24:52 AM »
I have no issues with borrowing for medium term stock purchases. I am UK based and have cú85k of borrowings at 1.5%. I get tax reliefs via my ISAs and SIPPs (the latter ranging between 40 & 62%). My ISAs have well over this amount. Performance in 2012 was TR of c11.5% and c20% in 2013 on my trackers.

When interest rates go up or tax reliefs are withdrawn I may change tactics but I am happy with the risks I am exposed to.

warfreak2

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Re: Index funds: Too good to be true?
« Reply #12 on: February 18, 2014, 08:59:04 AM »
I was replying to the abstract question of, "why would a bank lend to me at a significantly lower rate than they could make on the stock market?". A 2% mortgage does seem pretty low, though there are some 2.7-3.0% mortgages available around here (in the UK).

Heart of Tin

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Re: Index funds: Too good to be true?
« Reply #13 on: February 18, 2014, 12:51:58 PM »
Third, fixed rate mortgages are self-amortizing, which means you're paying a lot more interest than principal in the early years of the mortgage than in the later years.  So if you need to end the deal for any reason, say, moving, you can end up having paid a MUCH higher effective rate, quite possibly above 7-8%... I think that the structure of a self-amortizing mortgage makes this much less appealing than it looks at first blush, and I wouldn't do it.

This is a misunderstanding of loan amortization. With a fixed rate mortgage, you will always have an effective rate equivalent to the APR unless you make early payments that are not immediately applied to principle or you incur fees. With a 2% APR mortgage, your effective annual rate is (1+.02/12)^12 - 1 = 2.0184% regardless of the payment schedule. The interest portion of each payment is determined by the remaining balance on the loan. The interest payment is the fee that you pay to have borrowed the original loan amount lessened by the amount of principle that you have already repaid. You don't ever pay interest before it's accrued. It is, therefore, impossible to achieve any effective annual interest rate on the mortgage other than 2.0184% without specifically making early interest payments or incurring fees, both of which I think anyone on this board would have the good sense to avoid.

It is true, however, that a decreasing portion of each successive payment goes towards interest in all but interest-only or negative amortization schedules, but the interest portion of each payment is a function of earlier principle payments, the original loan balance, and the APR on the loan. It does not depend on the number of payments made. For example, if the original loan amount were $100,000, and $5,000 has been paid to principle, then the portion of the next payment that goes towards interest is always ($100,000-$5,000)*2%/12 = $157.36 regardless of whether this is the second payment or the sixtieth. That is the fee you pay for having an outstanding balance of $95,000, and it is equal to an effective annual interest rate of 2.0184%. That will be the effective annual interest rate whether the principle paid in the same payment is $763, as in the equal payment, 10-year schedule or $95,000, as in the situation where the house were sold.

A good metaphor would be to a savings account that is slowly being depleted. If you earn 2% APY on a $100,000 savings account, and withdraw an amount every month in excess of $167, then the proportion of each withdrawal that was earned as interest will decrease over time because of the declining account balance, but the interest rate that you are earning on the account is always the same. Even if you were to take out $100,166.67 after only one month, you would still have achieved an effective annual interest rate of 2.0184%. Now imagine that you are the bank instead of the depositor. The structure of the savings account from the perspective of the bank is exactly the structure of the mortgage from the perspective of the home owner.

Tl;dr The effective rate on the mortgage is not affected by paying off the mortgage early as in huadpe's example of selling the house before the end of the mortgage term. Interest payments are only related to the outstanding balance of the mortgage and the APR on the loan.