VeriPlan Information

Section 9 -- Using Asset Allocation Method #3 with borrowing or negative financial asset positions

Subject: Section 9 -- Using Asset Allocation Method #3 with borrowing or negative financial asset positions
by The Skilled Investor on May/18/2007 18:00:24

Section 9 -- Using Asset Allocation Method #3 with borrowing or negative financial asset positions

Because of personal investment risk aversion, the great majority of VeriPlan users will probably wish to maintain only positive or 'long' positions throughout their lifecycle projections. For them, maintaining a zero or positive percentage allocation in each of their cash, fixed income, and equity financial asset classes will impose a long-only strategy in their projections. However, when using Asset Allocation Method #3 on the orange-tabbed "5-Asset Allocation Tool" worksheet, VeriPlan does not require that you choose only positive or 'long' positions for all of your financial asset classes. Some of your financial asset classes can have negative or 'short' asset holdings. These negative and positive percentage adjustments still must offset and total zero percent.

If you are a very highly risk tolerant investor, Method #3 can calculate leveraged lifecycle projections with borrowing. This method can project the lifecycle results for aggressive or more risky investment strategies that use borrowing or leverage to create equity positions that exceed 100% of your net assets. Because the historical equity asset class total return has exceeded the total returns that have been paid on the cash and fixed income asset classes, leveraged strategies usually involve negative or borrowed cash and/or bond positions to fund leveraged or greater than 100% holdings in equities. Risk tolerant investors use leverage with the expectation that they will capitalize on differences in the relative risk premiums paid to different asset classes over time.

The remainder of this section will provide several cautions about adopting a leveraged investment strategy, and then it provides instructions on how to use VeriPlan to develop leveraged projections, if you are still interested.

These next three paragraphs provide a cautionary high-level discussion about using leveraged financial asset investment strategies. These cautions relate to 1) sustaining leveraged strategies during equity market downturns, 2) borrowing rates associated with leveraged strategies, and 3) risks to collateral used to borrow funds for leveraged investment strategies:

1) You probably should avoid leveraged investment strategies, if you do not have a thorough understanding of: A) your personal penchant for investment risk taking, B) your ability to sustain such strategies through stock market downturns (Managing upturns is easy.), and C) reasonable expectations about expected investment risk and return tradeoffs across the financial asset classes.

When you analyze any VeriPlan projection that involves net negative cash plus bond-fixed income asset positions, you should note that the blue-tabbed '21-SAFETY MARGIN' graphic will indicate a zero safety margin across your lifecycle projections. (See the orange-tabbed '8-Portfolio Safety Tool' for more information about this tool, this graphic, and the subject of managing during equity market downturns.) Because the '21-SAFETY MARGIN' graphic reinforces the idea that you will have no net cash or bond-fixed income assets to draw upon, your employment prospects need to be highly stable and/or your living expenses need to be relatively modest. Otherwise, if equity markets were to retreat substantially or borrowing costs were to rise unexpectedly in the future, funding your living expense short-fall will require you to liquidate equity assets at an unappealing discount. This is one of the primary reasons that most investors avoid leveraged equity positions.

2) Leveraged strategies are appealing, only if the expected difference between the total equity return and the net cost of borrowing is wide.

The asset class risk premium information on the orange-tabbed '4-Historical Asset Returns' worksheet indicates that only a few percentage points separates bond and equity risk returns. While a difference of a few percentage points compounded annually could lead to a huge asset return differential, individual investors cannot borrow at rates equal to expected total bond asset class returns. Therefore, borrowing costs can narrow or eliminate any expected equity to bond asset class return differential. In fact, if borrowing costs are high enough, then the expected return of a leveraged strategy could be both lower than a long-only strategy, while the concomitant risks are dramatically higher. The corporate yield spread chart on the '4-Historical Asset Returns' worksheet shows that yield margins increase dramatically on lower grade corporate debt. Even using personal equity or real estate as collateral, individual investors usually must borrow at rates that have a much larger spread than lower grade corporate bonds. For example, recently when cash returns were under 1%, investment banks were charging close to 10% on their margin accounts -- even when equity securities were collateral and these accounts were subject potentially to margin calls and forced liquidation.

3) In addition to high interest rates associated with a leveraged investment strategy that individual investors may face, they also expose themselves to additional risks through debt collateral requirements.

Based upon their signatures alone, few, if any, investors can obtain advantageous interest rates that would justify using a leveraged investment strategy. Instead, to obtain 'more reasonable' interest rates, they must put up valuable collateral, such as the value of the stocks held, real estate, or other assets that have substantial, unencumbered value. Despite high margin interest rate charges, the equity held in margin trading accounts also provides collateral to protect the interests of the investment bank. Investment banks are protected from all but the most severe market panics through their ability to make margin calls and liquidate assets that clients hold. While many, many thousands of individual investors lost everything in the 1929 stock market crash, margin calls and account liquidations protected the banks. Not a single investment bank went out of business due to loses on individual investor's margin accounts. Another major source of collateral is real estate. Individual investors sometimes use real estate lines of credit to borrow funds that are then invested in the equities markets with or without additional margin interest borrowing. Severe market downturns could decimate an equity trading account. When this happens, the individual has lost his investment assets, but still retains the higher real estate debt. If the equity market downturn is directly associated with an economic shock that also affects an individual's employment, then his real estate assets also could be in much greater jeopardy.

These caveats aside, if a leveraged strategy is of interest to you, then VeriPlan can develop projections for you to analyze. If you wish to explore leveraged asset allocation strategies, do the following:

Step 1: Experiment with the settings above in Method #3, and enter a negative number that will reduce the cash asset allocation percentage to zero percent. (You should eliminate all cash holdings, because VeriPlan will model your leveraged position with a negative bond - fixed income asset class position. The negative return on this short bond position, in effect, will measure your borrowing cost for the overall leveraged strategy.)

Step 2: Increase the percentage for equities and lower the percentage for bonds in Method #3. Your percentage settings must offset, and they must total 0%. You bond setting must be negative for you to have a leveraged portfolio. The net negative percentage for your bonds will indicate the portion of your total financial assets that will be borrowed. Note that your settings in Method #3 will be constant throughout your lifecycle projection. You can view the results on the blue-tabbed '11-ALLOCATION' graphic. Above the 0% line, this '11-ALLOCATION' graphic will show 100% equities, and, in addition, below the 0% line, it will show the percent of equities that are borrowed.

Step 3: Set an "interest rate" for borrowed capital by adjusting the total return for the bond/fixed income asset class. You can do this on the orange-tabbed '7-Portfolio Risk Tool'. Use the Asset Class Total Return Adjuster in Section 3.3 (not the Projection Variance Tool) to increase the total return of the bond -fixed income asset class. Your bond percentage adjustment there should be positive. (Because the bond asset allocation above is negative, VeriPlan will treat a positive bond total return rate as a negative return that is equivalent to your expected interest rate on the debt.) In section 3.3 of the '7-Portfolio Risk Tool' worksheet, you should increase the total expected bond asset class return by an amount that would convert it into an effective interest rate. Adding several percent might not be unreasonable, but keep in mind any remaining spread between total equity and total bond returns. Also, the total bond rate you set with your adjustments should be a real dollar "interest rate," which would be approximately three percent lower than a nominal interest rate would be.

Step 4: Experiment with a variety of bond total return rates and compare the outcomes to other scenarios where you simply hold a 100% or lower equity allocation. Frankly, without also adjusting the equity total return higher -- perhaps unreasonably -- to maintain a positive return margin over your bond "interest rate," it will be difficult to set a realistic borrowing rate and still have enough return left to justify all the additional risk.

Keep in mind that the return rate adjustments that you make, when evaluating a leveraged investment strategy, will be applied across your lifecycle, where there inevitably will be numerous minor and major equity market setbacks. A reading of the scientific investment literature indicates that over very long periods an asset allocation that very heavily emphasizes equity returns can still benefit from a minority allocation to the bond/fixed income asset class. These findings contradict the supposed wisdom of holding greater than 100% equities in a leveraged strategy, when realistic measures of the cost of borrowing are taken into account. In reality, though, one might question the potential superiority of any leveraged strategy. Only large institutional investors might borrow at sufficiently attractive rates to make these higher risk leveraged strategies possibly feasible. The much higher interest rates at which individual investors must borrow would seem inevitably to doom leveraged strategies to inferior absolute performance. When risk-adjusted performance measures are employed, then inferior risk-adjusted performance seems to be an even greater likelihood.

Note that when you use negative settings for some asset classes in Method #3, these negative asset positions can distort how some of VeriPlan's graphics are displayed. On asset related graphics, in particular, negative asset positions will display in manner that is similar to asset graphics which include debts. Negative asset holdings, are equivalent to debts and will not display visibly on the graphics. Instead, these negative asset holdings will pull the lower edge of your positive asset positions down below the zero assets line. Whenever your assets are displayed below the zero dollar assets line, this indicates that negative asset positions are part of your portfolio and/or that your debt holdings are included with your assets on the graphic. However, no colored bar corresponding to any negative asset or debt will display, as long as your overall net asset holdings are positive. Your asset classes with positive values will instead display with their lower colored bands beginning below zero to the extent that your portfolio holds negative assets in certain asset classes.

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