This statement is not surprising: “if you borrow money to invest in stocks, you are exposed to a risk”. This statement is surprising: “if you can borrow money to invest in stocks, even if you don’t, you are exposed to a risk”. The reason for the difference is that most people don’t understand economics. While the risk isn’t exactly the same, many of the same things are happening when there is increased borrowing whether you take part or not.
I’m finally getting the chance to read Lifecycle Investing (which I heard about recently). It talks a lot about borrowing to invest and makes the comparison to housing where we don’t wait until we’re 50 and save up the full price of a house. This allows us to spread out our housing market risk since the market will go up and down over the 50+ years that we own one or more houses.
In both stocks and housing we can borrow money to purchase more. Both have seen an increase in the amount we can borrow. At one time people would borrow a small portion of the price of a house or even borrow as much as they had saved if they were really pushing it. Now people complain if they need more than a 5% downpayment. In stocks there have been varying amounts of leverage available at different times but it seems like large market players have been able to borrow more in the last 10-20 years than they could before. And both markets have experienced more risk and volatility in the last 10-15 years.
The reason is the same as when government affordability programs don’t make things more affordable. If buying a house required a 30% down-payment, some people would find it easy and others would struggle. If the government stepped in to make it more affordable by allowing people to buy with a 15% down-payment, people with a minimum down-payment could suddenly afford to spend twice as much on a house.
Since people don’t always make a strict economic calculation of the lifetime value the house provides, anyone who wanted to get a little more than they could before would spend more. And since it’s not the total amount you spend that counts but how much more you spend than others, the competition would soon lead everyone to spend twice as much. In the end people would end up struggling just as much to buy a house with a lower down-payment if the price increase balanced it out.
The same thing works with just about anything. Take student loans for example. It’s hard to go through an election cycle without someone talking about making things more affordable for students due to rapidly rising tuition. Now imagine there were no student loans, and guess what tuition prices universities and colleges would set. If they are too expensive for students to attend they aren’t gaining much.
When more leverage is available for things like stocks and houses, someone will borrow more, pay more, and increase prices. There’s also a chance that they will do this when it’s not a good move or when prices are too high already. Increasing prices that aren’t supported by fundamentals mean increasing risk that they will return to normal. So even if you buy a house or a stock without borrowing money, the chances are greater that the price will go down because others have borrowed.
This doesn’t mean all leverage is bad. When something important like houses, stocks, or education can’t be paid for with a loan it’s safer because the price is too low since many people who would benefit from it can’t afford to buy. And when you don’t borrow you don’t have the risk of paying back a loan when you’ve lost the money. But if it is possible to borrow it will affect you one way or another. If you vote for policies that increase leverage for everyone you are increasing your financial risk!
There’s a story from the dot-com bubble that we’ve probably all heard many times. Someone made a modest investment in a stock that took off. Within a couple of years the value was far more than they invested, adding hundreds of thousands of dollars to their net worth. They started spending more because they had made it. And then the stock crashed and they were left with nothing but worthless shares and big debts. It’s easy to mock this, but are we making the same mistake in our plans?
We all want to think we’re too smart to plan around investing in a company with no profits and making 10x our investment within a year. But the same model can play out in many ways. The problem in the story above is that the value of the stock at one point in time doesn’t matter if you sell it later at a much lower price. This story is just one clear example. In smaller ways this happens very frequently and it can easily sneak into our plans.
Many people make plans based on what they expect in the next few years. They might buy stocks and say “they should go up for a few more years so this is safe”. But if they keep holding those stocks while the price goes down after, there was no real gain. The price of something doesn’t matter while you own it, only when you sell it.
It gets even worse than that. If you plan to retire when your portfolio reaches a certain value you probably won’t sell it all and stick the cash in a mattress. In fact if you plan well enough to have a long retirement you will want to keep a good portion in stocks to make it last longer. But remember the value of those stocks on the day you retire means nothing unless you can sell them for the same value later.
Forget what your portfolio is worth today. What you really want to know is what each part will be worth as you sell it and that answer varies. At any given time stock prices can range from very low to very high. If you’re selling small parts over a long time you’ll get many different prices and the end result may be close to the average. But it’s always important to think about the future. What you could get today by selling your entire portfolio doesn’t matter.
I’m a young, aggressive, and well-informed investor. Many others in this situation would use an all-stock portfolio and avoid bonds. But I keep a portion in bonds because it’s not the peak that matters, it’s what you get in the end. By regularly rebalancing into bonds when the stock values get too high I can make sure some of that is kept when they come back down.
I do everything I can to avoid deciding based on how I feel about different investments. Instead I evaluate each option based on the fundamentals of all investments including how much cash it makes each year, how fast it’s growing, what could go wrong, what I can sell it for later, and when I will need the cash. If you ignore any of these it’s at your own risk and you may have a surprise later.
The recent book Lifecycle Investing has an interesting perspective. The message to borrow when you’re young and use a lower stock allocation when you’re older makes sense in a lot of ways. But given the many ways it can go wrong it’s worth looking at it closely before doing anything. I recently had the chance to read the book. There are a couple of details that might make it less attractive than it sounds at first.
Through many simulations the authors show that the strategy would have a near-perfect success rate in past scenarios and even artificial simulations. The simulations come in two forms. When compared to a conventional strategy with the same average outcome, the lifecycle approach brings the minimum and the maximum closer to the average so you aren’t exposed to chance as much. And when it is adjusted to have the same worst-case outcome, the lifecycle strategy has much higher average and best-case outcomes.
However there is one small detail that’s only mentioned in two sentences throughout the book. Although true lifecycle balancing might mean borrowing like a 2006 homebuyer, the authors recommend limiting leverage to 2 to 1. By borrowing as much as you invest you are 200% in stocks. This means that if the value of your investments falls your leverage increases and you have to sell a bit to bring it back into balance. Their recommendation is doing this every 1-3 months.
At one point they refer directly to leveraged ETFs that do this every day. They are forced to buy high and sell low. As a result those ETFs can lose money any time the market has enough volatility, whether it’s rising or falling overall. At another point in the book they point out that in 2008 the strategy would have a young investor selling on the way down and limiting their losses. But they don’t comment much on how this could limit long-term gains when the market rebounds. As of today, anyone who sold when the S&P 500 was below $1318 (between June 20 2008 and February 11 2011) and didn’t buy back since then has lost.
Could it actually help to sell on the way down? That may be the case temporarily, but most of us would be foolish to judge our investment results over one year. As the example above shows, selling in Fall 2008 seemed smart in 2009 but not 3 years later. When buying any investment you need to consider where it will be when you sell it and what you get paid along the way.
Overall their simulations still show a better result for past investors who would have followed this strategy throughout their lives, even during the Depression. But this may be something that increases the risk in the future depending on the sequence of monthly returns. And informed investors willing to take a chance might do better.
Don’t Focus On Tomorrow
The overall message of diversifying dollar-year exposure is good. If you have $100,000 invested for 10 years the returns are more predictable than if you have $1m invested for 1 year. But again the returns in any one year don’t matter as much as the end result. If you invested at the start of 1999 you would have a great year, but the long-term picture wasn’t so pretty.
That example is unfair because diversification means more of the bad and the good. The hope is that the good parts will be greater. Like dollar-cost averaging this strategy allows you to get more predictable returns than simply investing a large amount one day. For those who don’t want to do too much research this isn’t a bad way to go overall.
But since I believe my instincts are different from the average investor and I might profit from this, I look at ways to potentially do better. Instead of diversifying my dollar-years what I would really want to do is go further and buy more at the cheapest time relative to the final price I will be selling at. There is no grand strategy to do this since there are far too many unknowns but it does suggest small adjustments. A year ago when I considered the markets to be slightly over fair value I wasn’t giving up on stocks completely but I wouldn’t use a lot of leverage at that point.
Useful Tool If Used Well
This is getting long, so come back later this week for the second part with ideas on how to safely apply this. Even if you don’t follow the exact strategy it contains useful tools.
Most planning around investments is based on the current market value. If you want to know what they’ll be worth in the future, you take the current value and apply a growth rate. If you want to know how much you can live off of, you take the current value of your portfolio and apply a safe withdrawal rate. We know that this doesn’t always work (try applying a regular growth rate to the market value in 1999 and estimate where it was in 2009). Projections based on something more fundamental than the stock price might be more accurate. What are the alternatives?
Unless you’re a perfect market timer you don’t really know where the market will go in the future. But can we get a little closer and at least have a warning when standard conditions might not apply? In a way dividend investors have a better model. They know how many shares they own and they project the dividends from those shares, which they can live off of. If the actual share price falls by 50% they can keep collecting the same dividends unless the companies get into trouble.
Can you do this without being a dividend investor? One of the fundamentals in investing is the actual profits that companies earn, which is similar to the dividends they pay. The stock price varies a lot more than the profits. But they do go up and down too, so it might be more helpful to use something like the average of the last 10 years’ earnings.
If you did this you could translate all kinds of rules using a consistent P/E10 ratio. For example if you wanted a withdrawal rate of 4% and you estimated a normal P/E10 ratio of 12, that would mean withdrawing 48% of the 10-year average earnings. In fact this looks like a good result since a company that pays 48% of its profits in dividends would seem pretty safe. If you planned to retire with a portfolio of $1m and withdraw $40,000 per year this could give you a warning signal if you reach your desired portfolio size but the earnings aren’t high enough yet because stocks are overvalued.
Using this could prevent you from getting too optimistic when stock prices are high or underestimating future returns when they are low. But it does ignore one important signal. If you’re getting income from your portfolio it doesn’t show that it can be worth spending more when the prices are high and less when they are low.
If you’re interested in getting a view based on long-term stability this might be one way to get it. It would be good to see some research on whether it would help avoid costly mistakes in historical scenarios.
Do you look at your investments in different ways to see where they are going?
Many people agree with the idea of investing to create a retirement portfolio, and agree that it’s not that complicated to do. But the simplest things can be the hardest as we’ve all seen when we try to save and invest more. We aren’t made to dream about numbers growing on a spreadsheet. If that’s all the reward we get for investing most people will lose interest. There is hope though with a simple way to cut through that and make investing more exciting by understanding what motivates us.
Even if you are doing well, it’s easy to feel like you’re not getting anywhere and give up since the early years don’t show big results. It’s hard enough to convince yourself person to invest well. And if you’re married to someone who doesn’t share your interest in personal finance it’s even harder to explain to them why it’s so important. Mastering yourself and communicating well are two of the most difficult things in life. It almost sounds like too much to hope for a young couple to make and then execute a solid financial plan. I recently started doing something new that makes it much easier.
Break It Down
The reason this fails is that the goal can be anywhere from 10 to 40 years away. Many people just don’t have the motivation or ability to really plan that far ahead. Think about trying to plan a trip in 40 years. You might choose a place to go but after that you’ll say “forget about it, we have time”. Beating yourself up about it won’t help. This is part of our nature, just like many people don’t have the ability to reach over a basketball hoop without leaving the ground or the motivation to lift twice their bodyweight without help.
What will help is to use a timeframe that’s easier to understand. Almost everyone can plan for the next month. If that’s all you need to do you have a much better chance of reaching your goals. How do you reach a 40-year goal in one month?
One simple way to handle this is to plan a fixed amount you need to invest every month, using help from a financial planner if you need it. As long as you do that you’ll be working towards your goal. But even that can start to be frustrating when you do it for several years and you still have a small portfolio.
Reward Yourself Often
The next key is rewards. If you have a feeling of accomplishing something at least once a year you’ll have something to look forward too. If it’s every 3-6 months you’ll be even more motivated. And if you can share these rewards with your spouse you can avoid a lot of arguments. This is where I decided to try an experiment.
You’ve probably seen someone doing a fundraiser and drawing a thermometer chart that shows how close they are to the goal. Why not do the same for your investments? It’s no fun to be 1% of the way to your goal though, and then get to 1.1%. You need to start smaller.
Quicken tells us what we need to spend in various categories each month. Our regular utilities are one of the smaller categories, it’s easy to separate them into the different bills we pay, and we will never enjoy paying those bills. So I created a fancy thermometer chart in Excel (you could draw this on a paper too) showing how the 5 utility bills add up to to our monthly total, starting with the smallest ones at the bottom.
Then I calculated what kind of monthly income we would get from our current investments if we started living off of them, which isn’t a lot. Putting that over the chart shows how much of our bills would be paid by our investments today. Now instead of saying “we need to think about retirement” we can say “if we do this for 3 more months our power bill will be paid off, FOREVER”. Just writing that makes me want to find some cash to invest!
Make It Easy
The most important thing is starting small. When you have a large portfolio you can increase your potential investment income by $2500/month in one year but at first you will have smaller numbers. Start with something small and you will see yourself reaching your goal quickly which makes the next goal more exciting. By the time you get to the bigger expenses your portfolio will be growing faster so it will be easier to cover them.
Since this is the first category we take on I even cheated a bit by including a portion of our bills used for my business and including the payment from the business in our investment income. It’s more motivating to see that you’re 3/4 of the way to $1000 instead of 1/2 of the way to $500 even though you have $250 to go either way. When we add the next category I will continue including this one below it so we can see what we’ve already done.
I personally don’t have much trouble investing. I read about finance constantly and the more I learn the more excited I get to invest more and avoid wasting money. I expect that I’ll have the choice to stop working in 15-20 years with the current plan. But even for me it can all start to feel too abstract after a while if I’m just seeing numbers on a screen. And being married means my plan is just one part of the picture. We don’t need any reminders to stay out of debt but there’s a lot more to do beyond that.
Using this chart to see how we’re doing is a powerful way to increase motivation and show clearly that we’re making progress. To make this work, think about what would motivate you most. Is it not having to think about your bills? Or is it having your investments pay for a night out once a month? Look at the easiest things first and you’ll build your momentum quickly.
Daniel Kahneman’s recent book Thinking, Fast and Slow, provides a wealth of information for anyone interested in decision-making. As one of the researchers contributing to behavioural economics, he has shown many times how regular economists and ordinary people make mistakes by assuming we’re rational. One thing is certain: no matter how rational you think you are, there will be some times where you aren’t as rational as you believe. And personal finance is a great area to find them.
One thing that seems to happen frequently is that someone will take big risks when they are starting out and building their small portfolio. But once it grows and they get closer to the point where they can depend on it for their income they become much more fearful. I’ve thought about this a few times before but the book made it very clear.
Some of the experiments described in the book show that people have an extreme fear or losing what they already have. Researchers gathered a group of people and gave half of them a nice coffee mug and then set them free to buy and sell with others in the group. The average price the mug owners asked to sell for was twice what the mug-less people offered to buy it for. In another experiment, people were given one of two gifts at random and then asked 15 minutes later if they would like to trade for the other. Only 10% of them traded what they got for the other choice.
This applies to your finances in countless ways. It’s natural to not take risks when you don’t need to. And when you reach a goal you won’t try as hard to exceed it even if you could still benefit from getting more. But people who pass up the opportunity to add half a million to the portfolio will feel less regret than people who lose half a million in their portfolio even though the result is similar. On average you will do twice as much to avoid a loss as you will to gain the same amount.
None of this is bad. We don’t always make perfect decisions to increase our wealth, and sometimes other things really do make us happier. However when the decisions affect things that matter to you, this knowledge can help increase your wealth.
The book goes on to describe two types of people who surprisingly aren’t affected by the fear of loss. One is people who are very poor. They see themselves as having far less than they should. Even what they have now is a “loss”. Instead of seeing a choice between gaining something new and losing something they have, they see a choice between two losses (compared to what they really want) and judge it differently.
The other type of people who aren’t affected is people who trade frequently. As described in the book, the experiment of randomly giving people a gift and then asking if they would like to exchange it was done again. This time it was at a baseball card convention, and the subjects were experienced traders who had been exchanging cards for years. They chose to trade their gift almost 50% of the time, unlike the 10% of regular people who did. They found it easier to trade since they were used to deciding if they really wanted what they currently own.
The second type of exception is a bit harder to use. If you can look for opportunities to exchange things, and take risks on small trades to see if they make you better off, you might develop the mindset of trading up without being attached to what you already have. Starting a business is another way to do this since you have to make decisions on many transactions.
The first exception is much easier to use in your finances though. When your goals are much higher than what you presently have, you’ll feel the loss every time you drift away from them. And it will be easier to stay confident in your plan since the wins and losses are easy to see. If you have no goals it will be harder to understand what you really want and you might start to see any change as a loss to avoid.
People who are deep in debt can have a much stronger motivation to save than people who are debt free and trying to invest more. About 90% of the writing on personal finance seems to involve getting out of debt. If you just got out of debt you can get stuck there unless you set a new goal for what you want next.
If you make yourself feel “poor” you can make better decisions. And if you feel aimless and scared of losing what you have now, look out into the future and set a new goal for what you want to attain or do. As long as you don’t do things that harm that goal you will know you have nothing to lose.
When you’re looking for ways to earn more and work less, starting a business and the idea of passive income are two things that naturally come up. Can they be combined to reach your goals faster?
We know that it takes a long time to build up a regular investment portfolio. I recently calculated that if you want your investments to pay for a certain amount of expenses (say $3000/month) and you invest that much every month, it can still take 10-15 years before you reach your goal. And that’s far more than most people manage to invest.
Next you turn to starting a business. Here’s a way you can earn more, anywhere from earning a few extra dollars outside your regular job to creating a much larger income with less work and the freedom to do other things when you want. I prefer high-value services and specialized products while others turn to blogging which can get good results too. I’ve seen how running a business can allow you make a return of 25% – 300% on the money and the value of the time you put into something within a year.
Since a business can be such an effective way to make money, you naturally start to wonder. Do you really need an investment portfolio? Or can your business pay for everything while you gradually stop working completely? I’ve learned that this isn’t possible.
While everything might seem simple and smooth at first, the world of business is constantly changing. What people want, how they look for it, and where they get it can be completely different today compared to 5 years ago. And the competition is never-ending.
If you look at large corporations they are the best example of how to build a stable business. They have optimized and interconnected functions for everything they need from coming up with products to finding customers to making sales. As a shareholder in one of these corporations everything is done for you. This is very different from small private businesses that might vanish if you don’t keep contributing something every week.
And yet these corporations can barely manage to keep doing what made money a decade ago. They only survive thanks to visionary leaders who can transform them into a different company in a short time. Their management is in a desperate race to top themselves before someone else does, and the people choosing the managers are essentially gambling on who will get it right in time. Many of the corporations we know now will be gone in 30 years.
If the most successful businesses can’t last long, the chances that you can retire early on the income from a business with 10% of their sophistication are very small. True passive income is government bonds in the right countries. Going down from there, you can claim that things like blogs or niche sites are passive income but there’s a good chance that if you don’t keep putting in work their revenue will decline to $1/month.
My plans are based on this concept now. I see my businesses as the opposite of regular investments – I can get high returns but only for a short time before I need to do something new. At some point they might be able to create an income that’s several times as much as our expenses without requiring a lot of daily work.
But I will take a large portion of that and invest it in a conventional portfolio. When that portfolio grows large enough to cover our expenses I will have a lot more choice in what I work on. Until that time I will need to keep coming up with new ways to earn more regardless of how well things went in the last month or the last year.