Author Topic: Reducing sequence of returns risk with margin  (Read 4301 times)

MustacheAndaHalf

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Re: Reducing sequence of returns risk with margin
« Reply #50 on: November 30, 2021, 07:07:55 AM »
During a crisis, margin requirements can change at moment's notice.  The interest rate can also change significantly.  Brokerages will secure their assets and can raise margin requirements significantly and call your loans.  Everybody just wants to survive at that point.  During the internet bubble burst and the mortgage crisis, there was no liquidity.  Heck, during the mortgage crisis, even the money market almost collapsed. Ask people who tried to borrow money then.  There was no money to be borrowed.  There is also psychology at play - you don't really know how long the bear market will last or how bad it'll get.  If you haven't been through the internet bubble and the mortgage crisis, don't let the last 12 years of bull market fool you.  You think 2020 March was bad? It was nothing.
Where is the data that margin loans get very expensive?  We had a crash last year ("nothing"), where IBKR kept margin loans under 2%.

If someone owns a total market ETF like ITOT or VTI, do you think margin requirements are going sky high on those index ETFs?  That's what I'm proposing - someone with passive index investing, delaying when they pay for living expenses.

If you want to discuss my personal situation, I've created a thread for that, so that discussing what I did or have experienced isn't the topic here.
https://forum.mrmoneymustache.com/case-studies/passive-investor-20-years-turned-partially-active-in-2019/



MustacheAndaHalf

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Re: Reducing sequence of returns risk with margin
« Reply #51 on: November 30, 2021, 07:21:06 AM »
It would be really awesome if someone could actually run the historical test of this strategy, I'm interested to know whether it would help and by how much.

But one thing that I haven't seen considered: I read the Fidelity terms for margin loans and it clearly states that not only can the interest change by whatever Fidelity feels like at any time, but the margin requirements may as well. So it seems entirely plausible that when the market drops and stuff starts looking sketchy, the brokerage gets cold feet and suddenly increases the margin requirements.

Fundamentally, you're putting your financial fate in the hands of a single other entity (or maybe two or three, if you diversify your loans.) That fact alone is enough for me to not want to touch it with a ten foot pole.
I'm not following why you think "the brokerage gets cold feet".  Part of their business is making margin loans - they're going to get cold feet about their business?  If they're worried they can sell your assets to pay down the loan - that's also in the margin agreement.  If they suddenly get irrational, they have competitors to take their customers from them.

If Fidelity suddenly began charging 12%, someone with $50k left and $8k of loans could move 1/2 their assets to IBKR, take an $8k loan there, and pay off Fidelity's loan.  Then move the rest.  No assets sold - just one margin loan paying off the other.  And that 12% is charged daily, so if it takes a month to change brokers, they only charged 1% of the loan value ($80 in this example) before you left.

I would also like to see a simulation.  Someone could create a spreadsheet, with years 0 to N, and stock market performance each year.  But the margin loan would not happen at the start of the crash - only after markets are 20% down.  When markets return to that point, the margin loan is paid off with interest.  Then compare that to selling assets for living expenses every year.

MustacheAndaHalf

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Re: Reducing sequence of returns risk with margin
« Reply #52 on: November 30, 2021, 07:47:20 AM »
ERN was writing about carrying a margin loan from the start of one's retirement. However, the OP by @MustacheAndaHalf proposed a conditional or algorithmic approach - only going into margin AFTER a huge correction or bear market.

I wrote ERN asking if he could retool his spreadsheet to allow for algorithmic approaches. My question was about retiring on a conservative AA and then switching to an aggressive AA when a certain trigger point was reached, such as a xx% drop from the top.
Reading further, I see what you mean.  The article starts out stating something similar to what I mentioned here, but then goes off into borrowing multiples of the portfolio for decades.  Millions are borrowed off a $1 million portfolio, which is unlike my suggestion here.  They did mention the following crash:

From Jan 1973 - Sep 1974 was a -46% correction, with a recovery by Dec 1976.

With current margin rates, margin turns out better in this scenario.  But with 7% treasuries (10 yr) + 6% brokers like to add, 13% margin loan rates would have fared worse than selling assets.

That brings up another point: what is a crash?  I view it as the total percentage loss, and not 10% even if it happens in a few days.  I was thinking somewhere in the 20-25% range, which means I don't consider 1973 to be a crash.  Wikipedia's view:

"There is no numerically specific definition of a stock market crash but the term commonly applies to declines of over 10% in a stock market index over a period of several days."
https://en.wikipedia.org/wiki/Stock_market_crash

Lacking 1973 data, I don't see any mention of sudden percentage drops.  So the 18.2% loss in 1973 was probably not 10% over several days.  If you only go on margin after a 20-25% drop, that starts in 1974 and is 99% recovered in 1975.  So it's more like 2 years on margin, with far lower interest costs.

That's perhaps something I could explore more: what percentage loss is a crash, and so would trigger margin loans (only to pay for expenses).  And what is the breakeven rate on margin loans, where selling assets and the margin loan approach have the same outcome?

Intra-year declines of >20% have occurred every few years for the past couple of decades.
https://intelligent.schwab.com/article/stock-market-corrections-not-uncommon

According to the chart below, a correction >30% can be expected to occur at an average frequency of every 9 years. Of course, we cannot time or predict those dips, and I'm not saying you are trying to. In fact, you are talking about waiting until after the dip has already occurred to make a decision to borrow living expenses rather than sell assets. What we do know is:

1) The stock market will recover some day. It always has in 100% of historical scenarios.
2) The market is safer AFTER a 25% drop than it was BEFORE the 25% drop. Given #1, the bigger the drop, the higher the safety of a decision to buy or hold - even if further losses are ahead. There is simply less room to fall.
3) Bigger drawdowns are rarer than smaller drawdowns.  Across historical scenarios, when the market is down 25%, the odds of it dropping at least another 1% was "X". When it was down 30%, the odds of it dropping at least another 1% was "something less than X", because drawdowns >30% are rarer than drawdowns >25%. So as a drawdown occurs, the likelihood of the market continuing to go down decreases toward zero percent - though we can't see the odds - and then the market must recover.

Thus, by setting an IPS that says borrow living expenses if assets drop XX% in value, you're not market timing or prognosticating, you are bargain shopping for risk using only information available in real time. As prices fall, risk is falling too. When the risk to your remaining assets is low enough, you'd rather borrow living expenses because by holding your remaining assets you are taking a very tiny risk for a very high potential eventual return. I.e. risk assets went on a fire sale that is temporary from the perspective of decades.

I'd suggest setting the "crash" definition a good way down. If you set it too low, such as -15%, you'll be triggered almost immediately into borrowing living expenses. Plus, you will not have dodged much SORR in doing so, because the market could easily fall another 30% from there. Online tools or ERN's spreadsheet can help you identify specific timeframes when your WR would have failed, and you can then make a list of the drawdowns from the previous peak that caused those failures. For example, if the fatal stock drawdowns for your AA were -47%, -35%, and -40% (not actual numbers, haven't looked), you might be inclined to set your trigger at -30% because that's a potentially retirement-killing SORR event and your AA has survived all smaller drawdowns throughout history. Just a suggestion for how to set your crash definition. I know you're meticulous @MustacheAndaHalf , so I fully expect you to look up these numbers and report them here. :)

Looks like no takers on the invitation to rebuild ERNs spreadsheet so we could backtest algorithmic scenarios all day. :(
Wow - that chart was built from over 90 years of data! ("going back to 1928").  All of the 30% drops include a 20% drop, so less than half the time, a 20% drop falls to 30%.  The most common event for this approach is to go on margin for 0-9% loss, then recover and the loan gets paid off.
https://wacotrib.com/business/investment/personal-finance/this-simple-chart-shows-when-to-expect-the-next-stock-market-correction/article_39689cfa-b232-5cc9-a038-1868fb5e74b8.html

I was too busy replying to people who didn't understand this idea to search for data on it, so you beat me to it.  I lack data for -20%, and you've done your research: I would advise others to use ChpBstrd's -25% definition for a crash.

Just to provide context, selling at the bottom is what does the damage.  If stocks fall 1% and recover 1.01%, there isn't much of a difference, and living on margin (!) isn't valuable.  I initially simulated with any crash triggering margin loans, and that approach survived and beat selling assets in 2007-2009.  So it works when done too early, making me suspect defining a crash as -15% could also work.

DaTrill

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Re: Reducing sequence of returns risk with margin
« Reply #53 on: November 30, 2021, 01:38:20 PM »
This thread should be renamed "How to go bust in retirement".  Using margin because billionaires do it will not work for normal people.  Margin requirements can change to 0% at any time meaning that an individual will need to produce 100% equity to hold any position and be instantly liquidated (I was a margin clerk at several times of margin loan emergencies and cleared thousands of accounts).  This strategy is a total disaster on all fronts and will result in a 100% probability of busting.  Read your margin agreement before thinking this won't happen as it does all the time.     

secondcor521

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Re: Reducing sequence of returns risk with margin
« Reply #54 on: November 30, 2021, 02:11:32 PM »
Vand - you have been wrong repeatedly in this thread, and aren't willing to admit it?  You lack evidence for each of your statements, so why continue posting them?  Here's a sampler of your wrong statements in just this thread:


Do you think that in the teeth of the next panic when it seems our way of life is about to change, that someone is going to lend you money at the 1% or 2% rates that are available today? Hell no, borrowing costs go up, up up. If you go broke, they lose their money. So people will want 10% or 15%, or more to risk their capital.
Your claims are false.  In March 2020 the stock market crashed -35%, and after that crash IBKR did not raise margin rates above 2%.  The facts directly contradict your baseless statements.

Isn't there an infamous thread somewhere on Bogleheads that we sometimes link to, which chronicles the ups and downs of someone who tried to invest with leverage throughout the GFC and eventually ended up going bust?
I did not propose "invest with leverage", so you don't understand what I said.  Further, I showed this approach survived the Great Financial Crisis - using evidence, instead of baseless claims.

I know that OP is going to say "yeah, but I'm borrowing a tiny amount against the portfolio value." which may be true, but following the strategy doesn't have a circuit breaker other than "hang on until things recover", so borrowing amounts will stack up and compound if we have a sequence of poor years, and before too many years you are suddenly borrowing 20 or 30% of the original portfolio, only the portfolio has now halved or worse so it's more like 40 to 70%
You got the math wrong here (2 x 30 = 60%, not 70%).  You don't provide any examples or historical data.  "Poor years" usually means substandard returns, not losses.  Significant losses are called a crash, not just poor years.  Years of lower positive returns cause nothing to happen with the approach I suggest.

"If you can't take a small loss, sooner or later you will take the mother of all losses." -- Ed Seykota, trader.

A literal translation in this context - if you cannot bring yourself to voluntarily sell when the market is down, sooner or later you will be forced to sell when the market is much further down.
That is false.  The market was down in 2008, and the approach worked without being "forced to sell", as you claim.

It seems like you don't care if you're wrong over and over.  You don't admit it, you don't correct your mistakes, and you don't have any data to prove your points.

What happened to attack the idea, not the person?  Yes, you're being factual, but you also seem to be picking on an individual.

Many of your posts seem to have the theme of finding a shortcut to raise investment returns - Crypto, 90% passive 10% active,  factor investing. There is not such thing as a free lunch. Risk can be diversified and you can get lucky by picking the next best sector, factor, or vehicle (crypto), but you equally run the chance of pegging that tilt at its high and underperforming.
The forum rules say to attack an idea, not the person.  This has nothing to do with the current thread - you're simply attacking me.  I've reported you for doing so - please re-read the forum rules.
« Last Edit: November 30, 2021, 02:14:29 PM by secondcor521 »

ChpBstrd

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Re: Reducing sequence of returns risk with margin
« Reply #55 on: November 30, 2021, 02:27:16 PM »
It would be really awesome if someone could actually run the historical test of this strategy, I'm interested to know whether it would help and by how much.

But one thing that I haven't seen considered: I read the Fidelity terms for margin loans and it clearly states that not only can the interest change by whatever Fidelity feels like at any time, but the margin requirements may as well. So it seems entirely plausible that when the market drops and stuff starts looking sketchy, the brokerage gets cold feet and suddenly increases the margin requirements.

Fundamentally, you're putting your financial fate in the hands of a single other entity (or maybe two or three, if you diversify your loans.) That fact alone is enough for me to not want to touch it with a ten foot pole.
I'm not following why you think "the brokerage gets cold feet".  Part of their business is making margin loans - they're going to get cold feet about their business?  If they're worried they can sell your assets to pay down the loan - that's also in the margin agreement.  If they suddenly get irrational, they have competitors to take their customers from them.

If Fidelity suddenly began charging 12%, someone with $50k left and $8k of loans could move 1/2 their assets to IBKR, take an $8k loan there, and pay off Fidelity's loan.  Then move the rest.  No assets sold - just one margin loan paying off the other.  And that 12% is charged daily, so if it takes a month to change brokers, they only charged 1% of the loan value ($80 in this example) before you left.

I would also like to see a simulation.  Someone could create a spreadsheet, with years 0 to N, and stock market performance each year.  But the margin loan would not happen at the start of the crash - only after markets are 20% down.  When markets return to that point, the margin loan is paid off with interest.  Then compare that to selling assets for living expenses every year.

Tighter margin requirements are actually a legitimate concern that could make this strategy impractical, even if it looks good when backtested. The Federal Reserve Board sets the minimum standard for initial margin, and they used to actively manage margin requirements. Brokers, however, are free to set more stringent (higher) initial and maintenance margin requirements, and they're free to just say one day "we're no longer doing margin loans, so we liquidated your position". There's no law or contract that says they have to continue lending to you or maintain a particular maintenance margin.

So if IB or Fidelity or TDA or Scwab or Vanguard finds themselves taking on more risk than they can manage, they'll raise the initial/maintenance requirement. For IB, this occurred as recently as September 2020 simply because they could foresee a period of higher volatility around an election that had not happened yet!

https://www.yahoo.com/now/top-brokerage-tightens-margin-trading-as-competitors-stay-steady-144034004.html

Then there is Robinhood, which just escaped any liability for cutting off leverage to the WSB crowd when they were taking on too much GME risk.

The brokers are paying a tricky game of chasing a tiny margin on a high-risk business. If market prices fall overnight below maintenance requirements, they could be on the hook for losses or out of compliance. So they reel in the risk at exactly the time you'd like to make a low-interest loan against stock collateral.

Strangely, it is difficult to find information about broker behavior during crises such as 2020, 2008, 2000, 1987, etc. My Google only found academic articles with general mentions of the phenomenon. You can bet a table of brokerages during those crises would show them all tightening margin reqs.

Of course, this is also an issue for ERN's non-algorithmic approach of starting out with margin debt. If anything, it means you'd be called sooner, and the outcomes would be even worse.

A HELOC could be used in place of a margin loan IF (a) interest rates on such loans were low enough that it made sense, AND (b) banks weren't shutting down all lending like in 1929 or 2008, AND (c) the value of your home equity has not fallen too far during the crisis.

secondcor521

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Re: Reducing sequence of returns risk with margin
« Reply #56 on: November 30, 2021, 02:45:55 PM »
A HELOC could be used in place of a margin loan IF (a) interest rates on such loans were low enough that it made sense, AND (b) banks weren't shutting down all lending like in 1929 or 2008, AND (c) the value of your home equity has not fallen too far during the crisis.

I had a HELOC in place but unused on my house in the 2008 GFC timeframe.  My lender preemptively blocked all ability to draw on that HELOC sometime during the GFC.  The HELOC was still in place, I just couldn't draw on it.  The stated reason was that the lender (USAA in my case) could not reliably assess the value of my home and therefore couldn't quantify their risk, and therefore could not make a reasonable financial decision.  The lender did this on all of their HELOCs in my state.

I ended up canceling the HELOC as part of a refinance sometime later, but the general principal holds - in times of crisis where this strategy might help, the lenders don't want to play.  The only option I can see is to preemptively draw more than needed (i.e., in 2006, take four years worth of spending in case a GFC happens in 2008/2009) so you already have borrowed before they shut down your ability to do so.  But this means paying interest on yet-unneeded spending money in case something happens, which it may or may not.

I like the idea overall - it's clever, and in moderation it could work somewhat I think.  If I were to do it, I'd probably just do a straight up fixed 10 year mortgage on a small portion of my paid-off house.  Yes, higher origination costs and interest rate, but avoids margin calls and generally risks associated with the lender unilaterally and preemptively shutting me down.  It does also mean I get the money up front, but I think I'd rather manage that extra and early cash flow than the issues associated with margin loans or HELOCs.  Just my personal preference.
« Last Edit: November 30, 2021, 02:49:36 PM by secondcor521 »

ChpBstrd

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Re: Reducing sequence of returns risk with margin
« Reply #57 on: November 30, 2021, 03:11:40 PM »
^ Yea counterparties are the weak points any plan. When I think about algorithmic approaches to beat SORR, I think in terms of starting with a stupid-conservative AA, like 50/50 or 40/60 and then just waiting for the inevitable event to occur. Once the event occurs, you pounce and go all-in. 

Waiting an average of 9 years for the next 30% drop, or 4 years for the next 20% drop would certainly not be much fun, and there's a good chance a highly conservative portfolio would lose value during that time - especially at today's interest rates. However you'd probably earn much of that back by missing a big chunk of the big SORR event, and then going 90-100% stock at a time when long-term risk is lowest.

This would have been an awesome play in 2018, or 2020, and in 2000-2003 or 2008 one would have mitigated significant losses. To work, it would also have to be a one-shot play - a permanent change of AA - so if your pivot was triggered by the 20% drop in Dec. 2018, you'd get to ride the coronavirus correction with 100% stocks just 1.25 years later!

The reason it needs to be a permanent change instead of jumping in and out of AAs is because you wouldn't want to spend too long in a highly conservative portfolio; their long-term failure rate is very high. The goal would be to skip half the damage of your first big correction of retirement, which will inevitably occur during the first decade. This first big correction is THE source of SORR for you.

This plan might nonetheless end badly if you were heavily into bonds, and a 1970's style inflation crisis wiped them out. I'd honestly choose cash/stocks as my conservative AA at this point. This plan might also not yield a higher or better outcome than a B&H aggressive portfolio. If the market rises 30% while you sit on the sidelines, it doesn't matter that you get in at the bottom of the -25% correction that followed!