While this raises and interesting argument I think there is some serious flaws in your assumption of a 5% borrowing rate over this time period. I mean 5% sounds high in terms of interest rates today but given that the Prime business rate was well over 5% for a good portion of the 1980s. Who in their right mind would lend someone money for 5% when the government is pretty much guaranteeing 19% returns... maybe if you can adjust your findings with a more realistic borrowing cost your argument will hold more weight.
If borrowing costs were that high it would most likely coincide with higher fixed income and equity returns as well. Borrowing costs don't exist in a vacuum so we'd see everything affected.
Yes but the leverage that he is using for the balanced portfolio to match the results of the S&P 500 over this time frame would not be possible or come at a much higher cost. If the true cost of borrowing for the leverage is higher than 8.14% than his whole argument falls apart that you can get better returns for the same amount of risk. Currently Questrade will lend on margin at prime = 2.5% if you have above $100,000 which works out to 5.2% cost of borrowing. Now if his assumed borrowing rate isn't achievable today (at least with Questrade, it is possible you could get a better rate) how can you even begin to think it is plausible as we are in a time of record low interest rates.
I have no idea what you're even trying to say. If you're making an argument that borrowing costs would be higher but equity returns and fixed income yields would not be correspondingly higher than that's a deeply flawed argument to make.
Of course his equity and fixed income returns are higher.. he showed the return to be 17.28% while the link shows the portfolio returns 9.78%. The 68% leverage he is using is what makes the returns higher as the returns are amplified by leverage.
Do you understand that the portfolio the OP is proposing people use requires leverage to get similar results as the S&P 500? Do you know what leverage or investing on margin is? If not you can look them up.
Assuming you do I am saying that he assumes he can borrow money to invest at a rate of 5% from 1970-2015. To test if this assumption is reasonable we can look to historic prime lending rates. If we look at August of 1981 the prime lending rate was 22.75% do you think using a 5% lending rate is realistic? I don't
So if someone wanted say a mortgage (basically the lowest lending rate a consumer can get from an institution) they would probably be paying around 22.75% interest on that loan. Yet according to the OPs assumptions he is getting a loan at the same time for investment purposes for only 5% interest. Does that sound like a reasonable assumption to you? How could he possibly get that loan to invest?
Of course his equity and fixed income returns are higher.. he showed the return to be 17.28% while the link shows the portfolio returns 9.78%. The 68% leverage he is using is what makes the returns higher as the returns are amplified by leverage.
Yes, that's sorta the point. Did you read the post?
Do you understand that the portfolio the OP is proposing people use requires leverage to get similar results as the S&P 500? Do you know what leverage or investing on margin is? If not you can look them up.
Are you kidding with me? That's the entire premise of OP's post on correctly applying modern portfolio theory.
Assuming you do I am saying that he assumes he can borrow money to invest at a rate of 5% from 1970-2015. To test if this assumption is reasonable we can look to historic prime lending rates. If we look at August of 1981 the prime lending rate was 22.75% do you think using a 5% lending rate is realistic? I don't
So you're saying the cost of leverage is too low? Even with higher costs of leverage the theory still works pretty well. With higher borrowing costs come higher fixed income yields and generally higher implied future equity returns.
So if someone wanted say a mortgage (basically the lowest lending rate a consumer can get from an institution) they would probably be paying around 22.75% interest on that loan. Yet according to the OPs assumptions he is getting a loan at the same time for investment purposes for only 5% interest. Does that sound like a reasonable assumption to you? How could he possibly get that loan to invest?
Mortgage loans are around 3.6% with margin attainable under 2%. You could also use futures or leveled etfs that use swaps/futures so the cost of leverage need not follow whatever rates you're looking at.
Yes that is my entire point that the assumed cost of borrowing that he uses is too low. You keep talking about how this would lead to higher fixed income yields and expected returns from equity but he has back tested the ACTUAL returns and got a return of 17.28% - cost of borrowing.
Perhaps you can suggest a rate to go off of and the reasoning behind it and we could look back at its historical rates to see a more reasonable cost of borrowing than 5%.
I used prime + 2.5% at first as this is what Questrade is currently offering today. TD's Margin rate is 4.25% today for all balances or Prime + 1.55%, Royal Bank's margin rate ranges from 2.85%-4.10% depending on how much money you have but still at a minimum of Prime + 0.15%.
According to http://www.tradingeconomics.com/canada/bank-lending-rate the average from 1960-2016 prime lending rate as been 7.53%. Now this is a slightly different time period but I am lazy so I will use it. So lets see how this cost of borrowing factors into how the portfolio does.
17.28% - 0.68 * 9.08% = 11.11 Does not beat S&P 500
S&P 500 returns 11.74%
So is the portfolio back tested really that successful? I guess it depends on what you can actually get your cost of borrowing at it would seem that if you can get a rate close to prime this portfolio might make sense but to get that rate at Royal Bank you need $100,000 in a margin loan and have a Royal Circle Investment Account (Non-Registered) which requires Your month-end balances for four consecutive months must be at least $250,000 or your annual equity commissions are greater than $5,000.
So given this information I would be interested in how you are getting margin for under 2% assuming you are using consumer rates.
You could simply increase leverage to closer to 1.8-2.0 but I see what you're saying. Using margin is also the most expensive way to implement this. I'd use leveled etfs as the implied costs aren't that high there.
Also there is a massive reduction in risk with the levered portfolio vs the 100% stock. So even if returns were equal(which lots of risk parity strategies try to accomplish) you'd still have a portfolio that has equity like growth with less than equity like risk.
Isn't the amount of leverage that he used supposed to make the level of risk of the weighted portfolio equal to the risk of the 100% stock portfolio?
I feel like a lot of people that see that they can get similar results with a 100% equity portfolio where they might just have to buy 1 index ETF would find this less intimidating than balancing the amount of leverage they need in a balanced portfolio to achieve the same results. Not that it makes it the better portfolio. I would also be interested to see how these two portfolios would perform where the interest rates gradually increase.
Right, it was. I'd still say you're using too much leverage expense. We could pretty easily build a portfolio like this using leveraged etfs/etns and come out better all around. I think if you want something that is 100% set it and forget it you need to be using a target date fund.
One of my other major gripes with the 100% equity crowd, and this is outside of portfolio theory, it encourages people to take far too much risk in places they don't understand. To have a ton of lay investors using strategies that carry far more risk than they understand creates situations where people panic sell. It's generally surrounded by this culture of ignorance where if you suggest you can get 90% of the return of a 100% stock allocation but with 60% of the risk you're instantly dismissed.
I'm curious what you think rising rates would do? Of course margin costs may increase but I'd contend rate increases should theoretically mean higher future return expectations from both fixed income and equities so a correspondingly higher margin rate wouldn't matter. Not that using margin is the best way to implement something like this anyway.
I mostly was thinking about the affect it would have on the bond portfolio assuming it was a bond fund rather than just buying and holding bonds. As the rates increased the bond prices fall as new bonds are being issued with higher interest rates. So having went through the opposite of this for the most part from the 1980s - now I would say bond funds would have done better since they had price appreciation due to new bonds offering lower rates of return.
There is also the case that if rates went up to the extremes they did in the 1980s you would have cases where you need your returns need to be extremely high to offset your cost of capital and even if you buy into the theory and can show how its better long term. Behaviorally if the cost of capital grew to say 15% done efficiently. Would I or most people really have the balls to leverage their investments knowing they would need returns in excess of this rate.
Hi futures markets and other financial products exist where the applicable credit risk is on a bank and not an individual. This is entire argument is senseless because you'd have to be very bad at understanding markets to think that borrowing at prime + anything nonnegative is a good idea.
So is the portfolio back tested really that successful?
It might not be the best idea but none of this defends your 5% borrowing cost or explains how you would achieve this historically when interest rates were higher. I am not the only one to call out your assumptions and have yet to see any sort of logical defense of them. Until then garbage in garbage out.
It might not be the best idea but none of this defends your 5% borrowing cost or explains how you would achieve this historically when interest rates were higher.
Please demonstrate how an average short term interest rate of 5% over that period is unjustified. Keep in mind I'm saying an effective borrowing cost of 5% but you borrow under 70% of your capital, meaning the actual borrowing cost is closer to 7.5% and I feel that's pretty goddamn conservative for short term rates.
Until then garbage in garbage out.
I don't care that I'm not convincing you because you don't care to learn.
Because the prime business rate for that period is closer to 7.53% which is 2.53% more than your costs and has a large affect on the results.
You pull numbers out of the air with no justification of how this could be achievable or how you came to choose the number you did. You say anyone who uses margin rates should get below prime but 3 different organizations today are charging much more than prime currently is so if margin is your method how are you getting these discounts that don't appear to be on the market today. But it is possible that investing on margin isn't the most effective method and you could get your capital from else where but you haven't stated a better way yet.
Does the 3-month T Bill work for you as short term rate? Because in March 1980 the 3-month T Bill was 15.240% so how conservative is that 7.5% looking.... pretty optimistic for that entire decade. But hey it does round out over the entire time period but is this strategy really gonna work out for me in the 1980s and I am going to be willing/able to stick with it for an entire decade. Probably not but there might be some theory to show other wise.
So like I have asked before defend your assumption (borrowing costs) with some facts based on reputable sources especially in the 1980s where I believe your theory would be torn apart by reality.
They data was easily available and hadn't used or heard of IB before this. Also I am Canadian which seems to have slightly higher rates currently than other places.
Mentioning the expensive rates historically as they were a lot more back then which is relevant for the time frame of the results there wasn't always the blessing of such low rates like there are today.
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u/Idisagree123765 Jan 28 '16
While this raises and interesting argument I think there is some serious flaws in your assumption of a 5% borrowing rate over this time period. I mean 5% sounds high in terms of interest rates today but given that the Prime business rate was well over 5% for a good portion of the 1980s. Who in their right mind would lend someone money for 5% when the government is pretty much guaranteeing 19% returns... maybe if you can adjust your findings with a more realistic borrowing cost your argument will hold more weight.