Interesting WSJ article says now is a good time for disciplined investors to take on leverage. Any thoughts?
Without having read it yet I simply said it was a bad idea. Well yesterday I read it and you can read it here. Before getting into this I should disclose that I am very conservative with this sort of thing. I've disclosed before that my parents made some poor financial choices in their 30s and 40s which caused permanent obstacles for them which is impacted how my wife and I manage our finances.
If it is not clear the idea would be to take on debt, most likely mortgage debt, and invest the borrowings into the stock market. The article makes the point that mortgage rates are about at all time lows which is factually correct and does some math about tax rates and returns needed to have it pay off and notes that now could be a great time to do this strategy and there are plenty of financial advisors quoted in the article to explain the merits albeit with a few caveats. There are also examples of people taking mortgages out to beef up their portfolios, make up for lost ground and the like.I've had a few clients ask me about this. I try to steer clients away from the idea which so far I have been able to do. Now keep in mind that if someone wants to cash out and have us manage the money it obviously means more revenue for our firm. The way I steer clients away is talking a little bit about the numbers and the risks and that it could work but that Joellyn and I have paid off our house awhile ago and there is no chance we will be doing this.
I come at this sort of thing wanting to understand what could go wrong and what the consequence will be if it does go wrong. It seemed like the math from the article lead readers to needing a 5.015% return to break even and if you buy into the idea that you wouldn't do this hoping to net an extra 100 basis points then maybe the targeted return ideally would be 7-8% annually. Anything about 7-8% ring a bell? That is about the same number that is slowly blowing up state pension funds.
A big tenet here has been you can only take what the market gives you. If the next ten years provides an average annual gain of 3% it is very unlikely you will get 8% consistently. Of course you might but have you ever beaten the market in this sort of fashion before? If you have, do have any introspective thoughts about what role luck may have played? Are you willing to bet the equity in your home that you can repeat this?
And what if the market goes down 20% from here and trades between SPX 850 and 950 for a while instead of the current range? I might say down 10% in a down 20% world is a good result but that is still 10% of what was home equity now gone if the market stays in the above range for a while.The next issue is the payment that would have to be made. A $400,000 loan at 5% requires a $2147 monthly payment. Um isn't there something about a 4% withdrawal rate being sustainable? So maybe the article is aimed at people who are still working. Working or not do you really want to take on an additional $2000 in monthly expenses?
One commenter on the WSJ article talked about the interest paid over the loan. Per the numbers I got from Yahoo Finance the interest over the life of the loan would be $373,000. If you are still working and could take on a new $2000 mortgage payment why not just save an extra $1600 a month which would about be the interest portion on that loan.
In that last paragraph lies a key point. If you need to beef up your portfolio and you can afford a new debt payment well then you can afford to just save more money without taking the risk of incurring more debt.
The article also talked about margin loans. Really? Margin is a good idea?
There are two ways to be rich. One is having a lot of money and the other is having no overhead. Assuming you are not a trustafarian you may end up with a lot of money but this seems less within our control. I believe it is easier to get the overhead down. If all you are paying for each month are utility bills, various insurances, various taxes, groceries (including prescription costs) and gas for your car then $500,000 saved plus social security plus maybe some sort of part time work has the makings for a pretty successful retirement.
A slightly bigger macro here is the idea of not learning from past mistakes. People have blown themselves up many times in the past by misusing leverage. This is guaranteed to happen again to people but it is pretty difficult to misuse debt if you don't have any debt.
The two pictures are from New Zealand.
6 comments:
Bad experience with debt or not Roger, ANY leverage is much more complicated than it appears. However, it is a tool and if used, use with extreme caution. Unless of course you are the Federal Gov't or Alan "Easy-Money-Go-Mortgage-A-House" Greenspan!
Good advice here Roger.
Something else to think about however. An old quote:"conservatism is the enemy of great wealth". At some point in everyone's life, one should carefully think about and plan to execute one great hit out of the park. Not with all the marbles, but with enough to be involved and still stand the possible loss.
It may not be in equities, maybe a business venture or something else, but it ought to be something.
A quote from Gerabaldi(sp?), " better to live one day as a lion than a thousand days as a sheep."
I would say most wealthy people I know have used leverage to their benefit and in fact would not have attained that wealth without it. It is next to impossible to form large business ventures with 100% equity. I have seen big time disasters too, especially in real estate. For the most part however, the disasters I have witnessed involved greed and speculation as the main component in the business plan. The key as you point out Roger is knowing what the downside is and having a margin of safety as Anon 7:06 points out.
I guess I thought the article was interesting from two perspectives; 1) the average retail investor will leverage himself to his own detriment and 2) a disciplined investor might seize the opportunity to "hit one out of the park." Perhaps I was wondering where I would fall along the continuum.
In general, I agree with your assessment that people should not do this with their retirement accounts. Thanks for taking the time to share your views on this topic.
The article has some merit.
When I was building a new, and hopefully final, home in late 2008/09 I was intending to pay cash. This would have resulted in liquidating assets that were in a downward spiral at the time.
I took out a 30 year fixed at 4.64%which more than covered my construction cost (I was the contractor).
By taking on this "debt", which was not significant vs. total assets, I was able to avoid selling investments at a terrible time.
This worked great for me, but I think the thrust of the article, to assume debt to leverage investments (err...bets) may well have unintended consequences for many.
T
Unfortunately I think this article will hurt more people than it helps. It was irresponsible of the author to not talk about real returns and real interest rates.
The core problem is that people who have a successful investment approach have probably already calculated what their optimal leverage is to meet their goals. Those people without a successful approach are the ones who probably had not thought through the leverage question. Those people should put less money towards their investments not more, until they start earning money ;->
That said imho real estate still has plenty of losses to go in real terms. I think the guy with the $1mil free and clear house, who sold $300,000 dollars worth of depreciating assets to the bank will probably come out ahead - unless he puts the money into stocks of course...
Here is an interview that supports the view that we are in a correction, but a crash is coming later. "Charles Nenner Says the Market Won’t Crash Until the Fall."
http://www.zerohedge.com/article/charles-nenner-says-market-won%E2%80%99t-crash-until-fall
Ongoing Case Shiller chart "U.S. HOUSING PRICES STILL MORE EXPENSIVE THAN ANY POINT IN LAST 120 YEARS"
http://pragcap.com/u-s-housing-prices-still-more-expensive-than-any-point-in-last-120-years?utm_source=twitterfeed&utm_medium=twitter
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