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Top 5 Asset Allocation Strategies





“Wide diversification is only required when investors do not understand what they are doing.” – Warren Buffett

Probably the single most common incorrect quote in investing is: “Asset allocation determines 94% of your investment returns.” The quote refers to a study1 that is misquoted by both the investment industry to market simple investment strategies and by the index industry to downplay fund manager skill.

“Asset allocation” attempts to balance risk and return by adjusting the mix between equities (stocks), bonds and cash. While the benefits are far less than touted, it is an objective and simple way to help investors understand both the risk level and return potential of their portfolio.

There is a common belief that it is just a matter of deciding whether you are more comfortable with the classic mix of 60% stocks/40% bonds or a more growth-oriented 80%/20% mix. However, there are actually a variety of asset allocation strategies.

Here are 5 possible strategies. All are reasonable and based on studies. The best strategy for you depends on multiple factors, including your risk tolerance, time horizon and your long term goals, especially your retirement goal.

1. Fixed Allocation

This is the traditional method. It is based on your risk tolerance. After filling out a “risk tolerance questionnaire” and based on the degree of ups and downs you can tolerate in your investments, you choose an allocation, say 70% stocks/30% bonds. You generally maintain the same allocation through your life, unless your risk tolerance changes.

Pros:

  • Investments should be suitable to your risk tolerance. Most investors are not very knowledgeable about investing and this allows them to have a constant level of ups and downs that they can get comfortable with.
  • Easy for you to understand the risk and return level of your investments.

Cons:

  • Risk tolerance for most people changes based on the situation. In great bull markets, most investors become more aggressive, while in scary bear markets most investors become more cautious.
  • You may end up with a portfolio that is too conservative when you are young and too aggressive when you are old.
  • Many investors end up with a portfolio too conservative to have any chance at all of having the retirement they want because they base their investments only on their risk tolerance, without knowing what return they need to achieve their life goals.

2. Target Date

This method is based on the “birthday theory” that you should become more cautious as you get older. The formula used is usually something like: 110 – your age = % in stocks. At age 30, you should have 80% in stocks and at age 60 that should have 50%. There are target date mutual funds that do the adjustment for you automatically each year.

Pros:

  • Automatically adjusts for the shorter time horizons and more conservative nature that is common as you get older.
  • Reduces risk as your portfolio gets larger with time. A 20% decline on a $1 million portfolio at age 60 may be harder to tolerate than a 20% decline on a $50,000 portfolio at age 30.

Cons:

  • Many people become comfortable with the ups and downs of their investments, so they may not want more conservative investments every year.
  • With more experience, not all investors become more conservative with age.
  • You may end up with a portfolio too conservative to have any chance of having the retirement you want.

3. Lifecycle Investing

Based on an in-depth study by two Yale professors2, they proved that retirement risk over your lifetime is lower if you “diversify across time”. Traditional asset allocation does not give you much growth when you are young and have a long time horizon with a relatively small portfolio.

Traditional investing also creates a big “last decade risk” because 80% of your investments over your working life are usually after age 50. If your last decade is a bad decade (like the 2000-09 decade), it probably means your rate of return for your entire working life is low. One bad decade can put you far below your retirement goal.

Lifecycle investing reduces “last decade risk” by diversifying across time. Essentially, you borrow to at least double the size of your investments in your first decade of investing and invest 100% in stocks. If you have $50,000, you borrow another $50,000, so you can invest $100,000 all in stocks. That means you essentially have 200% in stocks.3 Then you slowly pay off the leverage by your early 50s, when you start adding bonds, moving to your desired mix by retirement.

The study (and book) by two Yale professors proved lifecycle investing for your entire working life provided a better retirement 99-100% of the time.  For more details, check out the full article on Lifecyle Investing.

Pros:

  • Provides a better retirement income than traditional asset allocation 99-100% of the time (based on the study).
  • Offers more growth potential when you are young and have a long time horizon.
  • Reduces “last decade risk” that one bad decade can mess up your retirement.

Cons:

  • Borrowing to invest in your 20s and 30s is a riskier strategy at a time when you may not be experienced.
  • Borrowing to invest may magnify the bad investing behavior of most investors, who tend to “buy high” when there is a lot of good news and “sell low” by converting to more conservative investments when news stories are mostly negative.

4. Stocks for the Long Run

Investing seems to arbitrarily focus on 1-year returns, even though most investors will be invested for at least 30 years. In the investing bible “Stocks for the Long Run”, Prof. Jeremy Siegel proved that over long periods of time, stocks always produce higher returns and are more consistent than bonds. If your time horizon is more than 30 years, then stocks have historically beaten bonds 100% of the time.

His study shows that for investors with a 30-year time horizon, ultraconservative investors (least risk) should have 71% stocks, moderate investors 116% stocks (by borrowing), and aggressive investors 139% stocks.

One of my mentors, Nick Murray, worded it well – the long term return of stocks has been 10%/year, bonds 6%/year and cash 2%/year. How many 10%s vs. 6%s vs. 2%s do you want in your portfolio?

When you look at 30-year periods (instead of 1-year periods), the returns of stocks has been more reliable and consistent than bonds. This is because the return on bonds is highly susceptible to inflation. The worst 30-year period ever for the S&P500 since 1871 was a gain of 5.09%/year4, which would more than quadruple your money. After inflation, the worst 30-year period for stocks was +2.6%/year, while for bonds it was a loss of -2.0%/year.5

Many major countries have had their government bonds go to zero (or near zero) in the last century, including Germany, Italy, Japan, Russia and Brazil, but the stock market has always recovered in every country.4

The underlying theory is that stock markets are based on large companies that are able to adjust their businesses to keep raising their profits over time. They have many tools, including raising prices, getting new clients, introducing new products, expanding into new markets, cutting costs or buying competitors. As long as companies continue to increase profits over time, the stock market eventually goes up.

Pros:

  • Provides a much better retirement for investors with long time horizons that are able to tolerate the ups and downs.
  • Easy to understand and based on research.
  • Avoids the most common investing error of switching to more bonds at the bottom of the market.

Cons:

  • Most investors think short term, even if their time horizon is long.
  • Many investors are not able to tolerate the ups and downs of the stock markets.
  • Investing only in stocks may magnify the bad investing behavior of most investors, who tend to “buy high” when there is a lot of good news and “sell low” by converting to more conservative investments when news stories are mostly negative. The average investor makes 6-7%/year less than the investments they own because of bad market timing.7

5. Rempel Maximum

This is the strategy for people that want to build serious wealth – borrowing to invest for the long term.8 Borrowing to invest magnifies gains and losses, but the stock market has never had a loss for a 15-year period or longer.4 Borrowing to invest is a risky strategy, but the risks are far lower if you invest long term. The interest on an investment loan is normally tax deductible as well.  Details about the Rempel Maximum here.

It is the logical extension of “Stocks for the long run”. Long term, stocks have consistently outperformed both bonds and the cost of borrowing to invest.4 Leverage is the strategy used by nearly all wealthy people, who use “other people’s money” to invest in their business or in the stock market (many businesses), including 87% of the Forbes 400 richest people.9

The amount borrowed to invest can range widely and depends on many factors. Often the intent is to borrow the maximum amount that you can support long term.

Pros:

  • Can build significant wealth and the security that comes from having a huge nest egg.
  • Provides a much better retirement for investors with long time horizons that are able to tolerate the ups and downs – significantly higher than “stocks for the long run”.
  • Avoids the most common investing error of switching to more bonds at the bottom of the market.
  • Interest payments are fully tax-deductible every year, while tax on the growth of the investments can be deferred until you sell them far in the future if you have tax-efficient investments.

Cons:

  • Too risky of a strategy for most people who may not be able to stomach significant down periods, especially if the investments drop below the value of the amount borrowed.
  • Most investors think short term, even if their time horizon is long.
  • Borrowing to invest may magnify the bad investing behavior of most investors, who tend to “buy high” when there is a lot of good news and “sell low” by converting to more conservative investments when news stories are mostly negative.

The best strategy for you depends on multiple factors, including your risk tolerance, time horizon and your long term goals, especially your retirement goal.

Story of Jim and Jennifer

Jim and Jennifer are 35 and make a good income. They want to retire comfortably a bit early at age 60. They are deciding on their asset allocation. Consider the following:

  1. Goal: They sat down with us and created a detailed, line-by-line retirement lifestyle that they want. In order to make it given how much they can afford to invest, their investments will need to average 8%/year long term. That means they would have to invest 100% in equities to make their goal.
  2. Gut feel: They are thinking of investing with a balanced 50%/50% allocation because they are a bit nervous with the difficult markets recently.
  3. Risk tolerance: A discussion of their risk tolerance and a questionnaire show they can tolerate the level of ups and downs of the stock market.
  4. Market crash: They said that in a big market crash, they would invest more to buy low.
  5. Time horizon: Even though they plan to retire in 25 years, their time horizon is closer to 50 years, including after they retire.

Here are possible allocations based on these 5 strategies:

  1. Fixed allocation: 70% stocks/30% bonds. (They are young and have a relatively high risk tolerance, but are a bit nervous.)
  2. Target date: 75% stocks/25% bonds. (Formula is 110- age 35 = 75% stocks.)
  3. Lifecycle investing: 200% stocks/-100% bonds. (Borrow to double their investments at their age. Count the loan as a negative bond holding.)
  4. Stocks for the Long Run: 100% stocks/0% bonds.
  5. Rempel Maximum: 400% stocks/-300% bonds. (Just an example using a 3:1 investment loan.)

What strategy should Jim and Jennifer use?  Which asset allocation strategy is best for you?

About the Author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.  If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com.  You can read his other articles here.

1 Brinson, Hood, and Beebower (1986, 1991) The study actual shows that 40% of the difference in return between different balanced funds was explained by the asset allocation.
2 “Lifecycle Investing”, Ian Ayres and Barry Nalebuff
3 If you count the investment loan as a negative bond position, then you are investing 200% stocks/-100% bonds in your first decade.
4 Standard & Poor’s
5 “Stocks for the Long Run”, 4th edition, Jeremy Siegel
6 The only exception I am aware of is Russia when it converted to communism and the government seized many companies. This is a political reason, not an investment reason for a stock market collapse.
7 “Quantitative Analysis of Investor Behavior 2011”, Dalbar
8 Borrowing to invest for the long term is essentially a negative bond allocation.
9 “The Forbes 400 – The richest people in America”

“Disclaimer: Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Opinions expressed are the personal opinion of Ed Rempel.”

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124 Comments, Comment or Ping

  1. 1. SST

    Please do some research on Ibbotson for world-class, industry leading asset allocation strategies.

    In complete opposition to Mr. Remple, they in fact DO recommend a precious metals holding of 7-15% in ones portfolio and have the multi-decade research to show that precious metals DO, in fact, contribute a POSITIVE return to the over-all performance of the portfolio.

    This should be posted in the ‘Financial Quackery’ topic, but it fits incredibly well here, and the timing is perfect. I read this article just last night: http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/?iid=EL

    Then I took notice of the nice little bubble chart they constructed: http://fortunewallstreet.files.wordpress.com/2012/02/fate_of_100_dollars.jpg

    See what it says? “$100 into $6,072 if invested in the S&P 500 in 1965″

    (excuse the all-caps but I very much need to make a strong point)

    Please tell us, CNNMoney, Forbes, Mr. Buffett, and Mr. Remple, EXACTLY HOW could one have invested in the ‘S&P 500′ in 1965???

    The VERY FIRST full index fund was created in 1978, thus an investor would have had to buy ALL 500 of the stocks listed in the index at any time prior to that date. Not to mention that the world’s BEST fund manager of the last decade only had a mere 20 or so stocks in his fund…500 seems like such an over-kill. (do some research on the percentage of stocks in the ’500′ which actually contribute to the over-all positive gain — it’ll surprise you!).

    If I was to post such drivel it would be one thing, when it is posted by financial industry “professionals”…it SHOULD be CRIMINAL!

    Apparently people are blinded by facts and confused by greed, so this type of deception most likely won’t be changing any time soon.

    As Mr. Remple seems to have co-opted the Million Dollar Journey to promote his business, and sees nothing wrong with continuing to propagate an industry scheme, I will no longer be attending this website.

    Good luck, FT, on joining the 1-2% of factual net-worth millionaire Canadians.

    p.s. — one thing that always bugged me, FT, since you include your wife’s pension, your wife’s income contributions, and your principle residence (joint-owned?) in your net-worth calculations, shouldn’t your Journey be to $2 million? Because, as simple math shows, $1 million split does not create two millionaires.

  2. 2. DanP

    Now without large equity in your home, how does one acquire a large investment loan?

  3. 3. SST

    Just a couple more to really seal the deal!

    “…the return on bonds is highly susceptible to inflation.”
    Just as stocks are highly susceptible to inflation. Since the early ’80s when an influx of credit started pouring into the economy, the stock market has risen, far outstripping GDP. Prior to that, the two were fairly in-step.

    What happens when there is a flow of excess money into the system? Prices of assets increase. Stocks, being assets, did just that. And the more credit being pumped into the system, the more the stocks rose. That is, until they popped. Then houses started to bubble…but that’s another story.

    So if you really think today’s stock market and stock prices are a TRUE and ACCURATE reflection of 30+ years of easy credit and minimal GDP growth…then by all means, BUY! Because as reported, stocks aren’t effected by inflation (it’s called inflation for a reason!). ;)

    “Leverage is the strategy used by nearly all wealthy people, who use “other people’s money” to invest in their business or in the stock market (many businesses), including 87% of the Forbes 400 richest people.”

    Take a look at that list.
    Find the number of “richest people” who became millionaires EXCLUSIVELY through stock market investing.
    Get back to me if the number is higher than zero.
    Point being, millionaires — once millionaires — invest in the stock market; the stock market creates EXCEPTIONALLY FEW millionaires.

    Ignore the facts and enjoy the ride!

    :)

  4. Ed’s comment went to the spam box, here it is:

    __________________

    Hi Dan,

    Using a credit line to invest is not the only method. You can just get an investment loan and use the investments as collateral.

    Investment loans are available from some trust companies for investing in mutual funds. The 2 main types of loans are 100% loans (no money down) and 3:1 loans (they lend you 3 times your capital).

    Interest rates vary depending on a few factors, but are roughly prime +1%, which would of course be tax deductible. The amount you can qualify for depends on mainly on your credit rating, your TDSR and your net worth.

    The maximum you can qualify for is often somewhere between 50%-100% of your net worth for 100% investment loans. For 3:1 loans, the qualifications are much easier and are mainly limited by how much you can invest from cash (since you need to have 1/3 of the amount of the loan you ask for).

    Investment loans are an excellent way to build wealth long term, but they certainly are not for everyone. You should only consider them as part of a long term strategy

  5. @SST, thanks for the feedback! I’ve always counted net worth as family net worth regardless of who the main contributor is. We work together as a team and everything is co owned.

  6. 6. Samantha

    I’m 25 and I just started working full time last year. For most of last year I focused on paying off my student loans and I’ve only started invested in the last few months. I’m intrigued by life cycle investing but what I don’t understand is where a young person with almost no equity would be able to get leverage at a reasonable interest rate.

  7. 7. Fit

    lol oh my, interesting topic today. I am a fan of leverge, low MER funds (oppurtunity cost of spending time with family instead of looking at charts haha), and not trying to be an economist. I am also a fan of “behaviour” based investing… that states: Get out of your own way and let your investments do what they are supposed to do! If most (not all) people stopped mucking around with the latest and greatest investment tip, they would be much better off haha

    “I know I’ve tried a lot of get-rich-quick schemes. This is different. I know I’m going to get rich with this scheme… and quick!”

    – Homer J. Simpson

    lmao

  8. 8. Jerry W

    @Samantha, I would suggest paying off your student debts first, get as much saving as you can, before you enter this kind of money game.

    I believe FT had same suggestion for new grad like you in another article “Reader Mail: New Graduate, TD e-Series, RRSP or Non-Reg?”

  9. I would love to borrow money to invest, because at this time my portfolio is pitifully small and will not get much added to it in the near future because of school costs. But while I understand the advantages of stocks long term I am worried about the difficulties I would have adding the interest to my expenses and if after I graduate and the loans come due if I would have to sell off the investments for a loss. While my investment time line is long term my loan timeline is not.

  10. 10. Jimmy McJimerson

    Was this post actually serious…the Rempel Maximum….. unbelievable.

  11. 11. Al

    From the post: ‘Too risky of a strategy for most people who may not be able to stomach significant down periods, especially if the investments drop below the value of the amount borrowed.’

    I don’t think the banks/trust companies will let it get there, more likely your loan gets called at that point and wipes you out if you are using the investments as collateral. The loan to any amateur is probably recourse anyway so do you really risk the roof over your head for this scheme?

    Another big big risk is rates go up. This has happened before and you can find yourself in negative cash flow situation with a declining investment base and then get called out.

    I personally have a heck of a tolerance for risk but four to one leverage is a seriously seriously risky strategy full stop. Before anyone considers this be a student of history and look at 1929 and remember the words of J.M. Keynes that the market can stay irrational longer than you can stay solvent. Beware.

    @SST I hope you stick around, you still have to come back next September and see what the result of Gold v. Stocks is…

  12. 12. DanP

    I’ll give Ed credit. He truly believes in what he says and he always gets alot of comments from the people when his posts are around. At the same time, if this is a paid post(which it feels like it is) it should be disclosed.

    But back to the ideas….i do agree leverage is a great idea but most definitly not for everyone. However, anyone talking about what would have happened 40 years ago if they investment in some stock, mutaul funds, or etf shouldnt be allowed to discuss personal finance. That’s irrelevant. Lets look at future growth potential, where we see the best ideas and most potential, and if you don’t know where to find it, go find someone who does…aka…investment in mutual funds.

    Ed, would any company(or trust) give you an investment loan that didnt require you to use their funds?

  13. 13. Bob

    Oh man, talk about misrepresenting conclusions.

    If you are going to discuss LifeCycle Investing, you need to at the very least include their provision that there are situations where it is inappropriate (contra your 99-100% statement). Ayres and Nalebuff specifically say “if you worry too much about losing money” it should not be used. In addition, you must consider the potential that there will be people who will be entirely wiped out by the strategy and will need to declare bankruptcy — but, hey, over the long-run it will all work out, so don’t worry about them, they will be fine once they hit their peak earning years and can start to repay the loans . . .

    It is all well and good for you to say “Don’t worry – trust me, it will all bounce back”, but in real life it doesn’t work that way. You would have to not only stomach, but *survive* periods in which you are wiped out (i.e., imagine if you had 200% of your savings in stocks during the 2008-2009 crash).

    The strategy, as they describe it, also involves buying on margin or using index futures, which is beyond the scope of most DIY investors. This means you would need to use an advisor and incur added fees, which, as numerous studies have demonstrated, drain much of the benefit you accrue.

    No thanks.

  14. 14. Emilio

    As enlightened as Ed can be in topic of “asset allocation” and use of leverage, I wonder why he still has to work so hard at hustling clients on the intertubes…

    One would think that by now Ed would be retired with his BILLION$

  15. @DanP, if it was a paid post, which it is not, it would be disclosed. Ed has his convictions which work for this clients, but perhaps they are not in alignment with what a lot of the pf world believes. I like having differing opinions, discussions, and debates – so long as they don’t turn into attacks.

  16. 16. Leveraged Equity Investor

    I’m always amazed at the level of disdain for Ed regarding his articles. He clearly says that leveraged a 100% equity portfolio is not for everyone. Life cycle investing has merit even if you choose not to incorporate it into your asset allocation. He is giving a point of view that adds to everyone’s options for alternate forms of asset allocation/investment choices. Just because these may not apply to your financial circumstances or your behavioral finance persona, it does not invalidate the options.

    Most readers here believe in low cost index investing with a higher portion equity bias/bond ratio, as well as the buy and hold philosophy. So why is 100% equities bad? Who cares if there may be a 30-40% decline every 10 years if we know they perform better than fixed income securities and bonds over long historical time frames 100% of the time? (as shown in Stocks for the Long Run) This should only be a concern if you fixate on short time frames or get strongly emotional during bad times despite understanding the rational behind 100% equities. 100% equities is risky in the short term, but CONSERVATIVE in the long run as we attempt to beat inflation with our retirement funds.

    I am a leveraged investor in 100% equities ~ 3:1 investment at a young age, utilizing both investment loans and HELOC. I am blessed with a reasonable amount of excess cash flow and job security. Before enacting this plan, I did careful analysis on ensuring my cash flow would cover times of increase interest up to 10% (I guerilla capitalize the interest back onto the HELOC) and ensure I was covered during times of disability etc.
    My investment loan is NOT on margin, because it may force you to sell in a down market. The investment trust companies DO NOT require you to buy their investments – anyone here can put them in ETF’s/index funds if so desired.

    I believe almost anyone can utilize the SM safely with the appropriate behavioral finance make-up to add to their retirement portfolio safely. A smaller percentage of people have enough excess cash flow to begin leverage with an investment loan if so desired. The key thing is finding the appropriate margin of safety based on your job security/not using all your excess cash flow.

  17. 17. Joe

    What about #6? The “Canadian Asset Allocation”. You put 100% of your eggs in 1 basket: housing. Spend $400,000 on a dog kennel in the sky. Housing will only go UP UP UP! Markets fluctuate; Canadian housing skyrockets forever. It’s economic fact, supported by every genius two-week-course Realtor. And don’t forget to LEVERAGE into a 30 year mortgage with 0% down through a cash-back mortgage. Leverage will definitely decrease your portfolio volatility. Don’t forget: your 3% rate will never ever go up.

  18. 18. Ed Rempel

    Hi Fit,

    I agree completely. The behavioural finance errors that most investors make is one of the biggest risks of leverage.

    Investing conservatively for income when the market is low and then investing for growth when the market is high is what most investors do – and is why most investors should not be doing leverage.

    It seems logical that you can borrow at 4% and get a tax deduction, so that the net cost is perhaps 2.5%. To make money, you only need to invest to make more than 2.5%/year long term after tax – a very low hurdle.

    However, investors that make the common behavioural finance errors usually have trouble making much of a return – even long term.

    Good point, Fit.

    Ed

  19. 19. Ed Rempel

    Hi Poor Student,

    Investment loans usually have no due date. As long as you make the interest only payments, the loan normally stays in force forever.

    Ed

  20. 20. Ed Rempel

    Hi Jimmy,

    We have quite a few clients doing leverage strategies of various types, which essentially mean they have more than 100% equities and a negative bond position. Rather than getting into variations, I included the Rempel Maximum as a category of strategies.

    In the article, I am referring to any strategy that involves long term leverage into equities.

    There are a variety, though. For example, we have quite a few clients doing the Smith Manoeuvre. While it is not a “maximum” strategy, it is still leveraging into equities – even if it is only leverage by bi-weekly investment (eg. $300 bi-weekly).

    We also have a strategy that we call the Rempel Maximum which involves trying to maintain the maximum leverage reasonably sustainable for a client. It is suitable for very few people and clearly much more aggressive than just the Plain Jane Smith Manoeuvre.

    Long term leverage strategies are suitable for some people, though, so I presented them as a legitimate option. They are suitable for people that are focused on building wealth, can tolerate a lot or risk, have the right attitude to avoid the common behavioural finance errors, and have a long term outlook.

    Ed

    Ed

  21. 21. Ed Rempel

    Hi Al,

    Most investment loans are No Margin Call Loans, so there is no risk of a margin call when the investments decline.

    With all leverage strategies, you have to deal with the margin call risk. A No Margin Call loan works, as does a secured credit line. Using a Margin Call loan or a margin account are far riskier. You must avoid being forced to sell at a low. If you leverage for 20 years and have one margin call, the entire strategy is probably a bad strategy.

    3:1 leverage is not the most extreme. It is 75% leverage. Borrowing on a credit line is 100% leverage.

    I agree with you that it must be long term. 1929 probably won’t happen again, but there will be 1 or 2 major bear markets each decade. Recovery is usually within a year or 2, but sometimes it may take quite a few years. If you do leverage, you have to be able to think long term and stay invested through it all.

    Ed

  22. 22. Ed Rempel

    Hi Dan,

    None of the trust companies we use for investment loans require you to use their investments. If they did, we would not be interested.

    It is important to look at history in order to understand how markets work over time. It may not help much in deciding where to invest today, but I find it helps a lot in keeping the right long term focus.

    For example, many people fear various things happening in the economy or around the world. When you look at history, you find that long term the stock market does okay even when the economy collapses, wars happen, government bonds go to zero, inflation goes over 100%/year, 35% unemployment and major depressions. All of these happened in the same 25-year period and yet the stock market still made more than 5%/year.

    It puts today’s moderate risks in perspective.

    Ed

  23. 23. Ed Rempel

    Hi Bob,

    I agree – you have to be able to survive very large declines. 2008 was the largest decline in 80 years, but with leverage strategies you have to be able to survive it.

    For those that stayed invested through 2008, are still invested now, plan to stay invested long term and that don’t make behavioural finance errors, 2008 was not necessarily a problem. For long term investors, you need to ride through whatever happens knowing it does work itself out eventually.

    The 99-100% success rate in the Lifecycle investing study applied to investors that followed the strategy for 30 years.

    Ayres and Nalebuff are academics, not professional investors. Their use of options to create leverage is a bit unusual, but I guess it gave them a simple assumption for the purposes of the study. It also left them with an artificial ceiling of 2:1 leverage.

    Using an investment loan would give them much more flexibility.

    Ed

  24. 24. Ed Rempel

    Hi Leveraged,

    Great comment. You clearly have your head in the right place. You have that realistic optimism, a calm & clear mind, and your entire strategy is focused on the long term.

    Leverage should work out very well for you, Leveraged.

    Ed

  25. 25. Uncertain

    I am not very experienced as an investor, but leveraging always makes me nervous. If someone is willing to lend me money, it means that they would rather get my interest payments than whatever the stock market will bring.
    Can someone explain why institutions would rather lend money to individual investors rather than invest themselves?

  26. Uncertain: What’s the stock market return? Who knows.

    What do your interest payments bring? 6%, guaranteed. Because if you don’t pay, they’re taking your house.

    Your loan is likely backed with collateral. Your stock market investments, not so much.

    ————
    I’d also like to suggest that some of the criticism of Ed Rempel here is a bit overdone. I will wholeheartedly agree with some of the comments here on disagreeing with his post (in fact, I’d say ‘he’s wrong’, because I have my own version of ‘right’ asset allocation) – but that doesn’t mean anyone needs to go rabid on him.

    In fact, and to his credit, he posts a lot of stuff that he’s thought through very clearly. that alone is better than the 97th percentile of the other financial planners out there that merely regurgitate whatever they’ve been told by corporate head office. And even if you disagree, another well thought out disagreeing opinion in this industry is worth reading if only to learn and challenge assumptions. Disagree, but don’t burn the house down.

  27. 27. Jungle

    What about correlation studies suggesting a fixed income portion helps smooth out volatility and achieve higher returns over long term?

    I think this is called the efficient frontier. There is even a chart on FWF Finiki showing that 100% equity does not result in a higher return than 20% bond 80% equity. (over long term)

    Please note, I have not read stocks for the long run.

    Also what about the effect of rebalancing which boosts returns? Like last year, one would sell bonds high and buy equity low to rebalance back to allocation.

    Thank you again for this article Ed, well done.

  28. 28. Ed Rempel

    Hi Uncertain,

    Intriguing question. The reason why a trust company would lend money for an investment loan, instead of investing in the stock market themselves, is because that is the business they are in.

    The trust company gets money from GICs and lends it out for various types of loans including investment loans. It makes a profit on the spread between the loan interest rate and the GIC interest rate (less an allowance for bad debts). That is a reliable profit every year. That is the business the trust company is in.

    If they invested the money in the stock market, they would likely make more money long term, but it would be much less reliable.

    Since their profit on the interest rate spread is reliable, they can leverage it quite highly. Most banks and trust companies are leveraged 20:1 or 30:1. The leverage allows them to make a much higher profit on the interest rate spread.

    You also have to think of their shareholders. Banks and trust companies are there to make money for their shareholders. Who would buy shares in a bank or trust company if they were investing all their money in the stock market. If the shareholders want a stock market investment, they would buy one. When they buy shares in a trust company, they expect the trust company to operate like a trust company.

    For these reasons, a trust company is perfectly happy to lend you money for a relatively low interest rate and let you invest in the stock market.

    Ed

  29. 29. Al

    Reliable returns for shareholders investing in a trust company… sounds like something I should be a shareholder of, perhaps even 75% levered into…

  30. 30. Ed Rempel

    Hi Insure,

    Thanks for the support. I appreciate it. I guess us finance fanatics stick together.

    I get asked a lot why I blog. I was just interviewed by the top industry newspaper about how I use video and social media, and they asked me what my objective was when I started blogging about 8 years ago.

    Objective? I didn’t have any objective. I just love finance and love to read about it and talk about it. I have 4 book shelves full of finance books and I’m constantly reading. I love the exchange of ideas on these blogs. I like well thought-out comments, whether they agree or disagree with me. I like it when someone agrees with me. but I also like it when someone explains a different point of view and I can learn something. I also like questions from people trying to understand.

    I can’t really do anything with posts like, “Was this post actually serious?” There is no knowledge in that question. Obviously he disagrees, but I don’t know why.

    Leverage for the long term is a different way of thinking and too aggressive for most people, but there has been a lot of interest in the Smith Manoeuvre on MDJ. It is a “leverage for the long term” strategy.

    My articles are intended to be purely educational. I also like to challenge “conventional wisdom”. I think this article is cool, because:

    - most people don’t realize there is more than one way to approach asset allocation.
    - the concept of leverage as negative bond holding.
    - asset allocation can include allocations below 0% and above 100%.
    - a 30-year view produces completely different results than a 1-year view.

    All 4 of these challenge conventional wisdom. That’s the fun part for me.

    Ed

  31. 31. Ed Rempel

    Hi Insure,

    I should add here that I am not advocating any specific one of these 5 strategies. Different strategies are appropriate for different people.

    Of course I am following one of these strategies personally, but that does not mean I think everyone else should be doing it.

    I personally follow strategy #5. It is a wide range of levels of leverage and I am personally at the high end. Probably most people should be using one of the first 3, however, since most people cannot tolerate the market level of volatility.

    Most of our clients are doing either strategy #4 or #5, but we have some clients doing all of 5. Are clients are not representative of the public. They are a lot of young, technical people looking to grow wealth. The largest group are in their 30s and 40s, professionals such as engineers, accountants and IT professionals that are looking to build wealth and to have a plan to have the retirement they want.

    Strategies #1-3 are generally more suitable for people a lower risk tolerance looking for more steady returns. They also may suit people that already are older, or people that are wealthy and are more interested in keeping it than growing it. Strategies #4 and #5 are more suitable for younger people, for professionals, for people focused on building wealth and for people with a long term outlook.

    I had to explain the last couple of strategies more, since they required more explanation.

    I’m curious – do you want to share your version of asset allocation? Should there be a 6th option?

    Ed

  32. 32. Ed Rempel

    Hi Jungle,

    Good point. When you add non-correlated assets, you can get a better return for a given level of risk. That is what the efficient frontier is about – getting a higher level of return for the risk you are taking.

    Owning both stocks and bonds does this – you can get a better return/risk mix.

    However, note 2 things:

    1. Adding bonds usually gives you a higher return for the risk level, but not a higher actual return. For example, by adding bonds, you might have a return that is 30% lower and a risk that is 40% lower. Your mix is better, but the return is still lower.
    2. The efficient frontier with a 30-year view is completely different than a 1-year view. With a 1-year view, the lowest risk is 100% bonds/0% stocks. Prof. Siegel found that with a 30-year view, the lowest risk is 71%/29% bonds. Similarly, a moderate mix for 1-year could be 70% stocks/30% bonds, while a 30-year view is 116% stocks/-16% bonds (using leverage).

    One of the most interesting things I learned in my hedge fund course was that if you add a riskier, non-correlated investment, it often reduces the risk of your portfolio. Sometimes, you can get the diversification benefit of bonds without having to take the much lower return of bonds.

    You should read “Stocks for the Long Run”, Jungle. You love investing and I think it is clearly the #1 investing book. It probably has more investing knowledge than any 5 other books. It covers a broad range of topics and is almost like a text book of investing. I don’t agree with everything, but it is full of knowledge. I would highly recommend it everyone interested in stock market investing.

    Ed

  33. 33. Park

    Siegel recommends up to 139% stocks in 2007. With a 30% margin requirement on stocks, that means with a 60% market decline, one gets a margin call at 139% stocks. In the 2007-2009 bear market, the world stock market declined 59%. I wonder if Siegel still makes the same recommendation.

    Please remember, the NZ stock market declined 60% in 2 weeks in 1987. In 2008, the Icelandic stock market declined 94%. National markets, such as the Canadian one, can be much more volatile than the world market.

    Ed would counter that the loans he mentions have no margin call. But what is the interest rate on those loans? For loan balances less than $100,000, IB charges 2.52%. For loan balances between $100,000-$1,000,000, IB charges 2.02%. The higher the interest rate, the greater the hurdle to overcome for leverage to be successful.

    For the S&P500, one can get relatively inexpensive insurance for market declines of greater than 50% by buying puts on SPY. But for other market indices, put protection is not as readily available and is not as inexpensive.

  34. This is a vibrant discussion indeed. Glad I stopped by. I am a believer in asset allocation because is provides consistency in investing through changing markets. FOMO (fear of missing out – in good times of an up market) brings emotions into the decision making process. These emotions can lead to chasing…and chasing is similar to the great fool theory (last one left holding is the one that loses).

  35. Ed,

    My version of asset allocation is clear. I only care about what works, statistically and mathematically. Everything else is voodoo.

    The book “The Pension Strategy for Canadians” by Andrew Springett is a layman’s guide to asset allocation based on modern portfolio theory. It’s a basic but clearly defined mix of equities, reit’s, bonds, etc. backed by math. All the right mix of correlated, uncorrelated, and inversely correlated selected to optimize long term returns and minimize risk. That’s what I believe is the proper mix.

    Most people don’t question the basic foundations of what they’re being told. They buy into what ‘sounds’ reasonable, which is where all the sales come into play.

    Just like the idea that at retirement one needs to change their asset allocation. What? Why is that? Oh, because it’s a shorter timeframe and one needs to invest conservatively. That’s what ‘sounds good’. But in reality a 60 year old still has a 30 year investment timeframe – sounds pretty long term to me. The only thing that changes at retirement is money being withdrawn instead of deposited – and that clearly has nothing to do with investment strategy of the base investments.That’s merely one example of the unsubstantiated stuff that’s common in the industry.

    Nothing is 100% perfect, but at least the industry could be challenged on some of the pablum they continue to serve consumers.

    And in case it’s not clear, I am not a financial advisor.

  36. 36. SPBrunner

    I have been investing in the stock market for some time. However, I never liked to borrow much. How I started out was to buy Canadian Savings Bonds on a monthly plan, cash them in in November and buy stocks with the bond money. Worked for me.

  37. 37. SST

    I see I’m not the only disagreeable “crackpot”.

    @InsureCanInc: “That’s merely one example of the unsubstantiated stuff that’s common in the industry. Nothing is 100% perfect, but at least the industry could be challenged on some of the pablum they continue to serve consumers.”

    Could be?
    SHOULD BE!
    But it’ll never happen from a place of power.
    Who’s going to challenge them?
    Their bed-mates in government?

    They’ve been pushing the same stuff for thirty years, why not keep pushing it for thirty more?

    eg.

    1982*-Current; per annum average (US figures)

    Wages: +3.5%
    Inflation: +3%

    Oil: +4%
    Gold: +5%
    GDP: +5%

    Dow: +8.6%
    US Debt: +8.3%

    Still think the “greatest bull market of all time” wasn’t COMPLETELY fueled by debt?

    If the Dow and GDP were still linked (growth of money based on growth of REAL things instead of based on smoke and mirrors), the Dow would be sitting at 4750. Let me repeat that:

    >>Dow 4,750<<

    But of course no financial industry employee is going to tell you that, not when their livelihoods depend on selling you the stock market.

    You have to break free of your own accord and study.
    Math, REAL MATH — not financial industry hocus pocus "math" — definitely supports that freedom.

    But they won't tell you that either.

    Yes, I know I said I wouldn't be back, but this kind of stuff infuriates me. Not for my own sake, I have the time and resources to do my own research; other are not. For those, I feel it a necessary service to present a TRUE picture of economics and finance, one that is most likely in bleak polarity with the "pabulum" available on the financial industry menu (and the never-down-trodden beat of this site).

    (*1982 because of the defining de-regulations which started the whole global mess)

  38. 38. Park

    About the 59% decline in the world stock market in the 2007-2009 bear market, I think that doesn’t include dividends. IIRC, with dividends, the decline would have been 56 to 57%.

  39. 39. Ed Rempel

    Hi Park,

    I agree. With leverage, you need to avoid using margin call loans and you need to be properly diversified. Some individual country stock markets, including Canada, are not really a proper holding. Canada is essentially 50% resources and 30% banks, so it can easily be argued that a TSX60 index holding should not be a core holding.

    The loss on the MSCI World index in the 2007-9 bear market was not that bad. I have monthly figures, but if you take the peak at the end of January 2007 to the trough at the end of February, 2009, it fell 43%.

    That is a short time period, though. Leverage for short time periods is very risky, but the risk is much less over long periods of time. The broad markets do bounce back consistently with enough time.

    A surprising stat is how quickly markets sometimes recover, even in worst case scenarios. If you invested $100 January 1, 1929, by the end of 1932, you would have been down to $37 – a loss of 63%. However, if you stayed invested, by the end of 1936 (only 4 years later), that $37 would have been back up to $109.

    The interest rate on a leverage loan obviously reduces your return, but does not negate the strategy. The rule of thumb is that you have to make 2/3 of the interest rate over time to break even after tax. Today, we can get a No Margin Call investment loan at 4%. 2/3 is about 2.7%, so we need to invest to earn at least 2.7% after tax long term. That is a pretty low hurdle.

    Interestingly, back in the mid-90s, I was an advance reviewer for Talbot Steven’s book, “Financial Freedom without Sacrifice” in which he advocates “conservative leverage”. His strategy is to leverage an amount so small that you can withstand a complete loss.

    The strange part is that his book used 9% as an interest rate in his leverage illustrations. You would need nearly 6%/year after tax from your investments to break even. Today’s rates are not particularly scary by comparison.

    Ed

  40. 40. Ed Rempel

    Hi Busy Executive,

    Right on. Investor behaviour is the biggest risk.

    Asset allocation does not prevent it, but it does reduce it. Investor behaviour for most investors is the worst at market extremes. That’s why it is important to stay within your risk comfort level.

    If your investments drop 40% and you switch to something more conservative, then clearly you cannot stomach the decline and you should have invested more conservatively.

    To be successful, you need to stay invested after a 40% decline. Better yet, you should become a bit more aggressive or invest more money to take advantage of the buying opportunity.

    If you use asset allocation, you can switch some bonds to cash to do that. If you are 100% stocks, you can still take advantage of it. For example, you could switch to more aggressive stocks or buy the ones that are down the most, or add to your leverage.

    Ed

  41. 41. Ed Rempel

    Hi Insure,

    Good post. I agree that there is not a real necessity for people to get more conservative at the time they retire, since they probably still have a long time horizon in front of them.

    I have not read that book, but I did look at it in Chapters. I believe it is a fixed allocation (strategy #1), but includes more asset classes, such as certain type of stocks (REIT’s, index funds and hedge funds). Is that correct?

    There is logic for a fixed allocation, since risk tolerance tends to stay constant and most investors have a long time horizon for most of their life. Even in their last decade, investors don’t necessarily know it, so they should still assume a longer time horizon in order to avoid running out of money.

    Thanks for the post.

    Ed

  42. 42. Park

    http://seekingalpha.com/article/138673-world-and-country-market-cap

    This is a source for the 59% decline number, although I think it excludes dividends.

    Markets can recover quickly, but not necessarily. IIRC, the Japanese stock market was 37.5% of the world stock market at its peak in 1989. If one ignores inflation and dividends, the Nikkei 225 is down 75.5% from its 1989 peak. Unfortunately, that’s far from the only example.

    Let’s assume a 6.5% real (after inflation) return on stocks. Let’s assume 2% is lost due to taxes. Let’s assume 2% MER on a mutual fund. With an investment loan of 4%, you’re levering a loss of 1.5%. That does not include the tax arbitrage of investment loans. But on the other hand, I’m not including the 1% that a retail investor may pay an advisor.

    If I can make 3% after inflation/taxes/costs with my investment loan (I consider that optimistic), a person who’s paying 2% more interest than me needs to lever 3 times as much to get the same return. The volatility of their portfolio will be much greater than mine. However, I am exposed to margin call risk, whereas they are not.

    About interest rates, Talbot Steven’s booklet “Dispelling the Myths of Borrowing to Invest’ states the average Canadian prime rate from 1937 to 2001 was 7.4%. At present, it’s 3%. Anyone planning to use leverage for any period other than the short term should be prepared for their interest rate to double or more.

    I myself use leverage, but I’d like to emphasize to anyone thinking about using leverage, that they have to go into it with their eyes wide open.

  43. 43. Ed Rempel

    Hi SST,

    I see. I was not sure what figures you based your conclusions on.

    First, I just want to say that I am not here to answer for the industry as a whole or for government. I just try to figure out what is happening and what are the best strategies to use.

    I’m not sure you can make macro conclusions like that based on the comparisons you used. The stock market moves long term based on the profits of the companies in it. If you ask business owners how much of their profit results from an inflated economy caused by government printing money, most will say not much.

    There are many things that affect corporate profits – new products, new markets, new technologies, competition, cost cutting, employee/labour issues, international trade, demographics etc. Most of the companies in the S&P500 do a lot of their business outside the US. The macro economic issues such as interest rates and inflation are just a couple of many.

    That is why the economy and the stock market are not at all correlated. Contrary to popular belief, in general countries with faster growing economies tend to have slower growing stock markets. and vice versa. Check out the article: http://www.milliondollarjourney.com/why-the-long-term-growth-of-the-economy-is-not-relevant-to-investing.htm .

    You might have a point about the US debt inflating the economy, but there seems to be little correlation to the stock market. From 1945-80, the US debt declined (after inflation), but since 1980 it has grown exponentially. If you compare the stock markets in these 2 periods, you find the growth is similar. Companies tended to grow their profits roughly similarly when the government debt declined and when it expanded.

    With proper spending controls, debt normally rises faster than inflation. Economists generally say that government debt should rise by roughly inflation plus population growth. If you have 3% inflation and 2% population growth, then a 5% increase in government debt should not increase the drain on the economy.

    The comparison of the DOW to GDP is also not a very useful comparison. As an accountant, I can see this. GDP is the total of all production by companies & government, so it is kind of like gross sales. The stock market normally trades at around 15x earnings, so that is 15 times the bottom line.

    This is easier to understand if you think of your personal finances. How correlated would your gross salary be to 15 times the cash left over at the end of the month?

    If you get a 10% raise:

    1. Many people would spend the entire thing, so 15x the money left over would be zero. That would mean salary (GDP) up 10%, while 15x money left over (DOW) would be zero.
    2. In theory, if your expenses stayed the same, if you saved 10% of your salary before and your salary went up 10%, then you should be able to save and additional 10%. 15×10% would be 150%. In this case, a 10% increase in salary (GDP) should be able to create a 150% increase in the DOW.

    My point is that there is no correlation. If you look at the graph here: http://www.milliondollarjourney.com/why-the-economy-is-not-relevant-to-investing.htm , you will see how GDP and the stock market are not at all correlated.

    It is strange. Most financial pundits make comments about where the stock market might go based on what is happening in the economy. That is silly. The stock market is the head and the economy is the tail. You cannot predict where the head will go by studying the tail.

    If you look at the long term growth of the stock market, your prediction would result in the worst stock market ever – even worse than during the Great Depression and WWII, when unemployment hit 35% and a few major countries’ bonds went to zero (Germany, Italy, Japan, Russia). You need to realize how extreme that forecast is.

    The stock market historically trades at about 15x profits. That tends to be higher in low inflation environments. Today, it is at 11.7%, which is quite low. Your forecast would bring it to between 3-4%, which I believe would be the lowest in history.

    I’m not sure what would compel investors to sell stocks that cheaply. Let’s take an example. The largest company in the S&P500 is Exxon. It is trading at $85 and has a dividend of 3.25%. A fall of 75% from here that you are forecasting would mean Exxon would fall to about $20 and the dividend would be almost 15%.

    With interest rates at 2%, what would possibly make stock market investors demand a 15% dividend from Exxon?

    The same story would apply to many other companies.

    I understand that you are very suspicious of the entire financial industry and the government, SST, but your forecast seems to be extremely unlikely to me.

    Far more likely would be that the stock market would return to its historical norm of a P/E of 15%, or possibly 20% since interest rates are so low. That is the average the investors have been willing to pay for companies through everything that has happened in the last 150 years, so it seems likely.

    That means the S&P500 is undervalued by 30-70% today.

    Ed

  44. 44. SST

    @Ed: “If you invested $100 January 1, 1929…”

    Invested in WHAT EXACTLY???

    If you are alluding to investing in the Dow index, please detail how someone could have done that in 1929. Thanks.

  45. 45. Dave

    SST,

    I think Ed just owned-you in his last post. Your predictions are wild and delusional…You would be wise to continue to read this website; it appears you still have a lot to learn

    Dave

  46. 46. Jungle

    Ed is using that as an example. We know dow jones index funds did not exist in 1929.

    But going forward we can make an educated assumption by looking at historal returns.

    If the market has returned XX % over the last 100 years, with evidence I would agree this could be used as a guage for the possible future retuns.

    Is there another way to guage and measure past performance?

  47. 47. Jungle

    Ed I was wondering if you could comment on this. I am having a discussion on the RFD forum regarding fixed income in a portfolio.

    I said that a mixture of 20% gov bonds and 80% equity can beat 100% equity, because during bad years, bonds really help to pull averages up. I remember reading about this in Asset Allocation for Dummies.

    Another poster is saying that 100% equity has always beat bond returns over long term (50 years on Andex chart) and bonds will always lower the portfolio return.

    Here is a chart showing some returns from 1972 -2008.

    http://www.finiki.org/wiki/Portfolio…d_Construction

    100% equity gave averaged yearly return of 9.4%, or 7.6% yearly compounded

    80% equity, 20% bonds gave 9.9% average return, or 8.8% yearly compounded.

    What do you think?>

  48. 48. SST

    @Dave: Ah, so now it’s about being “owned”? Thanks for writing from high school! LOL! I don’t care about being “owned”, I care about presenting facts which the financial industry does not, for whatever reason.

    (remind me to let you in on a great scheme Investors Group like to play with their customers!)

    As for my predictions…exactly what did I predict?

    The statements I made are no more delusional (actually far, far less) than what has actually transpired across the financial globe. My guess is that most people are too busy or too remiss or too indifferent to do serious digging into the facts and figures beneath the surface.

    It’s merely a game of how long the gov’ts can subdue the MATHEMATICAL inevitability.

    @Jungle: Ed (et al) is using a HYPOTHETICAL when referring to any pre-1973 index investment. Why use a FABRICATED situation instead of a FACTUAL scenario?!? Can I give my broker one million hypothetical dollars to invest and tell him I want my return in REAL dollars?

    Anyway, I’ll return to Ed’s posting when I have more time, hopefully the weekend(?).

  49. Jungle,

    I would expect equities to beat bonds in the long term…but a proper mix of both and other investments can beat equities AND lower the volatility. That’s why you want the proper mix.

    Say you have 50-50 allocation, $100 in equities, $100 in bonds. Assume they are inversely correlated (equities go down, bonds go up. Yes, I am making this stuff up).

    Equities crash 40%, bonds go up 20%. Now you have $60 in equities, $120 in bonds, total of $180. Your RFD buddy (this is why you don’t go there for investment advice) has $160 – they have less.

    Now rebalance to keep your 50-50 mix. Move money from bonds to equities, you now have $90 in both equities and bonds. Now equities go UP 10% and bonds go down 10%. You now have $99 in equities and $81 in bonds, total $180. Your RFD buddy in equities has $176. Again, you have more money.

    You earned more money, and had a more stable rate or return – removing some of the wild swings.

    My scenario is utter nonsense from a math perspective, but illustrates the basic idea that a proper asset allocation mix of inversely correlated and non-correlated investments can both increase the rate of return over straight equities AND lower the volatility.

    The trick is, what mix? And again, I point out that I prefer something based on mathematics and statistics rather than theorems that are based on emotions. Which is why I’m all for the mix indicated in the book I mentioned above.

  50. 50. Andrew F

    All of the trust companies I looked at seem to require that you invest in a given list of MFs. Can someone provide examples of a company that does not do this?

    And while loans may not be margin loans, they do seem to be all demand loans, where the lender can call the loan at their discretion, which could happen at an inopportune time.

  51. 51. Jungle

    Thank you for that explanation Insurecan. I remember seeing the math in Asset Allocation for Dummies and was surprised to learn what corelation can do to boost portfolio returns- just like your example.

  52. 52. SST

    FUN with FACTS!

    @Dave re:#45 — “Your predictions are wild and delusional…”

    My “prediction”, as you like to label it, calls for a reality-checked Dow 4,750 — down 63% from current levels.

    Think a 63% drop in valuation is “wild and delusional”?
    Let’s take a look at…HISTORY!

    Top-to-Bottom Losses in Stock Market History
    (ready, Dave?)

    DJIA (1906): 103 – 54; -48%
    DJIA (1929): 381 – 41; -63%
    DJIA (1937): 194 – 93; -52%
    DJIA (1973): 1,050 – 580; -45%
    DJIA (2007): 14,000 – 6,600; -53%

    S&P (1929): 32 – 4; -87.5%
    S&P (1937): 19 – 7.5; -60.5%

    NASDAQ (1972): 133 – 55; -59%
    NASDAQ (2000): 5,100 – 1,200; -76%

    FTSE (1973): 540 – 160; -70%
    FTSE (1999): 6,900 – 3,500; -50%

    Nikkei (1989): 39,000 – 9,400; -76%
    Hang Seng (2007): 31,600 – 11,000; -65%
    Shanghai (2001): 2,200 – 1,000; -55%
    Shanghai (2007): 6,000 – 1,700; -72%

    That’s a small sampling with an average decline of -62%!

    Yup, my so-called “prediction” of a -63% decline is pretty delusional! LOL!

    Go study some history, Dave.
    It’s just packed full of “wild and delusional” stories for your enjoyment!

  53. 53. SST

    Oop!

    Almost forgot these wild FACTS:

    S&P (2007): 1,560 – 675; -57%
    NASDAQ (1973): 136 – 55; -59%
    NASDAQ (2007): 2,860 – 1,270; -56%

    So real they are delusional! :)

  54. 54. Park

    I looked at the 1994 edition of “Stocks for the Long Run” by Jeremy Siegel. For those whose risk tolerance is minimal, conservative, moderate and high, he recommended 72.1%, 91.8%, 115.5% and 134.6% stocks respectively. But that is for those who have a 30 year horizon. If one assumes retirement at age 65 yo, that means those who are 35 yo and less. For a 10 year horizon, recommendations are 40%, 62.3%, 87.9% and 106.9%.

  55. 55. Ed Rempel

    Hi Park,

    The 59% loss you referenced is world stock market cap, not performance. Market cap would have also fallen because, as usual, many investors panicked and sold at the market low.

    The market decline was 43%, so the other 16% must have been the value of shares sold.

    In your leverage scenario, if you borrow money to invest, you don’t need to subtract inflation, tax or the 1% for the advisor.

    It does not make sense to subtract inflation from the investment return. If you borrow money to invest, the debt is not growing by inflation, so there is no need to subtract inflation from the investment.

    Let’s say your investment makes 8%/year long term. In the last 75 years, that is the lowest return for the S&P500 for a 25-year period.

    You can subtract 2% MER, if you assume that your fund manager has no skill. That would probably apply to the majority, but not all fund managers.

    Then you have 8% return – 2% MER =6%. If your loan interest rate is 4%, then you have a 2%/year profit.

    In addition, you should get tax refunds almost every year. The 4% is fully deductible, while the the gain of 8% is a capital gain that you can defer many years into the future, if you invest tax efficiently. Even if there was no deferral, the 8% capital gain would be a 4% taxable gain, which would be fully off-set by the interest rate deduction.

    In other words, there is no need to subtract tax, since you should get refunds almost every year and should net no tax in the long run.

    The 1% some people pay their advisor is usually part of the MER. In general, an MER includes 1% for the advisor (and his dealer), 1% for the fund manager (and fund company) = 2% + HST = 2.26%. That is how most of the MER is generally arrived at.

    For example, we do Fee-based accounts for larger clients where we charge 1% to the investment which is tax deductible to the client. If we do, then we buy Class F funds that have a lower MER and don’t pay any compensation to us.

    Ed

  56. 56. Ed Rempel

    Hi Jungle,

    Interesting question. Here are a few thoughts:

    1. Stocks have always outperformed bonds long term. Jeremy Siegel found that stocks beat bonds 100% of the time for 30-year periods. He also found that the highest return (not lowest risk) was 100% stocks, regardless of whether he looked at 1-year, 2-year, 5-year, 10-year, 20-year and 30-year periods.

    2. The period you showed is not representative. Bonds have gains when interest rates decline and losses when they rise. Bond rates were close to 20% at the peak in 1982 and have declined almost every year since. After inflation, US long bonds made zero from 1900-1982, but then rose 400% from 1982 until now.

    Bonds actually had stock-like returns since 1982 while rates declined from close to 20% down to about 2%. You can’t use that period as representative.

    3. Jeremy Siegel just compared returns. A good asset allocation should involve rebalancing back to the target allocation periodically, say once a year. If you do that, you may have higher returns, since you may put more in stocks after they decline. That means there MIGHT be a benefit.

    4. Most investors do the opposite of good rebalancing. When the markets are down they sell stocks and buy more bonds “until the market recovers”. It would take discipline to get gains of rebalancing, since it would always mean selling the better-performing investment to buy the lower performer.

    5. Bond returns are much consistent than stock market returns long term. The S&P500 has always made more than inflation after 20 years. Bonds, on the other hand, have had periods of 20 and 30 years, and even periods of 80 years with no gain above inflation.

    Stocks consistently go up long term, but bonds sometimes do and sometimes don’t. They tend to perform very badly when there is inflation.

    I have not seen a good study of a representative period assuming regular disciplined rebalancing. There should be one. My guess is that it would show that sometimes it works and sometimes not, but probably most of the time it would not work.

    Stock market returns normally are so much higher than bonds and bond returns are poor in inflation, my guess is that a small amount of disciplined asset allocation might work in low inflation environments, but would not work if there is significant inflation

    Ed

  57. 57. Ed Rempel

    Hi SST,

    Stock market returns are not hypothetical. Just because you could not buy an index fund in 1926, the lessons of what the stocks in the index did at the time are still very useful for understand how stock markets work.

    In 1926, the S&P was 90 companies. You could have just bought the 90 companies, if you wanted the index return.

    I’m not sure where you got your stock market figures, SST. We normally ignore the DOW. It is a price-weighted index, not cap-weighted like the S&P. The DOW can have weird results sometimes, especially when a large company has a stock split.

    The S&P500 is recognized as the definitive index for US holdings.

    Anyway, here are the correct returns for the S&P500 for the periods you mentioned:
    Actual
    DJIA (1906): 103 – 54; -48% +.64%
    DJIA (1929): 381 – 41; -63% -9.46%
    DJIA (1937): 194 – 93; -52% -32.11%
    DJIA (1973): 1,050 – 580; -45% -15.03%
    DJIA (2007): 14,000 – 6,600; -53% +5.46%

    S&P (1929): 32 – 4; -87.5% -9.46%
    S&P (1937): 19 – 7.5; -60.5% -32.11%

    The figures you used don’t consider dividends, but does not fully explain the difference in results.

    Ed

  58. 58. Ed Rempel

    Hi Park,

    Did you enjoy the book?

    Just one point. Your investment time horizon should include almost as long as you expect to live. It does not stop when you retire.

    At that point, you stop adding new investments and you start taking some income from your investments. Normally, in a retirement plan, you have most of your investments until 5-10 years before you die. That is normally until you are in your late 80s, since you should plan for only a low chance of running out of money.

    Ed

  59. 59. Park

    I don’t know where you’re getting the 43% number for the 2007-2009 bear market. Below is a link from Allan Roth giving a 55.2% decline for the American market. I don’t know if that includes dividends or not. If it did exclude dividends, it still would be considerably more than a 43% decline with dividends included.

    http://www.cbsnews.com/8301-505123_162-57381089/stocks-start-week-one-percent-from-all-time-high/?tag=mncol;lst;1

    Inflation has an effect on any investment, with the exception of inflation indexed securities such as real return bonds. What matters for any investor is return after subtracting inflation, tax and costs.

    The 6.5% real return (after inflation return) for stocks in the future is based on the historic 7% real return that researchers, such as Jeremy Siegel, have found for American stocks. However, many think the 7% return will be lower in the future. The cost of stock trading, such as commissions and bid-ask spreads is lower than it formerly was. The 7% return doesn’t include those costs. That 6.5% real return is realistic and possibly optimistic.

    That 6.5% after tax return applies to all investors, both levered and unlevered. We’ll ignore taxes; I’ll come to that later. Assume 2% paid in MER and assume that includes the cost of advice. So the unlevered investor is going to make 4.5%. Then subtract 4% interest. You’re down to 0.5% return for the levered investor. If HST was included on the 2%, the return is 0.24%. That 4% interest represents prime + 1%. The prime rate is presently low by historical standards. I certainly hope that the prime rate stays at 3% for the next 10-25 years, but I doubt it will.

    Your case for levered investing relies heavily on the tax arbitrage argument. Interest is fully deductible against income. Investment return is taxed less than income and can be deferred if in the form of capital gains. First of all, capital gains deferral is not a strong feature of many actively managed stock funds. In fact, there may be little deferral of capital gains. Secondly, part of stock return is from dividends. Right now, dividend yield on the S&P500 is 1.94%. Recently, dividends as a % of return has been low by historical standards, but the usual is in the 30-40% range.

    http://www.multpl.com/s-p-500-dividend-yield/

    Dividends on foreign stock are taxed at the level of income; they do not receive preferential treatment. Interest on investment loans is deductible, but the effect of that depends on your marginal tax rate. There are many Canadians for whom that deductibility would have a modest effect at best. Finally, there is the assumption that interest on investment loans will continue to be fully deductible. That is an assumption; tax laws are not always as favorable elsewhere. From what I understand, such interest is deductible only against investment income (dividends, interest, realized capital gains) in the USA.

    About one’s investment time horizon including almost as long as you expect to live, I would agree with that with one exception. When it comes to debt, I’ve never heard anyone recommend that one should enter retirement with an investment loan. Moshe Milevksy in “Are You A Stock Or A Bond” advocates leverage at age 45. But at 55, none of his model portfolios include leverage. In fact, his most aggressive portfolio at that age includes 15% bonds. In “Lifecycle Investing”, Ayres and Nalebuff also advocate the use of leverage. At 10 years prior to retirement, none of their model portfolios include leverage. Yes, Jeremy Siegel recommends leverage at 10 years prior to retirement, but to a maximum of 107%.

  60. 60. Park

    The criticism of my last post would be that I didn’t lever the final investment return. In the example, that was 0.5%. So if you have a 400% leverage ratio, your return would be 2%.

  61. 61. Park

    I tried to add to the last post, but it was too late. Jeremy Siegel doesn’t mention retirement. He mention time horizons, and he recommended a maximum of 107% stocks for a 10 year time horizon.

  62. 62. Ed Rempel

    Hi Park,

    My point in your leverage illustration was that you deducted inflation and tax from the investments, but not from the investment loan, and you double-counted the advisor compensation.

    In a leverage illustration, you should not deduct inflation, since you make money if the investments grow more than the loan. The loan is not growing by inflation.

    Also, you should not deduct tax because with your figures, there would be tax refunds. You need to add the refund, not deduct the tax.

    Ed

  63. 63. Ed Rempel

    Hi Park,

    A 10-year time horizon would generally apply to an 80-year-old. At age 80, you have a 50% chance of living another 10 years.

    If you want to reduce your risk of running out of money to 20%, then a 10-year time horizon would apply at age 87. At age 87, you have a 20% chance of living more than 10 more years.

    With retirement planning, time horizon refers death, not retirement. The issue is how long you need your money to last, not when you begin taking income.

    Ed

  64. 64. Park

    Assume an 8% return. Assume a leverage ratio of 150%, so your return with leverage is 12%. The loan was used to buy more mutual funds, and one will pay the MER on those mutual funds purchased with borrowed money. Assume 2% MER, so the unlevered/levered return is 6%/9%. Assume inflation of 3%, so the unlevered/levered return is 3%/6%. Assume 4% interest rate so the unlevered/levered return is 3%/2%.

    So in that scenario, you’ve lost money with leverage. One can make the case that a 5% real return, which is what this scenario assumes, is an underestimate. But one can also make the case that the 4% interest rate is an underestimate.

    My point is that the average annual return on stocks after expenses/inflation/taxes is in the single digits. With leverage, one may increase that return. But with a 4% loan as a handicap, it’s not a slam dunk. Unfortunately, the increased risk is a slam dunk.

  65. 65. Park

    My preceding numbers are wrong. Assume 8% return. Based on the assumptions of my last post, return will be 3% ignoring taxes if unlevered.

    Assume you borrow to invest. You gets an 8% return on the borrowed money. You pay 4% interest on that money. You pay 2% MER on the borrowed money. So your return on the borrowed money is 2%. With a leverage ratio of 150%, your return on your original capital is 4%.

  66. 66. Andrew F

    Park, there are a few flaws with your analysis.

    One, you assume that investors have to pay 2% MER. This is flat wrong. MERs from broad equity index ETFs are generally sub 0.2%. Once annual rebalancing/contributions might cost a few basis points for a reasonable sized portfolio. An investor can choose to pay 2% MER, but that is a suboptimal investment decision.

    Two, you use real equity returns and subtract from this nominal interest cost. Prime+1 is currently equivalent to 2% real. This is a low rate by historical standards, to be fair. Also, investors could well have access to lower cost sources of financing, such as a mortgage secured against a home, at real rates of as low as 0.15%. Interactive Brokers offers margin rates starting at Prime-0.5. You could have assumed that an investor financed the investment loan using a credit card, but that also would have been suboptimal.

    Three, you subtract taxes from the return but make no accounting of the income deductibility of the loan interest. If the nominal return assumed is 8%, a realized capital gain would be included at 50% in income, reducing the income to 4%. Subtract the interest cost from income at 4%, and you are left with 0% of the investment as a net increase to income. Thus the net tax effect is zero, regardless of the marginal rate. Adding dividends complicates the math, but the end result is largely unchanged. In this case, the investor is left with a after-tax 4% real return on borrowed money, vs 6% pre-tax return on an unleveraged investment. At the top marginal rate in Ontario, the real after-tax return would be slightly better than 4%.

    It seems unlikely that the tax treatment of investment loans will change substantially as it would have some serious unintended consequences. Your argument that this tax treatment could change is weak, and speculative. It is possible that tax law might be changed to make leveraged investing more favourable, but I don’t think this outcome is likely either.

  67. 67. Andrew F

    By the way, characterizing investment loan interest deductibility as tax arbitrage suggests that it is a risk-free transaction. I would argue that the investor is taking significant risk and is being compensated for that risk.

  68. 68. Park

    I use low cost broad equity index ETFs myself. But the mutual funds that I suspect Ed uses are actively managed funds with higher MERs. OTOH, Ed still has the possibility of beating the market, whereas I don’t.

    I have a margin account with Interactive Brokers and pay 2-2.5% interest for my investment loan. To present both sides, Ed pays a higher interest rate than I do, but there is no risk of margin call with his loans, unlike myself.

    In my last post, I use nominal equity returns and nominal interest rates. I also ignore taxes.

    Let’s assume one invests $100. Assume MER is negligible, so we’ll ignore it. Assume 8% nominal return all in the form of realized capital gains. For someone in the top Ontario marginal rate, your aftertax return is 6% or $6.

    Let’s make the same assumptions, but also borrow $100 at 4% interest. On one’s principal, the return is 6% or $6. On the $100 loan, the after tax return is 4% or $4 as you point out. So your total return on the original $100 is $4 + $6 or $10 (10%).

    As you mention, in this scenario, marginal tax rate is irrelevant. But assume that investment return is 0%. In that case, the marginal tax rate is relevant.

    About the impact of dividends, eligible Canadian dividends are unlikely to significantly change the end result. But foreign dividends, especially for those who focus on dividend investing, will have a greater impact than eligible Canadian dividends.

    About interest deductibility of investment loans, it may be a weak and speculative argument that the deductibility could change. However, levered investing is usually recommended for those with at least a 10 year time horizon. Tax laws do change, and an investor using margin must acknowledge the possibility. Please remember, there are Canadian investors who can remember when capital gains were not taxed.

    About the term tax arbitrage, that is a term that I have heard used to describe the full deductibility of investment loan against income, whereas the investment return may be taxed at lower rates than income and tax might be deferred if capital gains.

    Leverage is no way a risk free transaction. The investor is taking greater risk for greater expected return. That’s the point of my posts in this thread: people should think about this carefully. IIRC, Charles Ellis in “Winning the Loser’s Game” states that he has seen many fortunes lost to leverage. I once calculated the leverage ratio required to get a margin call in the Depression, and it was around 113%.

    Thanks to all who responded. Criticisms are most welcome. I would rather make free mistakes on blog sites than real mistakes in my account.

  69. 69. Park

    “As you mention, in this scenario, marginal tax rate is irrelevant. But assume that investment return is 0%. In that case, the marginal tax rate is relevant.”

    The above comment in my last post only applies to the investment loan portion of the investment.

  70. 70. Leveraged Investor

    Hi Park,

    I don’t understand your comment regarding inflation.
    Beating inflation is a factor for all investment classes – GIC, bonds, stocks etc and applies to both leveraged and unleveraged investments.

    Why are you applying an inflation cost to the loan? My loan does not grow by inflation yearly…..in fact I would make the opposite argument that my loan is a hedge against inflation.

    If I borrow $300,000 now and invest in compound growth and choose to never pay any principal for 30 years, chances are that the $300,000 has much less purchasing power than it did previously.

    Yet if I choose to pay the loan in full at that time, I am likely paying with wages that have increased secondary to inflation and my investment has had 30 years to attempt to beat inflation and have the compound growth effect on top of this.

    The reality is your biggest risk with leverage is
    1) poor behavioral finance
    2) insufficient cash flow to compensate for higher interest rate environments
    3) margin call loans – being forced to sell in a declining market

    Leverage is employed by all home-owners in Canada – why do they not go bankrupt and it ends up being the best financial decision of their lives?
    This is because the above risks are ameliorated:
    1) There isn’t a constant stock ticker for your home and it is a relatively illiquid investment
    2) people will ensure sufficient cash flow and pay their mortgage first – plus the option to fix payments
    3) it is essentially a no margin call loan – the banks never really test your equity:debt ratio

    Leverage can be part of a conservative strategy when done with a long time horizon if employed properly, especially for someone who is at risk of insufficient retirement funds when employing traditional “risk-free” retirement planning

  71. 71. Park

    In my last few posts when I determined the effect of leverage on investment return, I ignored inflation.

    I agree with you that an investment loan is an inflation hedge to some extent. On the other hand, it exposes one to the risk of deflation. In the Depression, there was around 25% deflation. I am not an economist, but from what I can see, deflation isn’t a significant issue since going off the gold standard.

    For the appropriate investor, there is a role for leverage. It increases the risk of a portfolio. However, it may decrease the risk of insufficient retirement funds. And Ayres and Nalebuff make the case that it may diversify retirement saving across time, so one relies less on the stock market return between ages 50-65.

    But I beg to differ when you describe leverage as a conservative strategy. With leverage, the risk of irreversible loss increases. One bad year can erase the benefits of 25 years of leverage. I have heard the analogy of leverage to dynamite. Used appropriately, dynamite or explosives have an important role in construction and mining. If used inappropriately, they can hurt those using them.

    The risks of leverage are investor dependent. Based on research results, most retail investors have a tendency to buy high and sell low. Leverage will make that worse. In other words, an investor should think very carefully before embarking on a levered strategy.

  72. 72. Ed Rempel

    Hi Park,

    Here is how I see an illustration. Let’s say you borrow $100,000 to invest.

    What is a reasonable long term return assumption? The long term return of the global, US and Canadian indexes since 1950 has been between 10-12%. We are in a low inflation environment, which may or may not make returns a bit lower. Let’s assume a long term average of 8-10%.

    We normally use an 8% return in an equity portfolio in a financial plan, to be conservative, even though we expect to make 10% or more. That is the long term index return and all our fund managers have beaten their index over the last decade, since inception and over their career.

    Investors could use an ETF or index fund. If they use a fund manager, they should choose one that they think will beat the index – either with a higher return or if they want lower risk, on a risk/return basis. So we can ignore the MER.

    Let’s be conservative and use 8%. That means an average year would have growth of $8,000.

    If you are in a 50% tax bracket, there would be $2,000 tax. However, most likely most or all of that tax is paid many years from now when you sell. We try to use very tax-efficient mutual funds (usually corporate class), so we would expect to pay very little tax on the growth until we sell, which could be 20 or 30 years from now.

    If the leverage is part of your retirement plan, then the tax on the investment income could be paid bit by bit over 30 years starting 20 years from now.

    That means the $8,000 growth can compound on itself for a long time, and then the $2,000 tax can be paid much later.

    For simplicity, let’s say we pay the tax now. That means you have $6,000 after tax.

    If the loan interest is 4%, then you pay $4,000 in interest. With your 50% tax bracket, you get a refund of $2,000, so the after-tax cost of the investment loan is $2,000.

    That leaves me a net profit after tax of $4,000.

    This would be $6,000 if your investments average 10% long term. It would in practice also be $6,000 in most years, with the $2,000 tax on the investment profit to be paid years from now.

    I do definitely agree that this is a high risk strategy not suitable for most people. Most investors mess up their return with common behavioural finance mistakes and may have trouble maintaining their strategy through big bear markets.

    I think the return in the illustration if you do this strategy over a long period of time – at least 20 years. In short periods of time, market returns can be far higher or lower, so this would be a much riskier strategy. The risk reduces significantly if it is a long term strategy.

    Ed

  73. 73. Ed Rempel

    Hi Leveraged Investor,

    I agree. There are different risks. Risk is usually measure by investment ups and downs (standard deviation). A better measure is the risk of permanent loss (ignoring market fluctuations).

    The most important risk is the risk of failing to have the retirement you want. Leverage is almost always part of a retirement plan for us. You could miss your retirement goal because your investment lost money, but you could also miss it if you invest too conservatively.

    I agree with you that GICs and bonds usually have an extremely high risk of failing to have the retirement you want.

    Leverage can have a high risk of fluctuations, which declines a lot over time. However, leverage for many people can reduce the risk of failing to have the retirement they want.

    Ed

  74. 74. Ed Rempel

    Hi Park,

    A better analogy for leverage would be a power tool. That would fit better than dynamite.

    A power saw can cut a board much straighter and cleaner than a hand saw. But you may be scared to use a power saw, or if you use it incorrectly you can hurt yourself badly.

    Leverage is similar. It can get you to your retirement goal much straighter and cleaner than just investing your hard-earned dollars bit by bit as you earn them. But you may be scared to do leverage, or if you use it incorrectly (common behavioural mistakes) you could hurt yourself badly.

    One more point. It would be very unlikely for the tax rules on interest deductibility to change. The same interest deductibility rule is also used:

    1. By business owners to invest in their businesses.
    2. By companies to buy plants and equipment to setup their operations.

    Remember also that you claim the interest as a deduction, while the bank is taxed on that interest as income.

    I’m not saying it is impossible, but it would be extremely unlikely. In fact, the government supports people investing, starting businesses, buying equipment, etc. CRA expects to collect tax on your investments in the future. With long term average returns, your investments would quadruple over 25-30 years, in which case CRA could eventually collect more tax than it pays out in refunds.

    This is similar to the RRSP deduction. CRA pays huge amounts in tax refunds every year related to RRSP contributions, yet it expects to collect more tax from you in the future when you eventually cash in.

    Ed

  75. 75. Andrew F

    Ed, you said that the trust companies you use offer no margin call loans, but all the ones I have looked at offer demand loans that can be called at any time. Do you have examples of trust companies that do not have such demand loans?

  76. This was a comment by park that was filtered by spam:
    ———————
    Park:

    “Industrywide, margin lending totaled $234 billion in February, down from a peak of $381 billion in July 2007, but up from $173 billion in February 2009.”

    http://investorshub.advfn.com/boards/read_msg.aspx?message_id=49392641

    I believe the February referred to here is that of 2010. Peak margin lending was greatest near the 2007 peak, but had decreased 54% close to the 2009 nadir. I am talking about the 2007-2009 bear market. In other words, margin borrowers tended to buy high and sell low, doing the opposite of what they should have done.

    http://www.investmentreview.com/files/2009/12/leveraged_portfolios1.pdf

    Above is a link to a research study on leverage in the Canadian stock market from 1950 to 2001. Mean annualized return was 12.42%. The average Government of Canada 91 day T bill rate was 6.15%. It assumes the interest rate on the investment loan is 2% higher than that rate. At present, the T bill rate is 0.93%. So the study implies that one would lend money at 2.93% presently.

    The study has weaknesses. It ignores the tax arbitrage aspect of margin lending. An investor should have exposure to foreign markets, with that diversification decreasing volatility; volatility hurts leverage. But this study only looks at Canadian stocks. Finally, the leverage ratio is kept constant by monthly rebalancing in this study. Such rebalancing will result in a tendency to buy high and sell low, and it also increases the risk of permanent loss.

    OTOH, expenses associated with investing, such as commissions, bid ask spreads, market impact costs (very unlikely to be an issue for an individual investor) and MERs are ignored. Also, there was no margin call risk in this study. Finally, the interest rate charged on the investment loan is lower than what some investors are presently paying.

    This study found the the results of leverage are not as impressive as one would like. Once you got past a leverage ratio of 150%, leverage became counterproductive. Other studies have also come to the conclusion that too much leverage hurts more than it helps.

  77. 77. Leveraged Investor

    This study has other significant biases.
    It time frame up to 2001 captures at the end a huge decline in the TSX based on the internet bust and Nortel falling. The height of 2000-2001 was a peak of irrational exuberance for individual investors with many amateur investors believing they had mastered trading internet stocks.

    After reviewing the study, I don’t see any mention of it being with no margin call risk. Without knowing any statistics, I would assume most leverage is done through margin accounts. These are easier to acquire than no margin call loans and often used in online brokerage accounts. This will lead to a significant skewing of results in my opinion, given many leveraged margin call loans would be forced to sell in 2000-2001 at lows.

  78. 78. Park

    It mentions in the Endnotes at the end of the paper that Figure 1 does not consider margin calls.

  79. 79. Park

    About there being bias in the end point of the study, consider the starting point of the study, February 1950. From February 1950 to January 1951, the Canadian stock market went up 50.6%. So there is a bias against leverage at the end point of the study, but a bias towards leverage at the starting point of the study.

    http://www.tradingeconomics.com/canada/stock-market

  80. 80. Park

    There is another bias in favor of leverage in this study. The longer one levers, the better leverage will look. Very few investors will use leverage over a 51 year period.

    The most important result of this study for me is that after a certain degree of leverage, the increased return associated with more leverage is small. In this study, after one goes past 130% leverage, it’s debatable whether further leverage is worthwhile. Of course, that 130% number depends on the assumptions of this study. Whether that 130% number is relevant to me, I’m not sure.

    But if one looks at those who recommend leverage, it is interesting that a maximum of 125% is not an uncommon recommendation. On an internet discussion board, I remember reading a post, in which someone has read annual reports written by Warren Buffett back in the 1960s. In that post, it stated that Warren Buffet wrote that he used leverage, but to a maximum of 125%. Of course, one should take anything written by an anonymous internet writer with a grain of salt :-).

  81. 81. Andrew F

    Park, I would say that assuming monthly rebalancing to maintain the leverage ratio is effectively the same as margin calls in a dip. If I were to use a leverage strategy, it would probably involve dollar value averaging, not maintaining maximum leverage during peaks (buying high) or selling at lows to reduce the leverage (selling low). I would expect this assumption to have a large impact on the performance of the strategy.

  82. 82. Park

    Long term use of leverage is not straightforward.

    One can treat leverage as similar to lump sum investing. For example, one starts off with 130% leverage. One then adds no further leverage, and with time, the leverage ratio will decrease. For those using leverage long term, this might result in underuse of leverage.

    In this paper, the authors rebalance to maintain the leverage ratio. But as you mention, rebalancing results in buying high and selling low.

    I’ve never heard anyone recommend value averaging, when it comes to leverage. The portfolio balance increases by a set amount. If the portfolio is doing well, one decreases the leverage ratio. If the portfolio is doing poorly, one increases the leverage ratio. It does get around the problem of buying high and selling low.

    However, the amount of leverage could be volatile. Assume at the peak in 2007, your leverage ratio was 100%; you are not using any leverage because you are at your predetermined goal. At the nadir in 2009, your leverage ratio would be 222%. I wouldn’t be comfortable with such a leverage ratio.

    One way to decrease the volatility of the leverage would be to look at it as a stock; fixed income portfolio. Bonds are positive fixed income; leverage is negative fixed income. So when the portfolio is doing better than expected, the fixed income is in the form of bonds. When the portfolio is doing worse than expected, the fixed income is in the form of leverage. However, this would result in bond ownership. If you have a 20+ year time horizon, one can make a good case for no less than 100% stocks.

    About the optimal leverage ratio, obviously one size does not fit all. However, stocks have significant volatility. Any investor planning to be in the market for decades must be prepared for a 50% decline or more. The market went down 55% in the 2007-2009 bear market. If you had a leverage ratio of 182%, such a decline meant you have nothing left. IMO, a 180% leverage ratio strikes me more as gambling than investing. This paragraph ignores margin call risk.

  83. 83. Ed Rempel

    Hi Andrew,

    The 2 main trust companies that I know of that do No Margin Call investment loans are B2B Trust and Canadian Western Trust. M.R.S. Trust was also in the game, but was just bought out. We also have a contacts in special departments at BMO and TD that do them.

    They allow investment in nearly all mutual funds and some hedge funds, but I don’t believe they accept any individual stocks or ETFs.

    They also work mainly through financial planners. I’ve never really asked which ones work directly with DIYers.

    Ed

  84. 84. Len

    “They are suitable for people that are focused on building wealth, can tolerate a lot or risk, have the right attitude to avoid the common behavioural finance errors, and have a long term outlook.”

    Well,that screens out 99.99 % of the population over the course of a lifetime. I normally enjoy Eds posts but like many here found this was way over the top. If you would encourage your 24 yr old kid with $30k in student loans (a superb investment), to take out yet another loan for this kind of leveraged investing, you should be charged with parental incompetence. I’m sticking with grandpa’s advice- don’t spend what you don’t have and don’t invest what you cannot afford to lose.

    Leave it to harvard geeks to come up with this. I wonder how many financial experts actually practice what they preach with their OWN money. It always looks good on paper or with someone elses money.

    No thanks (and kids please look away)

  85. 85. Len

    In post 54 Ed says “Stock market returns are not hypothetical.”

    This is koolaide. FUTURE returns are what an investor is counting on and they are 100 % hypothetical.

  86. 86. Park

    About long term use of leverage, this was my plan. Start off with a leverage ratio of 1XX%. Don’t maintain that leverage ratio, except new money going into the account is levered at the same ratio of 1XX%.

    Bear markets (20% decline) occur approximately once every 4 years. When there is a 20% decline, look at one’s leverage ratio. If it is less than 1XX%, increase the leverage ratio back to 1XX%.

    A variant of the second paragraph is to use corrections (10% decline) instead of bear markets. With bear markets, one is more confident of buying low, but there would be a greater time period between adding to one’s leverage.

  87. 87. SST

    re#72: “What is a reasonable long term return assumption? The long term return of the global, US and Canadian indexes since 1950 has been between 10-12%.”

    WOW!!! LOL!

    Return of WHAT?!?!
    The average investor had NO way, let me repeat that — NO WAY — of investing in “global, US and Canadian indexes” until the 1970′s, certainly NOT in the 20 years prior!

    Until the time when index funds were available, the indexes themselves were nothing more than general indicators — PERIOD!

    Why not use REAL and FACTUAL stats and figures instead of purely hypothetical nonsense scenarios?

    @Ed: “We normally use an 8% return in an equity portfolio in a financial plan, to be conservative, even though we expect to make 10% or more. That is the long term index return and all our fund managers have beaten their index over the last decade, since inception and over their career.”

    And to think that the world’s BEST fund manager could reap only a 13% return over the last decade. You have a pocketful of secret weapons, Ed!

    re #52, #57:
    My mistake for not emboldening that heading of data: “TOP-TO-BOTTOM Losses in Stock Market History”. Also my mistake for not clearly defining each and every parameter (ie. years of decline). To the point, equity markets can and do succumb to declines of 50-80%, and will continue to do so.

    Historical pre-index find data can be useful in observing trends of markets, but what it is absolutely useless for is any kind of value-to-dollar translation.

    Don’t give a “In the last 75 years, [8%/year] is the lowest return for the S&P500 for a 25-year period” example when it historically could never have taken place. If there was no possible way, barring buying all 90 or 233 or 500 stocks, to achieve the index return, then why even consider it?

    There is ZERO correlation between index returns and actual dollar returns pre-index fund days.

    Also moot is the dividend chatter — see above.
    (without the ability to invest in ALL the listed stocks, the investor would NOT receive the total portion of dividends paid out)

    I’ve also noticed the asset allocation strategies you list are completely focused on stocks and bonds. Are these really the ONLY two investment assets available? What of cash/equivilents and physical assets and commodities?

    VFINX has returned 8.5% per year average over the last 25 years (1987-current), including dividends.
    The S&P 500 index rose 6.3% per year on average for the same time period.
    Silver rose 7.8% and gold 6.1% per annum average for the last 25 years.
    Too bad the latter three give no dividends (one being merely an indicator and the other two being inert physical substances), but then again, the metals can be sold tax-free, a definite portfolio boost.

    Research spanning 1972 to 2004 showed that with a moderate precious metals allocation (12%), portfolio return increases 4%. Of course, since that time, the precious metals inclusive portfolio would see an even greater return over that of the metal-exclusive portfolio, as the metal portion has gained 300% from 2005 and all the other classes have…well, have not even come close by a long shot.

    That’s the cash equivalent, now real estate.
    The average Canadian residential real estate valuation rose from $100,000 (1987) to $348,000 (current), a gain of 5% per year on average.

    There’s rent (ie. dividend) to consider as well. Extrapolating price-to-rent ratio, rent saw a 0.5% increase per year from 1987-current; a 5.5% gross return per year for the AVERAGE residential real estate.
    However, returns jump drastically, or decline, on the market of said real estate (just as they would with individual stocks). A house in Fort McMurray bought in 1987 for $30,000, now valued at $400,000, could easily rent for $35,000 per year. Find me the stock which pays out a yearly 116% dividend yield.

    And what of basic commodities?
    For over 130 years stocks and commodities have flip-flopped for leadership in returns. The average span of dominance is 18 years. The general consensus is that the commodities bull market/stock bear market began in 1999, thus the winning ways of commodities looks to have at least another 5 years to go. The trend is your friend and all that.

    There are other allocations besides “70% stocks/30% bonds” in which to invest. Remember, the overwhelming majority of net-worth millionaires became so from sources other than the stock market. I personally know a handful of millionaires, of varied ages and backgrounds, a total of zero gained their initial wealth through the stock market.

    In closing, re#74:

    “A better analogy for leverage would be a power tool. A power saw can cut a board much straighter and cleaner than a hand saw. But you may be scared to use a power saw, or if you use it incorrectly you can hurt yourself badly.”

    That’s great if all you want to do is cut boards in half all day long.
    I know a wood craftsman who works exclusively with hand tools (he restores 100+ year old houses/mansions). He can create works of art (furniture and sculpture) that no power tool could ever do. Analogy? If you want the same pile of chopped up lumber that everyone else has…

    For example, two years ago I maxed out a 0.99% credit card (14-month term) to buy silver bullion. I paid an incredibly minimal amount of interest and have a nice 75% gain (and a physical asset). Leverage allowed me to buy a lot all at once, at a low price, rather than accumulating over time as the price inclined.

    Applying classical leverage in my above personal scenario, and mentioning that the margin requirement for silver is 30% but 50% for VFINX, this would have resulted in a 42% gain with VFINX vs. a 383% return for silver. Want a pile of fence boards or do you want to be a millionaire?

    I’m no “professional” fund manager or anything, so please, don’t take my advice on anything.

  88. A comment by Ed Rempel:
    ____________

    Hi Park,

    Using a margin account is completely different from a No Margin Call loan. The study you quoted is with margin accounts. I have not seen a similar study with No Margin Call loans, but I suspect the results would be quite different.

    Behaviour mistakes would still be common, but many investors with No Margin Call loans would be comfortable with far higher leverage.

    I would feel uncomfortable with more than 150% leverage in a margin account, but personally I would have no concern at all with 400% leverage with a No Margin Call loan.

    With a margin account, you have to constantly be aware of what is happening. A temporary market decline could continue and become a margin call. Even a quick drop or a “flash crash” could result in a margin call.

    You have to be very careful with margin accounts.

    However, with a No Margin Call loan, leveraging a much higher amount has no margin call risk.

    A 3:1 loan is a standard type of loan, which is leverage at 400%. A 100% loan of $100,000 -$300,000 is also quite common. Since you invest none of your own money, there is not even a leverage percentage (technically, it is an infinite leverage percent).

    If you have a long term outlook, it is possible to borrow a significant amount, invest in a solid investment and barely watch it for years. There is no risk of a margin call. As long as you are confident with the investment long term, there is no need to monitor it.

    The secret to successful leverage is for it to be a long term strategy. Dealing with the margin call risk is a critical part of this. With a No Margin Call loan, you can leverage for 20 or 30 years quite comfortably.

    The study you showed is interesting, but I think only applies to leverage with margin accounts.

    Ed

  89. 89. Ed Rempel

    Hi Len,

    I agree it screens out most people, but I think it would be more like 80%, rather than 99.99%. Clearly, strategy #1 or #2 would be the right ones for you, but doing some sort of leverage strategy is not as extreme as you think.

    I have met a lot of people that are the right type of person for some sort of leverage strategy. Most are not 24, but in their 30s and 40s (although some are older and some younger), with the right type of attitude and long term outlook.

    I also don’t think that it is necessarily bad advice for your 24-year old to buy a home. Do you? That would also obviously be against your Granddaddy’s advice. He clearly doesn’t have the money and can’t afford to lose it.

    As for experts actually following their own advice, Ian Ayres and Barry Nalebuff really believe their research. In their book, they talk about hoping that one day most people come to think of their strategy as lower risk than what most people do today. They also talk about trying to get some mutual fund companies to create a mutual fund that automatically does their recommended adjustment, similar to the was the Target Date funds do.

    I can tell you I am genuinely a big believer in leverage strategies. I have a very large leverage personally – larger than any of our clients. It is a figure that most people would find shocking. I’m perfectly comfortable with it, though, and was even comfortable with it in 2008 and 2009. I don’t plan to ever pay it off.

    I am able to do a very large leverage because I believe in leverage in general, I am very confident in my fund managers, and because I know I am the type of client that will be able to tolerate it long term.

    Ed

  90. 90. Ed Rempel

    Hi SST,

    I know I’m going to be sorry I asked, but why do you call S&P fraudulent? As far as I know, they are a reputable company accurately documenting stock market returns since 1926.

    In 1926, their index had only 90 stocks, but they made up 90% of the value of all stocks on the NYSE. In 1957, they expanded it to 500 stocks, which again made up about 90% of the value of all stocks on the NYSE. They have essentially been doing it the same since 1957.

    There is older data that is reasonably reliable. Alfred Cowles painstakingly documented the return of every stock traded on the NYSE from 1871 to 1926. The list of companies looks strange by today’s standards.

    The fact that there were no index funds and small investors could not buy it with one purchase is irrelevant. Larger investors could have made the index return by buying all the companies in the same proportion and just holding them.

    Since when is the existence of an index fund a criteria for not being fraudulent?

    As an interesting side note, if you held the original 500 companies from 1957 and made none of the changes in the index S&P made, you would have had a higher return. The additions and subtractions they make normally reduce the return, because they tend to buy high and sell low.

    Ed

  91. 91. Ed Rempel

    Hi Park,

    I like your strategy. It sounds like it would work. It would essentially be a discipline to make sure you buy low. You could be more sure of it if you used bear markets, then if you used just corrections.

    That is a simple way to beat indexes. Stay invested all the time, but buy extra whenever there is a bear market.

    What you do after bear markets is key to getting a good long term return.

    This reminds me of our market timing philosophy. I am often asked various questions that come down to how I time markets. We are not really believers in market timing, since short term predictions are very hard to make. The most common questions relate to getting out of the market before a crash. I have not really found a reliable way to do this. Markets often continue rising for years after being overvalued.

    However, the one market timing move we have been able to do reliably is recognizing the buying opportunity after a bear market. I’m not sure if this is actually market timing. It is probably just knowing the major markets always rise in the long run. Plus, the largest gains are usually either right before or right after the largest losses.

    This is an easy way to beat indexes. Just invest fully all the time and find a way to invest extra after every bear market. Forget about trying to hit the exact low. Just buy extra after a 20+% decline.

    Your strategy essentially does this. It sounds like a modest method, with just a small amount of leverage and just rebalancing after bear markets. Perhaps you should consider taking a more decisive step after bear markets.

    Good thinking, Park.

    Ed

  92. 92. Park

    http://faculty.london.edu/edimson/assets/documents/Jacf1.pdf

    From 1900-2001, the equity risk premium of the world stock market was 4.6%. That’s how much more you made in stocks than 1 month treasury bills. Right now, government of Canada 1 month treasury bills are yielding 0.88%. If one assumes that the above premium is what Canadian investors will get, stock returns will be 5.48%.

    If you’re paying 4% interest, your return is 1.48%.

    That ignores the tax arbitrage of levered investing, but it also ignores the costs of investing. The equity risk premium quoted may be overly optimistic; Denmark’s equity risk premium for 1900-2001 was 1.6%.

  93. 93. Andrew F

    Equity risk premium varies greatly over time. Hussman agrees with you that 10 year expected returns are about 5%, though. At the bottom of the 2009 low, 10 year expected returns were 10%,

  94. 94. Ed Rempel

    Hi Park,

    Andrew is right that equity risk premium varies greatly. For forecasting purposes, a more useful measure is equity returns above inflation. They have been remarkably constant over long periods of time, since companies are generally able to increase their prices and profits by higher amounts during periods of higher inflation.

    For example, here are the long term stock market returns above inflation:

    1802-1870 7.0%
    1871-1925 6.6%
    1926-2006 6.8%

    A long term return of 7% above inflation is a reasonable expectation. Inflation expectations over the next few years is about 2%, which would mean that
    stock market returns over the next few decades could be 9%.

    Stocks are very cheap right now, so it is possible that future returns could be higher. With the P/E of the S&P500 being 11.7% now, that means the “earnings yield”, or E/P, is 8.5%. With bond yields being about 2%, I believe that an earnings yield of 6.5% over bond yields is the lowest since 1954.

    Today, investment loans are about 4% and secured credit lines are about 3.5%. Prime rate is a bit lower than long term historical levels, but rates have usually been lower relative to prime. For example, secured credit lines are mostly at prime +.5%, but have usually been at prime.

    So, interest rates for leveraging are not much below what we would expect them to be going forward.

    If we can borrow for the next few decades at 4-5% and get nearly half back in tax refunds, and at the same time we can make 9-10% on an equity portfolio, then long term leverage can be very profitable.

    I think all these estimates are reasonable expectations. I present them because I think it is very important with leverage to look at it as a long term strategy and to have long term expectations.

    Ed

  95. 95. SST

    @Ed: “Inflation expectations over the next few years is about 2%…”

    Ed, by whose assumptions/projections is this true?

    I can give you list of basics in my area which have risen by up to four-fold that “inflation expectation” — eg. electricity rates up 8% this year, then 5%/year for the next four years (I won’t even get into sickening reason why). In parts of Alberta electricity rates recently went up 50%! Know anyone who doesn’t use electricity?

    But that’s a completely different conversation: true inflation vs. “official” inflation.

  96. Ed, your approach sounds like the only kind of “market timing” that works. It’s foolish to guess at returns for the next 12 months, but you can take a position that makes sense for the next 12 years based on what’s happened recently. The value doesn’t change a lot but the price does.

    SST: All of that is true, but if you bought wal-mart stock 30 years ago you wouldn’t be concerned with the inflation rate of electricity in parts of alberta over the last 12 months. Which proves that stocks rule! (I sure hope wal-mart went public over 30 years ago or I’ll take a beating)

  97. 97. SST

    @Value Indexer: I won’t even get into how “stocks” are also assets and just as prone to inflation (increase of price) as every other asset out there.

    It’s great to see yet another person playing the “But if” game.

    Regardless of how long ago Wal-Mart went public, a better focus would be the average length of time an investor holds a stock before selling. I don’t know the answer, but I’ll wager it is far less than thirty years.

  98. 98. Ed Rempel

    Hi SST,

    Stocks can be affected by inflation short term, but tend to make higher returns in higher inflation long term. This is because companies are able to adjust their operations to make up for it.

    When inflation is expected, companies can usually increase their selling prices by inflation.

    Jeremy Siegel found that over long periods of time, stocks tended to make 7% over inflation – regardless of whether inflation was higher or lower.

    Ed

  99. 99. Ed Rempel

    Hi Value Indexer,

    Right on. That is one of the easiest ways to beat the index. If your return is similar to the market most of the time, but you take advantage of the irrational pessimism that tends to happen once or twice a decade, you can beat the market by quite a lot with little effort.

    Once or twice a decade, the market offers a Big Sale, or market crash. Just take advantage by investing more heavily or more aggressively right after the crash. Buying on the way down when the market gets cheap enough is usually the best strategy.

    You are right that is the type of market timing that does work – market timing with a long term view. Forget about what may or may not happen in the next year. Just buy when it is low and hold for the long term.

    This is why value investors tend to beat indexes.

    Ed

  100. 100. Ed Rempel

    Hi Park,

    You can’t forecast equities by adding the 100-year equity risk premium to the current, extremely low T-bill yields. Andrew is right that equity risk premiums are all over the map. The have been above 50% and below -40%. To be a valid comparison, you need to compare similar periods of time.

    The long term equity returns have been relatively reliable at 7% over inflation. That has been much more consistent than T-bill returns. For example, note how consistent the returns after inflation have been for 70-year periods:

    Returns above inflation:

    Stocks T-Bills
    1802-1870 7.0% 5.1%
    1871-1925 6.6% 3.2%
    1926-2006 6.8% 0.8%

    Surprisingly, long term returns of the stock markets after inflation have varied less than T-bill returns after inflation. The strange numbers you are coming to are a result of weird T-bill returns, not low projected stock market returns.

    Ed

  101. 101. Ed Rempel

    Hi Park,

    You can’t forecast equities by adding the 100-year equity risk premium to the current, extremely low T-bill yields. Andrew is right that equity risk premiums are all over the map. They have been above 50% and below -40%. To be a valid comparison, you need to compare similar periods of time.

    A more reliable way to forecast equity returns would be to look at long term equity returns vs. inflation (since it tends to adjust for inflation over time), and then adjust for the current market valuation. Since today’s forward P/E of the S&P500 is about 11.7%, far below the long term average, the most likely scenario would be higher than normal returns.

    The long term equity returns have been relatively reliable at 7% over inflation. That has been much more consistent than T-bill returns. For example, note how consistent the returns after inflation have been for 70-year periods:

    Returns above inflation:

    Stocks T-Bills
    1802-1870 7.0% 5.1%
    1871-1925 6.6% 3.2%
    1926-2006 6.8% 0.8%

    Surprisingly, long term returns of the stock markets after inflation have varied less than T-bill returns after inflation. The strange numbers you are coming to are a result of weird T-bill returns, not low projected stock market returns.

    Ed

  102. 102. SST

    Inflation, at the minimum, is an increase in money supply.
    This free and easy credit is the reason behind the “Great” bull market of the 80′s and 90′s.
    Equities were the asset class in which prices were inflated.

    First a whole bunch of banks collapsed, then equities collapsed.
    All that money had to find a new home.

    Say hello to real estate and commodities.
    Now that real estate has collapsed (and more banks), it’s just commodities left.
    Where to next decade???
    (As a side note, inflation has all but left real wages untouched for a very long time.)

    I see some industry “professionals” on here are still touting the ridiculous “70-year periods” and “since 1802″ stock market return marketing scheme. Siegel regurgitation.

    Here’s what Hero Seigel states:
    “One dollar invested in stocks in 1802 would have grown to $1,250,000 in 1991, in bonds to $6,920, in Treasury bills to $2,830, and in gold to $14.20. ”

    Please, Captain America and Ed, can you tell us all EXACTLY WHICH STOCKS were invested in 1802? Since there was NO index fund until the mid-1970′s, that wipes clean over 90% of the data and makes the above statement completely FALSE.

    Funnily enough though, a person actually could have bought actual gold in 1802 for around $19 per ounce. It’s price is now ~$1,700 — a paltry 2% return per year. Or you could have cashed it in in 1976 for $105 — all the while the “other” dollar spent 170+ years playing buy-and-sell…and most likely going broke — and bought the first S&P index fund — all the while the “other” dollar would have had to come up with a whole new dollar…actually 86 new dollars, to match the gold-funded index investment. And that $105 would now be worth $3,730 (or $35.50 for every $1).

    And why, oh why, do stock market “gurus” and industry “professionals” even bother to back-date returns 200 years?!?! LOL!
    What is the average investment span of the average person?
    Certainly not 200 years, and my guess, these days, it’s closer to 20 than to 200.
    Why not do average 20-year index return calculations?

    Let’s see…average age of a Canadian is 39 years old…first foray into the markets…we’ll say age 20 (in 1993):

    S&P 500 returns 6% per year. After inflation, 4%.
    Gold returns 8.5% per year (6.5% adjusted).
    Silver 11.75% (9.75% adjusted).
    (I use gold and silver as a foil because they are the most non-correlated stock market asset)

    Hmmm. Stocks have sucked for at least 20 years.

    How about the Canadian Baby Boomers?
    Age range from 48 to 67; first investment at age 20:

    Elder Boomer (1966 – current)
    S&P 500 returns 6% per year. After inflation, 1.75%.*
    Gold returns 8.5% per year (4.25% adjusted).
    Silver 7% (2.75% adjusted).
    Real Estate 6.5% (2.25% adjusted).
    *(purely theoretical since there was no possible way to invest in the S&P 500 index in 1966; but still interesting to show the low rate of return.)

    Younger Boomer (1985 – current)
    S&P 500 returns 8% per year. After inflation, 5.5%.
    Gold returns 5.5% per year (3% adjusted).
    Silver 5.5% (3% adjusted).
    Real Estate 6% (3.5% adjusted).

    Huh.
    So much for that.

    Looks as though the Younger Boomers got a great boost over their Elders via all the loose credit regulations brought to life in the ’80′s.

    It also looks as though over a REAL historical investment period (45+ years), the stock market gives the WORST returns (but don’t let the industry “professionals” tell you that!).

    Great to see those precious metals that produce nothing at all and pay zero dividend beating out the top 500 companies in America for 50 years running. Weird. No wonder so many retirees can’t, they all bought into the hype.

    Oh, almost forgot, according to Canadian black-letter LAW, each and every ounce of silver (and gold, depending on size) can be sold TAX FREE. Try doing that with a stock. Remember, it’s not how much you make, it’s how much you keep. How much will you be giving away to the stock market and tax man?

    I know, I know, reality and facts are irrelevant when talking about the stock market. Can’t blame them for spouting what they were taught.
    Oh well, done with all that silly “opposing view point” and “facts” and “think for yourself” stuff. Can’t fight the machine forever.

    Have FUN in the stock market!
    Let me know if anyone makes a million bux! :)

    p.s. — if you still believe the stock market and bonds (and the ever losing cash) are the ONLY assets in which to allocate your money…you most surely will never become a millionaire.

  103. 103. SST

    The recently dusted-off seminal ‘old money’ asset allocation:

    1/3 land;
    1/3 gold;
    1/3 fine art.

    See any stocks or bonds on that list?

    http://blog.cambridgehouse.com/2012/04/16/james-rickards-the-three-ways-old-money-holds-on-to-its-riches/

    I’m thinking I’d rather emulate REAL wealth which has persevered across generations than take the advice of “professionals” who only get paid when they sell you paper products.

  104. Ah yes, old money… where anyone can pretend to have anything because no one needs to know that you’re overspending while earning a pitifully low return on your assets and pretending you still own them, and you don’t have to mark to market when the market only opens once every 50 years. That’s a better study of how to impress people on reality tv (appearance is everything) than how to invest successfully :)

    Warren Buffet went from ordinary to the top in one lifetime, why didn’t all the “old money” do even better since they started with a lot more a lot earlier?

  105. 105. SST

    You obviously have a very shrewd insight in how wealthy families operate!

    Warren BuffetT’s money has thus far lasted ONE SINGLE proprietor.

    I guess only time will tell if his fortune is still alive and well within his family tree in another 200 or 300 years. Oops! That’s right, since he will be giving away 99% of his wealth to charity, guess that leaves his heirs among the bottom-rungers in the ‘old money’ department.

    Besides that, at the time, all of the ‘old money’ founders — Rockefeller, Du Pont, Vanderbilt, Astor, Carnegie et al were all considered the wealthiest men on the planet — and adjusted for inflation, were all much, MUCH wealthier than Buffett.

    Then, of course, there is the all-time power-house in old money: Rothschild. At their peak they held the single largest ever fortune in modern history. Due to a voluptuous lineage, the core family fortune has shrunk, but the Rothschild conglomerate wealth has grown massive ($400 billion???) over the past 250 years.

    Let’s say the Buffett children get $500 million…think they and all their heirs can turn that into $400 billion in the next 200 years?

    Maybe…if they follow one of the Top 5 Asset Allocation Strategies!

  106. 106. SST

    Just ran across this incredibly timely item:
    http://finance.fortune.cnn.com/2012/04/19/buffett/?hpt=hp_t3

    Oops! Guess twelve more ‘new money’ families won’t be making it onto the ‘old money’ list any time soon!

  107. But all those fortunes came from somewhere, surely not gold speculation. We’re talking about two different things.

    If you want your children to manage your money well the best thing is to make sure they don’t manage it at all and it’s under the control of someone who can do the least possible harm, more or less keep up with inflation and maybe grow the assets a bit, and limit the fights when you have a growing number of people with access to the same money.

    But if you want to manage your own money well in your lifetime, the best thing to do (if you want to have more than you do now) is to get the highest return you can get safely while keeping full control.

    These days there’s no point in merely “preserving” $100,000 to be passed down through the generations. If you invest like old money or “spend like a millionaire” before you are, you never will be.

  108. 108. SST

    @VI: “But all those fortunes came from somewhere, surely not gold speculation. We’re talking about two different things.”

    I notice you didn’t read the article.
    For one thing, putting money into the stock market is — by DEFINITION — speculation. Putting money into physical gold is — by DEFINITION — investing. Sorry to all that the financial industry has warped and twisted these words to suit their own marketing ventures.

    “If you want your children to manage your money well the best thing is to make sure they don’t manage it at all and it’s under the control of someone who can do the least possible harm…”

    Ah, thus it is NOT your FAMILY keeping the fortune afloat. Family-controlled wealth is kind of THE hallmark of “old money”. Lack of financial knowledge is why most family money never makes it past puberty

    Oh well. Enjoy what ever money you do have. :)

  109. 109. Andrew F

    SST, you have it backwards. Long-term holdings in the stock market are investments that can be justified on a discounted cash-flow basis. Gold has no cash flows, just speculation that someone will pay you more (in real terms) for it than you paid originally.

  110. If your main concern is that you’re sitting on a few billion and your descendants won’t be qualified for anything other than managing investments with no one to report to (but strangely they will all be exceptionally good at that and they will agree on the best way to manage it), you could start a blog called “trillion dollar journey” to talk about those issues :)

    Us peasants over here will be too busy with other things to think about that :)

  111. 111. SST

    Actually, Andrew F, by ECONOMIC DEFINITION which has been established for a very, very long time, buying stocks is SPECULATION, buying gold is INVESTING.

    As I mentioned above, you have fully bought into the financial industry’s malformation of transactions. The power of decades of marketing!

    To V.I., perhaps a more realistic blog for 99% of us would be “Hundreds of Thousands Dollar Journey”, because that is most certainly our destination.

  112. 112. Andrew F

    SST, that is a hand-waving argument. There are real cash-in-hand returns to investing in the stock market (or equity in general). Gold is purely speculative. If everyone decided they didn’t like how gold looked tomorrow, gold would drop in value to approximately that of copper. The price of gold does not reflect its practical usefulness.

  113. 113. SST

    Ah yes! I remember when Enron and Nortel had “practical usefulness” too! No speculation at all! Pure INVESTING! RIMM, too! Oh, GM was pretty practical, right? Cars and trucks and all…oops! Guess their usefulness ran out! And on it goes.

    Sorry you don’t understand speculation vs. investing.
    Maybe if more people did, more people would be millionaires.

    I’m certainly not saying don’t buy stocks, a lot of common people do. The rich, however, allocate their assets in stuff which basically cannot disappear — land, gold, art — stuff which will endure over centuries.

    The island of Manhattan was bought for $24 (some say $1,000) worth of animal pelts and supplies. Today the land of Manhattan is valued over $200 billion. That’s a steady 6% annual average return for almost 400 years running.

    How many stocks are still around from 1600? 1800? 1900?

    Vincent van Gogh never sold a painting yet one of his most expensive paintings (based on auction) might now be valued at $150 million. From $0 to $150 million in 120 years — an outstanding 18% average return per year!

    What has the S&P 500 returned (theoretically) since 1890?

    As far as gold goes, humans have valued gold for close to 10,000 years — good luck trying to change human nature!

    Point being, if you want your financial legacy to last past your own funeral, best to have a look around at other venues in which to park your money.

    Have fun in the market! :)

  114. 114. Andrew F

    SST, that is more hand-waving.

    What has been the real return on gold over the last 500 years? Just about nothing.

    You cherry-pick a few stocks that failed. No one said investing was without risk.

    You cherry pick Manhattan and Vincent Van Gogh. Yes, they provided good returns in retrospect. Through the benefit of hindsight. Take the asset classes of all land, or the asset class of all paintings, and tell me how much those returned over time.

    And please give me some samples from your list of rich people who got rich through investments in land (not development of land–just holding land over a long period), gold or art. That is not how most very rich people got rich. Most of the very rich are entrepreneurs or the children of entrepreneurs. I don’t understand how you square this fact with your assertion that the rich don’t invest in equities, and instead make all their money in speculative asset classes like gold or art. Land is a reasonable investment, as it at least flows cash through rents.

  115. 115. SST

    I guess poor people will continually focus on cash-flow (and incorrect financial verbiage). The rich adopt a different mind-set, and it shows.

    As for the claim of cherry picking…isn’t that what YOU do with YOUR equities??? Or do you just buy them ALL and hope for a good return on your speculation?

    The stocks I picked were not microcap nothings, they were giant companies which had, as you put it “practical usefulness” — and they failed spectacularly. When has gold ever been reduced to $0 in the last 8,000 years?

    I’ll repeat, since you seem to have missed it: point being, if you want your financial legacy to last past your own funeral, best to have a look around at other venues in which to park your money — gold, land, fine art.

    Regardless of your opinion, it is a reality that the rich hold these assets allocations, and it has obviously worked for centuries. It’s a bit foolish to argue money management with generational wealth.

    Thanks.

  116. 116. Andrew F

    No, I don’t cherry-pick equities. I buy broad index funds. You can’t do that with land or art. You have to cherry pick. And most of the time you are not picking a Van Gogh or Manhattan pre-rapid price appreciation.

    I ask again: please give me an example of a rich person who became rich through holding (not trading) gold, land, or art.

    That’s what I thought.

  117. 117. SST

    Ah, another fallacy: “I don’t cherry-pick equities. I buy broad index funds.”

    Are you buying ALL global index funds? Or SPECIFIC funds?

    Please give me an example of a person who became rich through holding (NOT TRADING) ONLY equities. Remember, only 1-2% of North Americans have a minimum net worth of a million dollars. And if you could also provide an example of a rich person holding ONLY equities. Or an example of an equity (ie. stock) which has endured more than one century.

    That’s what I thought.

    I explain again — because you simply can’t understand the concept of wealth — if you want your financial legacy to last past your own funeral, best to have a look around at other venues in which to park your money: gold, land, fine art.

    Good luck to you. :)

  118. If you truly aren’t concerned about anything that you will personally see, giving your descendants a better world to live in and not just a bigger castle to hide in seems like a pretty good investment.

  119. 119. SST

    @VI: Agreed.
    Guess that’s why Buffett is giving away 99% of his wealth to charity.

    But for the rest of us mere money mortals who don’t possess the dollar clout to influence government policy or corporate strategy…the best we can do to create a better world to live in is to create better descendants. What better asset allocation than that.

  120. 120. SST

    http://money.cnn.com/video/markets/2012/04/30/mkts-art-picasso-sothebys.cnnmoney/?iid=GM

    As I was saying….

    Art: a $64 Billion market.

    All of it not worth a penny! LOL!
    AAPL on the other hand…

  121. 121. Ed Rempel

    Hi All,

    Let me see if I can bring this back to what is applicable to the average person.

    The reason that stocks are the most appropriate investment for most people to build their wealth is that stocks have consistently returned a good return and protected purchasing power over the long run.

    This chart by Prof. Jeremy Siegel is fascinating. It shows returns from 1802-2010 comparing asset classes after inflation:

    http://ludwickandshirman.com/about-ludwick-shirman/articles/stocks-for-the-long-run

    Note that with everything that has happened in the last 200 years, stocks were always able to adjust and continue to grow. The reason for this is that the stock market is made of a bunch of large companies that are able to change their operations to continue making money.

    Companies have many ways to do this, such as getting new customers, changing products, cost cutting, buying other companies, becoming more efficient, etc. Individual companies go under, but the stock market as a whole has always continued to grow long term.

    The surprising fact from this chart is that the 200-year trend line for stocks is drawn with a ruler, which cannot be done with other types of investments. Bonds are considered to be lower risk, which is true over shorter time periods, but not true over 30-year periods or more. Bonds get killed in high inflation environments and stocks have beaten bonds 100% of 30-year periods.

    That is part of what this article is about. There are different asset allocation strategies. The longer your time horizon and the more you are able to stay invested through down periods, the more equities are appropriate for you – up to and including leverage which is an allocation over 100%.

    For more conservative investors with shorter time periods, the first 2 or 3 strategies are more appropriate.

    In the vast majority of cases, at least some allocation to the stock market makes sense. The chart from Prof. Siegel shows the logic for this clearly.

    Ed

  122. 122. Rich

    I recently read about a sixth strategy that is somewhat different than the five mentioned in Ed’s article. In this strategy you place all of your investments in a diversified set of stocks that you will not require for the next 7 years (or 10 years if that suits you better) and the rest goes into fixed income liquid investments. The idea of 7-10 years being that the market normally recovers by the time you need the money from the stocks.

    With this strategy you would invest 100% stocks when you are 20 because you will not need any of that money in the next 7 years. When you are 30 and buy a house and have children you may want to back off to 75% stocks so that in case of unemployment or other setbacks you still have a cash-cushion to prevent you from losing your house or having to sell stocks at a bad time. If you are 45 and have a big mortgage and children starting to enter college you may go to 70% stocks to cover the large obligations you have going. By 55 your mortgage is paid off and children graduated so you go back to 90% because you plan on retiring at 60 and you only need a little cushion for the first few years of retirement. As you approach 60 you reduce your stock allocation according to your years-to-retirement number. Even when you retire you may still end up with 75% stocks because 25% would cover you for the next 7 years. The numbers are just examples because everyone will have different values depending on the size of their portfolio and obligations.

    There are several things I like about this strategy. You can have a fairly high percentage of stocks while still being sure that you have enough in liquidity to cover your costs in case of financial setbacks so you can relax about market fluctuations and not do anything stupid like sell low and buy high. You really only have to adjust things about once per year and this is a good time to plan your next 7 financial years. You can make it simple by investing in low management expense ratio exchange traded funds; I pay around 0.25% MER for my ETFs and it only takes me a few hours to readjust the portfolio. You can tailor the plan to suit your financial needs and not rely on some questionable financial risk test that is dependent on your mood that day to determine your stock allocation. You are unlikely to be stuck in a situation where you go bankrupt, lose your house or are stuck with a big loan that causes great personal pain to you and your family.

    It is a very steady and simple approach that makes you wealthy in the 20-25 year time frame but experience has proven to me that this is the best way because you grow with your money and are less likely to lose it that way.

  123. 123. Ed Rempel

    Hi Rich,

    Interesting to associate it with life events. I’m not sure this would work as well in practice as it sounds, though.

    There are a lot of ideas that sound good in your head but don’t really when you do the math, and I think this is like that. I have a few issues with this method.

    Your figures are just an example, but you end up only 70-75% equities for your main growth years from age 30-55. A higher equity allocation for these 25 years should give you quite a bit more in retirement.

    Then going to 90% equities for only 5 years from 55-60 and then back to 75% equities would be a risky, shorter-term bet.

    It seems to me that you are using the cash/bond allocation for your emergency fund. Perhaps it would be better to establish a proper emergency fund of, say, 3-6 months’ expenses either in cash or an available credit line, and then maintain a higher equity allocation for the long run.

    The amount you are holding in cash for possible life events would grow exponentially as your portfolio grows. For example, at age 30, your portfolio may be $50,000, but at age 50, it could be $500,000. Having 30% in cash of your $500,000 is a lot.

    You would also run the risk of having your emotional market view affect your allocation. There is not a formula. The allocation depends on your opinion of your possible cash needs in the next few years, which is very subjective.

    Don’t you think you would be better off creating a proper emergency fund and then investing long term with a high equity allocation based on your risk tolerance?

    Ed

  124. 124. SST

    The ultra-wealthy Tiger21 members allocate their assets as such:

    Hedge 9%
    Cash 10%
    Fixed 15%
    RE 21%
    Public Equity 23%
    Private Equity 20%

    Since 2008, this diversified group of rich people has doubled their Private Equity holdings and decreased their Public Equity holdings by 10% (all other sectors remained fairly stable).

    Still think you need to be “fully invested” 100% in public equities?

    This diverse group of rich people didn’t amass their $95 million (average) buying mutual funds.

    Don’t believe the hype and get closer to the profit!

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