Author Topic: Time Magazine - Invest on margin to reduce risk?  (Read 8276 times)

Jack

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Time Magazine - Invest on margin to reduce risk?
« on: January 11, 2013, 11:20:19 AM »
Why Young People Should Buy Stocks on Margin

This article is 2.5 years old, but I just read it and I didn't see where it had previously been discussed here. The gist is that the Yale economists being interviewed argue that young people should buy stocks on margin in order to diversify their risk over time (i.e., so that they can have relatively more stock while they're young). They claim that their studies and models show that their strategy outperforms an un-leveraged portfolio (in the long run, of course) under all the different conditions they could think of, including recessions.

So, what do you guys think of the idea?

Richard3

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #1 on: January 11, 2013, 12:36:45 PM »
If buying stocks has a positive expected return that is greater than the margin interest rate, then sure.

Nords

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #2 on: January 11, 2013, 01:03:10 PM »
So, what do you guys think of the idea?
It's the same idea as taking out a mortgage and investing the proceeds in the stock market.

It all works great-- as long as you have a steady job with reliable income and can sleep at night.

The nightmare (= sleep at night-- get it?) scenario is the economic recession.  Your portfolio drops 20% or more, including the stocks that you own on  margin.  You get laid off from work (because of the economy) and you're trying to conserve cash for your job search.  The following week your brokerage delivers a margin call that will wipe out your cash stash.  They also inform you that they're raising their variable-rate interest on your margin account from 4% to 6.5%.

Let's take another look at the history of a rock-solid stock like Berkshire Hathaway.  In 2007 the "B" shares hit a staggering high of a split-adjusted $100/share and a famous analyst claimed that they were overvalued.  In early 2008 I started moving our daughter's college fund from the "B" shares to cash:  long-term CDs.  They were yielding a pitiful 3.5% alongside my other CDs (purchased in 2004-05) which were yielding over 6%. 

Over the years, a notable Berkshire author has advocated buying the shares on margin and holding them "forever".  The theory is that your shares would appreciate each year at more than the interest rate of the margin loan.  At the end of the year you'd sell shares (for long-term capital gains) to pay the margin interest.  If I'd followed that buy-on-margin advice in early 2008 then I would've paid ~$94/share.  I would have watched the share price drop to the low $70s, and in March 2009 it bottomed at $46 (well below book value).  It "recovered" a year later but still fluctuated between $70-$85/share.  This week-- nearly five years later-- the share price reached $94 again.  I would've been paying margin interest for five years.  If I'd sold shares to pay that margin interest then I would have racked up sizeable capital losses. 

Today those 3.5% CDs are lookin' pretty righteous, and our daughter's finishing her junior year of college.  I've slept comfortably these last five years.  More importantly, I haven't had to have any of those miserable "Let's stay the course, honey!" conversations with my spouse. 

In 2004 we took out a 30-year fixed-rate mortgage to invest the proceeds in the stock market.  I've been tracking that spreadsheet for over eight years.  It went gangbusters until late 2007, but then collapsed in 2008-09.  Only in the last six months has the eight-year APY beaten the fixed-rate mortgage.  I shudder to think of how it could have been if I'd backed that investment with a variable-rate margin loan.

Like all great investment ideas, that Time article proves that the back-tested math works just fine.  The future volatility is what kills your morale.

Tyler

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #3 on: January 11, 2013, 01:47:03 PM »
Awesome reply, Nords.

James

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #4 on: January 11, 2013, 02:27:56 PM »
Awesome reply, Nords.


Agreed!


I have a hard enough time knowing I'm underwater on my house, being underwater on stocks would really weigh on me.

projekt

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #5 on: January 11, 2013, 02:34:05 PM »
FYI: Original 2008 paper: http://www.nber.org/papers/w14094

If you bought in mid 2008 after reading the paper, the market would have lost about 25% and then crawled back up to an 11% gain. So, it would have been pretty cash flow negative during that exact time when you didn't have much money. If you had waited until 2009, you'd have done fine.

Looking over the chart of the S&P 500 from 1996 to now, the pattern makes me worry about stock market growth strategies in general.

http://www.google.com/finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=0&chfdeh=0&chdet=1357939908640&chddm=1676877&chls=IntervalBasedLine&q=INDEXSP:.INX&ntsp=0&ei=DoPwUNCFLaeYlwP-Fg



Jamesqf

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #6 on: January 11, 2013, 03:20:59 PM »
Only one thing to say on this: Wall Street, 1929.

marty998

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #7 on: January 11, 2013, 03:35:18 PM »
Only one thing to say on this: Wall Street, 1929.

Australia 2007-2009 works for that too. We didn't have a recession and our market still fell 55%.

A finance journo put a graph up on his TV news spot about lengths of recovery after crashes to previous peaks. This recovery after 07 is apparently the slowest and most sluggish in history.

Margin loans are personal WMD's. If you were 50% geared in 07 you would have pretty much lost the lot here as many people did.

Jack

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #8 on: January 11, 2013, 03:35:50 PM »
Only one thing to say on this: Wall Street, 1929.

Quote
Do people wind up with more money even for time periods like the Great Depression and our more recent financial turmoil?

Ayres: There is this beautiful chart that shows year by year how our strategy works against two traditional strategies — investing every year of your life in 75% stocks and 25% bonds, and a target-date fund that ramps you down from 90% stock when you're young to 50% stock when you're old. The cohort that retires just after each crash still winds up with more money than in either of the traditional strategies.

Nalebuff: The place where we do the worst most recently is people retiring in the early 2000s. We had them investing less in their final years, so they missed some of the run-up. If you invest more when you're young and less when you're old, and there's a great run at the end, you won't get the same benefit of that.

One interesting point -- which I thought I read in this article, but it must have been somewhere else -- is that in the '20s people were leveraging at ratios like 10-to-1, but the article only advocates leveraging to 2-to-1, so it's (allegedly) not comparable.

Khan

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #9 on: January 11, 2013, 04:18:41 PM »
Considering the long term finance charge for going on the margin at TD Ameritrade is ~9%, and the long term growth rate(not year to year) of the US stock market is between 7-9%.

No. I use my margin to do one thing: Buy what I want when I don't have the cash available(and then fund it ASAP). Yes, leverage is a powerful tool, but only if invested intelligently(which is even less likely for someone who's drunk on it). Warren Buffett has used leverage throughout his career. The difference? He's Warren ****ing Buffett, and he was using leverage from his insurance underwriting business to fund his dividend/value stock and business buying. So far the furthest I've leveraged is 1/2 of my stock portfolio, so in the event of a crash I wouldn't have to sell stocks to cover the margin, and at my current income I can fund that in a little over a year. As my stash increases that will fall because of that second rule, being able to fund it with my own income.

Long term gains from the stock market are most assuredly made from dividends. Dividends breaking above 9% are typically from companies that the market worries about, and for good reason. Margin is a WMD for personal wealth and financial suicide. As written in The Intelligent Investor, avoiding losses is one of the most important things to long term gains. Leverage can eat into those gains, and also makes losses more possible.

Warren Buffett quotes:
"Stay away from leverage," he said. "Nobody ever goes broke that doesn't owe money."
"A long, long time ago a friend said to me about leverage, 'If you're smart you don't need it, and if you're dumb, you got no business using it.'"

arebelspy

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #10 on: January 11, 2013, 04:47:31 PM »
Interesting article.

I prefer to take my risk in other ways.  And though I do leverage real estate, it's at rates of about 4%, not 9%.

Thanks for the insight as well Nords, very thought provoking. 

I have one question though.

It's the same idea as taking out a mortgage and investing the proceeds in the stock market.

It all works great-- as long as you have a steady job with reliable income and can sleep at night.

The nightmare (= sleep at night-- get it?) scenario is the economic recession.  Your portfolio drops 20% or more, including the stocks that you own on  margin.  You get laid off from work (because of the economy) and you're trying to conserve cash for your job search.  The following week your brokerage delivers a margin call that will wipe out your cash stash.  They also inform you that they're raising their variable-rate interest on your margin account from 4% to 6.5%.

Let's take another look at the history of a rock-solid stock like Berkshire Hathaway.  In 2007 the "B" shares hit a staggering high of a split-adjusted $100/share and a famous analyst claimed that they were overvalued.  In early 2008 I started moving our daughter's college fund from the "B" shares to cash:  long-term CDs.  They were yielding a pitiful 3.5% alongside my other CDs (purchased in 2004-05) which were yielding over 6%. 

Over the years, a notable Berkshire author has advocated buying the shares on margin and holding them "forever".  The theory is that your shares would appreciate each year at more than the interest rate of the margin loan.  At the end of the year you'd sell shares (for long-term capital gains) to pay the margin interest.  If I'd followed that buy-on-margin advice in early 2008 then I would've paid ~$94/share.  I would have watched the share price drop to the low $70s, and in March 2009 it bottomed at $46 (well below book value).  It "recovered" a year later but still fluctuated between $70-$85/share.  This week-- nearly five years later-- the share price reached $94 again.  I would've been paying margin interest for five years.  If I'd sold shares to pay that margin interest then I would have racked up sizeable capital losses. 

Today those 3.5% CDs are lookin' pretty righteous, and our daughter's finishing her junior year of college.  I've slept comfortably these last five years.  More importantly, I haven't had to have any of those miserable "Let's stay the course, honey!" conversations with my spouse. 

In 2004 we took out a 30-year fixed-rate mortgage to invest the proceeds in the stock market.  I've been tracking that spreadsheet for over eight years.  It went gangbusters until late 2007, but then collapsed in 2008-09.  Only in the last six months has the eight-year APY beaten the fixed-rate mortgage.  I shudder to think of how it could have been if I'd backed that investment with a variable-rate margin loan.

Like all great investment ideas, that Time article proves that the back-tested math works just fine.  The future volatility is what kills your morale.

How'd you know to listen to expert 1, and not expert 2?

(And, followup question: where can I sign up for your newsletter? ;)  )
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Paul der Krake

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #11 on: January 11, 2013, 05:36:40 PM »
Great analysis Nords. A fellow surfer who understands finance? You might just be my favorite person ever.

Jack

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #12 on: January 11, 2013, 05:43:51 PM »
How does this...

Considering the long term finance charge for going on the margin at TD Ameritrade is ~9%, and the long term growth rate(not year to year) of the US stock market is between 7-9%.

... jive with this?

Quote
How much does it cost?
Ayres: Over the past 138 years, the wholesale lending rate for margin loans was just 0.34 percentage points above the T-bill rate. Don't do it from Vanguard or Fidelity — they don't have competitive margin rates. But if you shop around places like Interactive Brokers, you can basically borrow very close to the T-bill rate, if you stay at a 2-to-1 basis.
Nalebuff: It's also possible to do this via long-term options. Ideally, this idea will catch on and there will be funds that do it for you. Today there are a few, like the Ultra Bull fund from ProFunds.

Is the latter a lie? Or is it true, but irrelevant in some way? Or are the folks here who claim the interest rate is too high wrong?

I'm not sure what good the "wholesale" lending rate does for any individual trying to implement their advice.

Nords

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #13 on: January 12, 2013, 01:13:47 PM »
How'd you know to listen to expert 1, and not expert 2?
Well, I didn't.  Expert #1 was right in the "short" term (five years) while expert #2 is right in the long term (40 years). 

We reframed the discussion.  A good friend delivered a clue-by-four upside my head, saying that he'd never heard of anyone putting half of their college fund (and a third of their ER portfolio) into a single stock, even if it was Berkshire Hathaway.  And then he asked how I could sleep at night?

By this point spouse and I had learned that if we were having a discussion over whether a stock was fully valued, then it was time to sell.  So we did.  We sold all the equities in the college fund and sold our ER portfolio portion of Berkshire Hathaway down to about 25%.

Since then we've learned to be a little more rigorous about rebalancing, and we also sell call options on the shares we'd have to sell to rebalance.

Three decades of investing experience, and I feel as if I'm just beginning to get a handle on it.

(And, followup question: where can I sign up for your newsletter? ;)  )
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sol

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #14 on: January 12, 2013, 02:16:22 PM »
The internet is full of horror stories from people who leveraged their market investments in the mid 2000s and then were wiped out by the recession.  Some of them were the very hedge fund managers who caused the market to tank by taking out so much leverage in the first place.  The whole episode clearly highlighted for me how illusory stock market wealth really is.

Why would anyone think it rational that a company's value would double or triple because it takes on a huge amount of debt?  Yet not only is this the way the stock market works, it's the way all of capitalism works.  Money IS debt, all profits are arbitrage, and actual economic productivity (food, shelter, machines, art) is merely a byproduct.

KingCoin

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #15 on: January 12, 2013, 06:52:52 PM »
Interactive Brokers is far cheaper than most retail brokers and can be used by retail investors. The one minor catch is that they automatically liquidate in order to meet margin calls (you can specify which securities are liquidated first).

http://www.interactivebrokers.com/en/index.php?f=1340

The margin rates at other brokers are borderline predatory as far as I'm concerned.

projekt

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #16 on: January 13, 2013, 11:44:33 AM »
The one minor catch is that they automatically liquidate in order to meet margin calls (you can specify which securities are liquidated first).

That is a little worrisome. If you are really buying into the strategy, you need to be able to supply funds from another source when you drop below your maintenance margin requirement (which can be as low as 25% but in the example on their website is 33%). This could get dicey. You will definitely not benefit from margin if you are forced to liquidate your portfolio during market crashes.

I wonder if they are using their company as a hedge, closing short positions with liquidated stocks as they hit margin calls.

bigchrisb

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Re: Time Magazine - Invest on margin to reduce risk?
« Reply #17 on: January 13, 2013, 04:33:14 PM »
Interesting article, and the theory seem sound.  However, my concerns in applying it are:
- The relative interest rate of margin debt
- The issue of portfolio wipe-out from margin calls in high volatility events
- The psychology of actually buying and holding on leverage through the full market cycle - its much harder to do this than people assume!

That said, its not far from the approach I've taken personally.  I've used margin debt extensively since I've been investing, with gearing ratios between 2:1 and 4:1 (currently sitting at a LVR of 70%, or 3.3:1), and my margin debt has typically been 2-3 years gross income.  I've been margin called twice (one I managed to re-buy all at lower prices (resulting in a paper profit of ~7k), the other I ended up re-buying at a loss of about $5k.  i.e. in practice, I've ended up about break-even on margin calls.  Neither was a pleasant experience at the time though.

I've also taken the approach that I'm only prepared to expose part of my portfolio to margin - I effectively invest through three vehicles, my super fund (retirement), which has no margin debt, an investment company, which has no debt, and my personal portfolio, which does have debt.  I've taken the view that I'm prepared to take this risk with a part of my portfolio, but that I'm not prepared to face a total wipe-out. In terms of equity,  I've got about 52% exposed to margin, 30% in retirement, and 18% in the investment company.  My intent is to keep reducing the quantity of leverage over time.