Lifecycle Investing and Leverage -Alternative Strategies

[bargainman]

I don't think this is a bad idea in general, but the timing of choosing to implement 5 years into a bull market is not the best.  I was fortunate and happened to graduate in 2007 with a job that paid well enough for me to afford saving at least half my after-tax income each year.  I was levered in 08/09/10, and again after the US debt downgrade in 11, but have delevered since then. 

....

Bottom line: I'd advise you to use leverage carefully, consider the market level, and also consider how much money you can save in a year.  When I was levered in 08/09/10, I was at the beginning of my career, and because my portfolio starting out was small relative to the savings each year, the amount borrowed could have been paid off with savings within a year if needed.  This provided a degree of protection from margin calls, because I was continuously adding deposits from paychecks.

 

Good points.  Also consider correlation between earning potential and downturns.  When market goes down and you lose a lot on paper and on margin, is your job at risk?  Is your income tied to the stock market via options or performance?  Then you're more likely to blow up if all these are correlated..

[ERICOPOLY]

Shelby Davis bought on margin and had CAGR of 23% over 47 years. He turned 50K into 900 Million.

 

http://www.valuewalk.com/2011/02/shelby-davis-spectacular-unknown-investor/

 

But for every one person who did really well, there could be 3 that did okay, 5 that barely kept up with the market and 3 that blew up. You could probably afford to blow up once or twice if you are highly risk-tolerant and start very young.

 

Right, remember Warren Buffett's protege who wanted to get there quick and blew up?  Can't remember his name..

 

Are you thinking of Rick Guerin?

 

He could have used at-the-money puts to protect his margin borrowing.  I think that's really the lesson to learn from him, not that margin itself is bad (or at least that's my takeaway).

 

Using puts simply means you losses might grow up to the cost of the put and the cost of the margin interest (which today costs nothing at IB).

 

So really, just the cost of the put.  You can't "blow up" if you go 2x levered this way -- just a bit of damage, but not "blow up".  Say the put costs you 10% -- what, a year of setback?  Maybe less?  Maybe a bit more?  It's not a big deal.

[yitech]

Shelby Davis bought on margin and had CAGR of 23% over 47 years. He turned 50K into 900 Million.

 

http://www.valuewalk.com/2011/02/shelby-davis-spectacular-unknown-investor/

 

But for every one person who did really well, there could be 3 that did okay, 5 that barely kept up with the market and 3 that blew up. You could probably afford to blow up once or twice if you are highly risk-tolerant and start very young.

 

Right, remember Warren Buffett's protege who wanted to get there quick and blew up?  Can't remember his name..

 

Are you thinking of Rick Guerin?

 

He could have used at-the-money puts to protect his margin borrowing.  I think that's really the lesson to learn from him, not that margin itself is bad (or at least that's my takeaway).

 

Using puts simply means you losses might grow up to the cost of the put and the cost of the margin interest (which today costs nothing at IB).

 

So really, just the cost of the put.  You can't "blow up" if you go 2x levered this way -- just a bit of damage, but not "blow up".  Say the put costs you 10% -- what, a year of setback?  Maybe less?  Maybe a bit more?  It's not a big deal.

 

Blowing up may be a slight exaggeration, but it is possible for someone to feel the need to double down or average down on losers when you have additional (borrowed) capital or have a sudden urge to ramp up the leverage that may cause some serious damage. Leverage can be addictive and people can't be said to be rational all the time. I'd be the first to admit that I am not rational all or most of the time. I think the key may be controlled leverage and apply caution.

[rayfinkle]

Shelby Davis bought on margin and had CAGR of 23% over 47 years. He turned 50K into 900 Million.

 

http://www.valuewalk.com/2011/02/shelby-davis-spectacular-unknown-investor/

 

But for every one person who did really well, there could be 3 that did okay, 5 that barely kept up with the market and 3 that blew up. You could probably afford to blow up once or twice if you are highly risk-tolerant and start very young.

 

Right, remember Warren Buffett's protege who wanted to get there quick and blew up?  Can't remember his name..

 

Are you thinking of Rick Guerin?

 

He could have used at-the-money puts to protect his margin borrowing.  I think that's really the lesson to learn from him, not that margin itself is bad (or at least that's my takeaway).

 

Using puts simply means you losses might grow up to the cost of the put and the cost of the margin interest (which today costs nothing at IB).

 

So really, just the cost of the put.  You can't "blow up" if you go 2x levered this way -- just a bit of damage, but not "blow up".  Say the put costs you 10% -- what, a year of setback?  Maybe less?  Maybe a bit more?  It's not a big deal.

 

Eric- any chance you can explain this a bit more? Are you just saying that you can buy puts against the borrowed portion of capital to prevent a situation where you owe more than you hold in a market decline?

[ERICOPOLY]

Shelby Davis bought on margin and had CAGR of 23% over 47 years. He turned 50K into 900 Million.

 

http://www.valuewalk.com/2011/02/shelby-davis-spectacular-unknown-investor/

 

But for every one person who did really well, there could be 3 that did okay, 5 that barely kept up with the market and 3 that blew up. You could probably afford to blow up once or twice if you are highly risk-tolerant and start very young.

 

Right, remember Warren Buffett's protege who wanted to get there quick and blew up?  Can't remember his name..

 

Are you thinking of Rick Guerin?

 

He could have used at-the-money puts to protect his margin borrowing.  I think that's really the lesson to learn from him, not that margin itself is bad (or at least that's my takeaway).

 

Using puts simply means you losses might grow up to the cost of the put and the cost of the margin interest (which today costs nothing at IB).

 

So really, just the cost of the put.  You can't "blow up" if you go 2x levered this way -- just a bit of damage, but not "blow up".  Say the put costs you 10% -- what, a year of setback?  Maybe less?  Maybe a bit more?  It's not a big deal.

 

Eric- any chance you can explain this a bit more? Are you just saying that you can buy puts against the borrowed portion of capital to prevent a situation where you owe more than you hold in a market decline?

 

I'm to the point now where I only ever use margin if the loan amount is hedged with at-the-money put (in a "portfolio margin" account).  So the loan is completely non-recourse.  The put is generally expensive only in the early years (if done right) -- if you are right and the asset is truly deeply undervalued, then after a few years the asset should have risen substantially and going forward the puts will be a lot cheaper (due to skewness).

 

You still will lose money if the market drops after you use leverage, it's just that it will be contained.  It's easier to plan for when the worse-case is baked in the cake and part of the plan from day one.

[gary17]

 

Eric

So if the stock starts to appreciate, the at the money puts become in the money puts. Would you sell them and start rolling or you wait a bit for when the difference becomes bigger to roll? 

 

Thanks

 

Shelby Davis bought on margin and had CAGR of 23% over 47 years. He turned 50K into 900 Million.

 

http://www.valuewalk.com/2011/02/shelby-davis-spectacular-unknown-investor/

 

But for every one person who did really well, there could be 3 that did okay, 5 that barely kept up with the market and 3 that blew up. You could probably afford to blow up once or twice if you are highly risk-tolerant and start very young.

 

Right, remember Warren Buffett's protege who wanted to get there quick and blew up?  Can't remember his name..

 

Are you thinking of Rick Guerin?

 

He could have used at-the-money puts to protect his margin borrowing.  I think that's really the lesson to learn from him, not that margin itself is bad (or at least that's my takeaway).

 

Using puts simply means you losses might grow up to the cost of the put and the cost of the margin interest (which today costs nothing at IB).

 

So really, just the cost of the put.  You can't "blow up" if you go 2x levered this way -- just a bit of damage, but not "blow up".  Say the put costs you 10% -- what, a year of setback?  Maybe less?  Maybe a bit more?  It's not a big deal.

 

Eric- any chance you can explain this a bit more? Are you just saying that you can buy puts against the borrowed portion of capital to prevent a situation where you owe more than you hold in a market decline?

 

I'm to the point now where I only ever use margin if the loan amount is hedged with at-the-money put (in a "portfolio margin" account).  So the loan is completely non-recourse.  The put is generally expensive only in the early years (if done right) -- if you are right and the asset is truly deeply undervalued, then after a few years the asset should have risen substantially and going forward the puts will be a lot cheaper (due to skewness).

 

You still will lose money if the market drops after you use leverage, it's just that it will be contained.  It's easier to plan for when the worse-case is baked in the cake and part of the plan from day one.

[Uccmal]

Eric, I dont think individual stock pits were around when Rick Geurin had that situation in the early 70s. 

 

Gary, If the stock appreciates his puts go toward zero.  Puts generally lose value quite quickly.  He will take the loss against his gains in the margin account.  I have my BAC leap position nearly completely hedged this way.  You need a stock you believe is deeply undervalued.  You cant get a portfolio margin account in Canada but the strategy still works well.  The losses offset your taxable gains elsewhere.  Essentially you transfer the tax payment to whomever wrote the puts. 

 

You need a deeply undervalue, highly liquid stock to do this.  I have done it with Bac to preserve my gains into next year and push the tax man out to a year when I project having a lower income. 

 

[ERICOPOLY]

 

Eric

So if the stock starts to appreciate, the at the money puts become in the money puts. Would you sell them and start rolling or you wait a bit for when the difference becomes bigger to roll? 

 

Thanks

 

They become out-of-the-money puts as the stock starts to appreciate. 

 

Optimally you roll them after the stock has appreciated a lot (so the incremental cost of another year of insurance is cheaper).  I want this situation because I intend to lose the entire value of every put already paid for -- cost of doing business.  The best I can hope for is that the future puts that I will roll to are as cheap as possible.

 

The only thing I like about the prospects of a higher BAC dividend is that it gives me liquidity to roll puts.

 

[gary17]

Thank you very much, Eric.

And yes for put options it becomes out of money

Psychologically it's just so different to be buying puts hoping to lose money on, but I can start to get comfortable with this strategy I think.

Merry Christmas !

 

 

Eric

So if the stock starts to appreciate, the at the money puts become in the money puts. Would you sell them and start rolling or you wait a bit for when the difference becomes bigger to roll? 

 

Thanks

 

They become out-of-the-money puts as the stock starts to appreciate. 

 

Optimally you roll them after the stock has appreciated a lot (so the incremental cost of another year of insurance is cheaper).  I want this situation because I intend to lose the entire value of every put already paid for -- cost of doing business.  The best I can hope for is that the future puts that I will roll to are as cheap as possible.

 

The only thing I like about the prospects of a higher BAC dividend is that it gives me liquidity to roll puts.

[scorpioncapital]

Instead of buying puts to lose money on, why not sell puts to make money on? The latter has worked quite well when they are deep out of the money on companies with conservative balance sheets and some degree of stock buy-back.

[ERICOPOLY]

Instead of buying puts to lose money on, why not sell puts to make money on? The latter has worked quite well when they are deep out of the money on companies with conservative balance sheets and some degree of stock buy-back.

 

I live in California.  I will pay 50+% tax on selling puts -- they are taxed as regular income.  There is no point taking on risk if I can't keep the money as compensation.

 

Instead, I purchase the underlying stock and hedge with a put.  The put expires worthless (as a short-term capital loss) and the underlying stock keeps on compounding tax deferred.  The expired put shields my tax bill elsewhere (allowing me to keep some profit for myself, which is a novel concept).

 

After the first year or two, the underlying stock should have appreciated quite a bit.  Then the additional cost of puts (at the same strike) will go down (due to skewness).  That's when I begin to make money.

 

Then there is risk profile -- I am taking the downside risk when I write a put.  I am putting the downside risk on someone else when I buy a put.

 

I want to keep all of the profits while letting others shoulder the bulk of the risk  8)

 

 

EDIT:  Take for example BAC.  I bought the common for $12 in March and hedged with $12 strike put (about $1.10 cost).  The stock is up a bit since then.  Now the 2016 $12 strike put (to replace the 2014) costs only $1.  So for a total outlay of roughly $2.10, I can get three years of BAC's upside.  During this time, the gains compound tax-deferred and the puts expire worthless (offsetting dividends and realized capital gains).  Then for 2017 expiry, I expect the next round of $12 strike puts to cost maybe 20 cents a year.  Then I'm keeping nearly all the profit.

 

So costly at first, then after a few years extremely cheap!  So the leverage gets cheaper and cheaper -- it's like adjustable rate non-recourse loan that adjusts lower (at least for the puts it does).  I expect the interest rate to move up over time (on the margin loan).

 

 

What happens when I get more dividend income from BAC than the puts cost me?  I buy shares of something that doesn't pay a dividend -- like Berkshire.  I hedge that with puts.  That gives me more write-offs to charge against my BAC dividends.

 

I'm hoping this is the solution to California's nasty tax situation.  It's like my Australian heritage is coming to light -- using leverage for negative gearing (isn't that the Australian way?).

[dpetrescu]

Eric,

I was curious but why do you keep the put insurance always at the same strike even as the stock increases over time. This way your worst case is always zero less cost of insurance. Why not increase the put strike price over time to also insure profits not just initial investment. Is the insurance too expensive? I've been considering a similar approach.

 

Instead of buying puts to lose money on, why not sell puts to make money on? The latter has worked quite well when they are deep out of the money on companies with conservative balance sheets and some degree of stock buy-back.

 

I live in California.  I will pay 50+% tax on selling puts -- they are taxed as regular income.  There is no point taking on risk if I can't keep the money as compensation.

 

Instead, I purchase the underlying stock and hedge with a put.  The put expires worthless (as a short-term capital loss) and the underlying stock keeps on compounding tax deferred.  The expired put shields my tax bill elsewhere (allowing me to keep some profit for myself, which is a novel concept).

 

After the first year or two, the underlying stock should have appreciated quite a bit.  Then the additional cost of puts (at the same strike) will go down (due to skewness).  That's when I begin to make money.

 

Then there is risk profile -- I am taking the downside risk when I write a put.  I am putting the downside risk on someone else when I buy a put.

 

I want to keep all of the profits while letting others shoulder the bulk of the risk  8)

 

 

EDIT:  Take for example BAC.  I bought the common for $12 in March and hedged with $12 strike put (about $1.10 cost).  The stock is up a bit since then.  Now the 2016 $12 strike put (to replace the 2014) costs only $1.  So for a total outlay of roughly $2.10, I can get three years of BAC's upside.  During this time, the gains compound tax-deferred and the puts expire worthless (offsetting dividends and realized capital gains).  Then for 2017 expiry, I expect the next round of $12 strike puts to cost maybe 20 cents a year.  Then I'm keeping nearly all the profit.

 

So costly at first, then after a few years extremely cheap!  So the leverage gets cheaper and cheaper -- it's like adjustable rate non-recourse loan that adjusts lower (at least for the puts it does).  I expect the interest rate to move up over time (on the margin loan).

 

 

What happens when I get more dividend income from BAC than the puts cost me?  I buy shares of something that doesn't pay a dividend -- like Berkshire.  I hedge that with puts.  That gives me more write-offs to charge against my BAC dividends.

 

I'm hoping this is the solution to California's nasty tax situation.  It's like my Australian heritage is coming to light -- using leverage for negative gearing (isn't that the Australian way?).

[ukvalueinvestment]

I have a quick question that someone on this thread might be able to answer.

 

I'm in the UK and hoping to the US in the next five years or so.  By that point, my portfolio will be big enough to buy all or a large portion of my house - very little mortgage required.  But I have heard that in the US, it is possible to get a mortgage and secure it on an investment portfolio.  Obviously (I think), the investment portfolio would need to be held with the mortgage provider.  I have heard that the provider will generally advance 50% of the portfolio.  So, using some made up numbers:

 

House Value: 1mln.

Income: 100k

Investment Portfolio: 1.2mln

 

This implies that I could keep my investment portfolio and get a mortgage at an implied 4* income level, if my portfolio is given a 50% haircut.

 

My questions are:

 

1) Is this scenario reasonable?

2) What income multiple will banks generally advance?

3) How common is this type of mortgage - are they a standard product offered by all banks?

 

[bizaro86]

2) Applying for investment loan with pledged collateral:

I've found out about two types so far (first I have done and second is proposed)

 

a) long-dated term loan of 25 years at prime + 1% interest where established long term holdings were submitted as collateral and 2x was given in loan amount with all assets being collateral for the bank (ie. $250 K in assets led to $500 K loan to invest with $750 K in total collateral). Benefits of this were margins were tested at 1 year and then never again. Downside was the holdings could only be sold down if the same L:V ratio was maintained. This would work well with established owner-operators that are long term holds.

 

Do you mind if I ask who wrote this loan for you? I'm in Canada and would love to set something like this up at some point with some well selected compounders and let it sit for the 25 years.

[tripleoptician]

2) Applying for investment loan with pledged collateral:

I've found out about two types so far (first I have done and second is proposed)

 

a) long-dated term loan of 25 years at prime + 1% interest where established long term holdings were submitted as collateral and 2x was given in loan amount with all assets being collateral for the bank (ie. $250 K in assets led to $500 K loan to invest with $750 K in total collateral). Benefits of this were margins were tested at 1 year and then never again. Downside was the holdings could only be sold down if the same L:V ratio was maintained. This would work well with established owner-operators that are long term holds.

 

Do you mind if I ask who wrote this loan for you? I'm in Canada and would love to set something like this up at some point with some well selected compounders and let it sit for the 25 years.

 

The long dated loan was from the private banking side of BMO. They see happy to lend against mutual fund holdings but may be less eager with individual stocks. I've got a small term loan at prime with RBC private banking as well held against indivudal securities but this is of shorter duration and they will test the margin yearly.

[bizaro86]

 

The long dated loan was from the private banking side of BMO. They see happy to lend against mutual fund holdings but may be less eager with individual stocks. I've got a small term loan at prime with RBC private banking as well held against indivudal securities but this is of shorter duration and they will test the margin yearly.

 

Thanks!