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Comment by fairity | Hacker News Reader

One question that's been top of mind lately for me is how optimistic you should be in your investing strategy.

IBK currently allows retail investors to trade on margin with an annual interest rate of only 1% (yes, really). You can borrow up to 2x your principle at this rate.

If you were extremely optimistic, you would borrow 2x your principal and expect to 3x your annual return.

If you were optimistic but wanted to avoid risk of ruin, you would borrow between 0-1x of your principal.

Curious if anyone here has considered this or has a strong opinion on it.

Side-note: I'm assuming my "principle" in the above scenarios is the remaining cash I have on hand after my rainy day fund (i.e. the saving like a pessimist part).

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One should target volatility, not leverage. Without leverage, you can usually only take the most risky of strategies in order to get a return. If you're willing to take on leverage, you are much more likely to find a good strategy.

Source: work at a small prop firm that takes on around 10x leverage. Even at this leverage ratio, we are considerably less risky than the S&P 500. Even at 10x, our volatility is somewhere between 1/2 to 1/3 of the S&P.

If you take on very little directional risk and are doing stat arb like us, there's nothing wrong with taking on a lot of leverage. Even at 10x, we are safer than the vast majority of retail portfolios in existence.

Leverage (through futures, options, shorts, or borrowing) is the cornerstone of almost all active outperformance in the industry. Without leverage, you will be forced into high beta names that trade at a premium compared to their risk adjusted return. See the "low beta anomaly" for more information.

And certainly you are well protected against black swan type events, even at 10x leverage...?

Shit happens and even the smartest people can get fucked, just look at the LTCM blow up. So of course it's possible.

It's impossible to eliminate all risk, regardless of the leverage ratio. I'm just saying that leverage isn't a reasonable proxy for risk. You have to dig deeper.

That sounds reasonable at first glance, but it would be really interesting to see a proper study of leveraged investments throughout the modern era, and their tendency to blow up compared to the volatility of what would be the reasonable alternative.

if you have 10x leverage, your insurance against black swan events is to try to go 10x bankrupt.

it really depends on the underlying asset. short dates bond trading involves large leverage because short-term bonds tend to not move much

But increased leverage doesn't mean your risk-adjusted returns are any better.

You can't eat on risk adjusted returns alone! gotta make that chedder

But leverage necessarily decreases your risk adjusted return assuming non zero volatility of the strategy. This is called "volatility drag."

would you recommend any literature more broadly argumenting the ideas you defend here? thanks!

The book Lifecycle Investing by Nalebuff and Ayres, both professors at Yale, argues fairly convincingly that trading on margin is optimal for young people, especially those expecting high-earning careers (e.g. software developers).

The calculations in the book use much more pessimistic annual interest rates than the 1% you quote, too.

I'm too risk averse to actually do this, even though I believe their arguments. However, it has convinced me that at least 100% stocks, 0% bonds is optimal, if we avoid margin (for a young person expecting a good job).

path dependency is the main problem with margin trading. S^P 500 fell 60% in 2007-2008. So that should give you an idea of how much of a cushion you need to give yourself for the worse case scenario.

If this is just retirement money, so what? It rebounded pretty well since.

if you have have 100% margin and the market falls 50%, the broker will close out all your positions at a large loss to protect its own assets (often well before the 50% target), at which point it will not matter how much the market rebounds after that

I personally don’t invest on margin. It just feels weird to take a short-term loan (whatever the interest rate) when I have the cash to cover the loan. And if I don’t have the cash to cover the margin loan, I should be working on increasing my emergency fund instead.

In short, there’s no set of circumstances where my decision tree comes down on the side of taking the loan.

I actually have a somewhat controversial opinion (that shouldn’t be controversial because it’s all math, but it still is regardless) that, after you save 5-6x your emergency fund, you don’t need an emergency fund at all and you’re better off investing it all in a total market index fund. The reason being that even if there is a market crash, you’ll still be able to afford the emergency since you’ve saved multiples of it already, and in general in the long run having stocks instead of cash or T-bonds in an EF will be better. Various blogs have done the math and it all checks out, but people still push back at me for this. Having an EF if your net worth is a few multiples of your emergency fund, is entirely psychological. Which is fine. But people should just be aware that it’s a bias they have.

Perhaps investing on margin is the same. I have personally taken the leap and got rid of my emergency fund. But I haven’t looked at investing long-term on margin yet. I did see a test from HEDGEFUNDFIE on bogleheads forums about this. But I haven’t looked into it. I definitely think taking out a margin loan while simultaneously having an EF in cash makes no sense though.

You have $100k. Put 80% of it in the stock market. The stock market drops by 40%, your investment is worth $48k and you withdraw nothing but spend your entire emergency fund. The market recovers and now your portfolio is worth $80k.

You have $100k. Put all of it in the stock market. The stock market drops by 40%, your investment is worth $60k and you withdraw $20k. The market goes back to 100% and now you have $67k in your portfolio.

If the market dropped by 80% your portfolio would be gone entirely. Meanwhile if you had enough emergency funds you would have kept everything.

The worse the emergency, the higher the ROI of the emergency fund. Since there is no upper bound for how bad an emergency can be the theoretical ROI of an emergency fund is also unbounded.

In this comment the definition of an emergency is a stock market drop combined with unexpected unemployment.

You've just given a cherry picked example to show that yes, withdrawing during market downturns is bad. I don't disagree with this? I'm merely saying that, on average, over the long-term, it makes more mathematical sense to ditch the EF if you're a high net worth individual. For example, you have literally just picked the worst case scenario and used that to justify why the strategy is bad. What about all the times your emergency doesn't coincide with a total market crash? My all stock "emergency fund" will actually grow larger than yours, on average. You probably have several emergencies over the course of your life.

Honestly your example is about as useful as me saying investing in stocks in general is bad, because sometimes, they go down. So what? We're talking about broad long-term averages here, nothing more.

It's fine to argue about personal psychological preferences, but as I say, this purely a mathematical statement I am making here. It should not be controversial, but it always is.

in theory, all your money should be in the market if the market is efficient and has a positive drift

Yeah, I mean there's also some practicalities involved like having cash to withdraw from an ATM or paying rent, but yeah pretty much I'm fully invested.

That's all for an emergency on day one! If the stock market goes up 70% before your emergency, you'd have been better off with the all in strategy.

I know. I get the exact same push back every time I mention this. I don't know why? I'm literally saying, on average, over the long-term, it's mathematically better to ditch the EF. This is a mathematical statement, but always someone says ""but what about 2008!?" as if I havn't considered it. It's quite bizarre. I suppose an EF is an emotional issue for a lot of people maybe.

That’s another use of margin. Invest 100% (but not more). Emergency hits and you can withdraw cash without selling stocks (up to a point).

I mean honestly, using a credit card for a month before interest hits is usually fine too? My credit limit is like 50k or something ridiculous across all my cards. Not to mention when all in on stocks you can sell for better long-term capital gains tax treatment or even tax loss harvest losses too, which you can't do with a savings account. And ETFs are actually pretty liquid: I can sell and withdraw in a few days if I wanted to anyway.

Yes, but then you need cash to pay off the credit card, which is cheaper to pull from your margin available than to let the credit card charge you interest.

I'm not suggesting to pay credit card interest. I'm saying you can cover any emergency expense with a credit card which buys you a month, and then you might have ordinary salary or time to sell your stocks before interest is due.

No offense but I'm pretty surprised you commented what you did. Literally my first sentence says "... before interest hits...".

I’m perhaps equally surprised that you’d consider anything an emergency that would covered by your ordinary salary within a month’s time. I mean, that’s just normal credit card use, right?

Maybe we’re talking cross purposes here because I generally save a large % of my paycheck. So if an emergency came up (and I was still employed) I would just save a smaller % of it.

But regardless I’m just saying you can use a credit card to buy time interest-free before you pay off the emergency with your salary/stocks/whatever. It’s better than taking a margin loan, no?

> So if an emergency came up (and I was still employed) I would just save a smaller % of it.

i mean that's not really an emergency.

An emergency is one such that if you weren't prepared for it, you can't handle it. For example, losing one's job can be considered an emergency (a short one, if you're in high demand).

A medical emergency is a good example of an emergency - to which you prepare for by purchasing insurance.

So by saying that a person's portfolio would perform better by ditching the emergency fund is just the same as saying 'take on more risk and get more return'.

You’re kind of nitpicking here. It doesn’t matter how much the expense is: the point is that you can use a credit card to buy time interest-free before you pay off the expense with stock/paychecks/whatever. Regardless of what the expense is, this is clearly better than taking out a margin loan immediately.

I’ve thought about this too, and came to a different conclusion. The primary reason is just because the markets haven’t collapsed more than 85% over a months long period before, doesn’t mean it won’t in the future. And, my marginal utility for money gets so high below a certain level, that it’s not worth risking this outcome when the marginal utility of more money is relatively smaller.

Yeah, it’s essentially just estimating the probability of you getting an emergency which coincides with a total market collapse so horrific it reduces your semi-liquid net worth to less than your emergency. I’m at a point where I’m ok with that risk. At some point you would be too: 85%? 90%? 99%? Clearly we agree Jeff Bezos doesn’t need 6 months cash on hand at all times. So the limit is somewhere. I think a total market collapse reducing the Dow Jones to like 3,000 is pretty unthinkable at this point. Or rather, if it did happen, there are bigger problems than my cash, like the zombie apocalypse which caused this horrific stock market collapse.

> a total market collapse so horrific it reduces your semi-liquid net worth to less than your emergency

I don’t follow the logic here. It doesn’t need to reduce your funds anywhere near the emergency amount.

If it reduces your investments to 3x your emergency you were just forced to sell 1/3 of your portfolio at what is potentially the lowest point.

Because there are actually two goals, not one:

1. To have enough money to survive an emergency no matter what.

2. To maximize long-term net worth on average.

I was only talking about 1. You are talking about 2. But, to address your point: yes, stocks can indeed go down, but on average they go up. Sometimes your emergency will coincide with a good stock market. You're literally choosing the worst possible situation and then saying "see, this strategy doesn't work!". But I'm actually being very careful with my words here. I am saying: mathematically, backtesting with real data and with monte carlo simulations, you will maximize your long-term net worth on average if you forgo the EF after a certain net worth level.

Consider also the original comment I replied to talked about investing on margin while simultaneously having an EF. Which, if you're against me forgoing an EF, you must really be against investing on margin while having an EF: That's kind of the same to what I'm currently doing, only paying interest for it!

People don’t keep EFs to maximize their expected net worth. They do it to keep worst case scenarios within reasonable bounds.

You argue keeping stocks is ideal for 2 (sure) and it doesn’t hurt 1 (assuming your net worth is significantly higher than what you’d keep as EF). Agreed.

An EF is for 3. Maximize long-term net worth in x th percentile of outcomes (where x < 10)

EDIT: “ you must really be against investing on margin while having an EF”. Yep.

Ok but now we're just personally disagreeing on what x is, which as I said in my first post, is fine. But just be aware of the bias.

Makes sense. 99% sounds about right for myself. But, how do I estimate the degree of downswing that I'm 99% confident will never happen in my lifetime? Or, is there a way to buy options to protect against this outcome that would economically make sense? Thanks!

Yeah it’s hard. There is about 200 years of stock market data so I would look at the biggest crashes to get a sense of what the biggest of them all could be. I guess that’s the German tank problem. It seems very unlikely we’ll get a crash relatively twice as bad as the Great Depression though

Why does that seem very unlikely? It seems to me that the right way to think about that is that the likelihood is simply unknowable either way.

It seems very unlikely since there's 200 years of data to show that was the biggest crash ever. So a crash twice that size is very unlikely. You could do the math to calculate the exact probability given the sample size of stock market years.

But ... that 200 years of data has nothing to do with what is going to happen in the future...

Not nothing.

I guess this always devolves into philosophy, but yes, the future is actually unknowable.

Right, and at some point you have to choose to live your life assuming there isn't an undetectable asteroid about to wipe out all human civilization, even though you don't know the probability of it happening.

I keep roughly 10% of my net worth in cash... That equates to several years of expenses. It may be excessively high but it lets me sleep at night. You joke, but the past year shows something like a zombie apocalypse is a possibility.

Yeah as I say, it's fine to do whatever you want with your money to provide emotional comfort. I'm merely saying it's a psychological bias you may want to be aware of.

I mean, you chose a 10% figure. Why 10%? Why not 20% or 5%? I think it's helpful to really think through the math sometimes.

Yes, you're right... Mathematically, I know I can be fine with less, it just makes me feel uneasy. I was actually trending towards a lower percentage, but I got scared and depressed earlier in the year. I sold off some poorly performing stocks and ETFs, giving me some more cash cushion. It felt like the sh*t was really hitting the fan. It still does, in many ways, just not for my investment accounts. When (if?) things "go back to normal" I will re-assess...

I suspect if you know not to trust yourself to stay the course when the sky is falling, then you are in fact probably better off in the long-run with a less risky asset allocation. There’s plenty of evidence out there to show that the more you buy/sell/tinker, the more likely you are to get worse returns. Literally the best investors are dead people. So if you need some % of cash or bonds to stay the course and do nothing, that’s good. Which shows some self awareness and maturity. Ideal would be to dispassionately follow the math, but your strategy is the next best thing.

> You joke, but the past year shows something like a zombie apocalypse is a possibility.

For me the past year shows that the economy has been more resilient than most people expected, that the Fed is willing to drop rates to zero in order to keep it that way, and that the stock market actually goes up when that happens because it is the only investment that might return more than a fraction of a percent.

If you are going to keep that much in cash, I might suggest putting some of it in inflation-protected securities like I-bonds. They are backed by the US government, and I can't forsee a situation where the government could default on them without the value of the dollar also tanking. They are better protected from inflation than money in a savings account.

I agree with what you say about the economy. I am also impressed by the resilience there. My apocalypse comment was more in reference to the non-economic aspects... sickness, death, isolation. I put on the news and it's awful. Working-from-home has also really worn me out. Many nights, I have trouble sleeping.

I will look into something like the I-bonds more seriously.

In the very worst scenario, you’re going to need guns, source of food, land, and most importantly a network of people who you can call to help defend you (or go on offense with you to acquire necessary resources).

The dollar is only useful as long as the US government continues to perform as an organization. However, as the US approaches dissolution, I would expect the value of USD to approach zero as the government increases the supply of money and prospective owners of the currency lose trust in its ability to retain value in the future.

>or go on offense with you to acquire necessary resources

Are you seriously suggesting, on a hacker forum, to be prepared to use the proceeds of your emergency fund to violently steal life-critical resources from other people in a crisis?

I really hope I've misunderstood, and you're using the phrase "go on offense" as a euphemism for deer hunting.

No, I am suggesting that in a worst case scenario, an emergency fund full of cash is useless (on a multiple year timescale, of course how many years is subjective).

It’s conceivable to imagine a scenario where resources are so limited that acquiring them becomes a do or die situation, which is what I imagine the previous poster meant by “zombie apocalypse” scenario (or more realistically, war). Or I erroneously assumed “zombie apocalypse” to mean worst case scenario.

I also forgot to include a less drastic measures of also owning assets in a different country and the rights to live there in case you need to immigrate.

This is true. However, I think there are a variety of scenarios, less extreme than total societal collapse, where it still may be useful to have a large emergency fund. It may not be rational.

Do we all agree with that? I feel like I'd probably still keep 6 months of cash on hand if I were Jeff Bezos... But presumably that's one of the many reasons I'm not.

I think the central banks and government will prevent any future collapse of that scale. Don’t fight the fed. They have more money than you.

This sounds true if you only optimize for (hedge against) one risk only - stock market crash.

To me, an emergency fund is a hedge against various different risks like these (I am guilty of not being prepared for all of them):

1. A pandemic. For this I was ready even before we thought it's indeed possible - I have funds in several different banks (debit cards) that allow me to not have to visit a bank physically for several years (even if some of the cards expire in the meantime, or one bank suddenly goes bust)

2. AI glitch, identity theft, a bank holiday (this happened to me actually some years ago) that blocks you from accessing banks (and investment brokers if you have nowhere to withdraw your funds) for several weeks/months - for that you hold paper cash, physical gold and cryptocurrencies stashed at different physical locations.

3. Natural disasters - again some combination of diversified physical and virtual funds

4. Legal trouble - yes, even if you are not guilty you could get your funds blocked.

I presume you are from the US, hence the purple goggles ;) (I hope I'm not offending you)

purple goggles?

Rose tinted glasses

Yes, sorry, not a native speaker

The bad part is that you are going to have to pull money out of the market at the worst time, when prices are way down.

You won't necessarily have to, but yes, no risk no reward. Doing this is what people who have retired have to do whenever there is a market crash.

Really this shouldn't be that controversial. It's super simple: Which does better long-term? Stocks or cash? That's pretty much all I'm saying. There's a ton of data to back up what I'm saying.

https://earlyretirementnow.com/2016/05/05/emergency-fund/

Leverage allows the execution of strategies that have a high Sharpe but low natural return.

I work at a small prop trading firm and we run 10x or even more leverage most of the time. Without leverage, we wouldn't be able to run the vast majority of our strategies.

Basically, leverage is immaterial: what matters is the risk of the strategy. A leveraged strategy could be less risky than an unleveraged one.

Things that you should consider when deciding leverage: beta exposure, correlation to the market, volatility of the strategy, and the risk adjusted return of the strategy.

A classic example of this is risk parity: risk parity uses high leverage but is often safer than a classic 60/40 portfolio.

To be honest, what you just said went right over my head, but I really want to learn more. Can you recommend where to start given that the strategy I'm evaluating is akin to levering up 1x and investing in index funds?

I have a blog post I wrote awhile ago that might be of interest:

Diversification, Risk and Leverage https://cryptm.org/posts/2019/11/28/div.html

If I was rewriting the post today, I would make some changes, but by and large, I stand by the post.

@smabie: Thanks a lot for the post. I am for the first time understanding concepts that in words were very hard to process. The math connection you make really helps, as basic calculus as statistics are part of an engineering background.

I really appreciate it! Finance can be a really opaque topic and there's a lack of rigorous yet straightforward material about the subject.

Most information about trading either falls into the total bullshit camp designed for idiot retail investors, or complex papers/books designed for academics or professionals.

My blog tries to straddle the two: providing rigorous material but geared to those without a background in finance.

> It just feels weird to take a short-term loan (whatever the interest rate) when I have the cash to cover the loan. And if I don’t have the cash to cover the margin loan, I should be working on increasing my emergency fund instead.

I see. Would your thinking change if your emergency fund was sufficiently large but much smaller than your investable cash?

For example, let's say your rainy day fund was $10, and you have $100. You have $90 to invest. In this case, the short-term loan you're taking out could range from $0-270 (the majority of cases would not be covered by your rainy day fund).

I like the OP don't use margin. Long term it will lead to trouble, it may work for a little while but long term the trend is against you. Especially when you have a larger account they will give you 4x margin, this is a great way to loose a lot of money quickly if the market makes a quick turn against your positions. To be clear the market invariably at some point will quickly turn against you!!

In my opinion, and practice, emergency funds should not be used for investments ever, this includes covering the losses from investing. Yes it can feel like you are not maximizing your returns on that amount of money but its job isn't to generate returns, it is your help smooth out the bumps in the road of life for you. In my experience life can punch hard and it never throws just one punch, it is usually a 1,2,3 combo. That emergency fund is merely there to help raise the chances of you standing on your feet after the vicious flurry.

If you want leverage and you are in the US or have a US based brokerage account use options. By using options your all in is basically the cost of the option and this ensures you will not ever lose more than you paid. PLEASE note the previous sentence is predicated on the golden rule of NEVER WRITE an uncovered/naked option, seriously do not do it!!!! I also use the 5% rule, which no one trade is more than 5% of my portfolio so no one trade will destroy me.

No. If a margin call came in a down market, it would wipe out my emergency fund; that’s the exact opposite of “saving like a pessimist.” If I have $90 to invest, then I have $90 to invest; I’m not going to gamble with someone else’s money whatever the odds.

Let's say you found a strategy that had 10% return and 1% volatility. you really wouldn't leverage this? Even after 4x leverage is applied, it would still be considerably less risky than the S&P 500.

Those numbers sound too good to be true. I’d stay as far away as possible, smelling a con. I certainly wouldn’t invest money I can’t afford to lose.

They're not too good to be true. it's just the people making those kinds of returns aren't taking retail investment.

For example in crypto, market makers are commonly making 100% return. You haven't heard of these firms and they aren't interested in your money.

Market makers usually do quite well for themselves, but are capacity constrained: they can earn stellar returns on tens of millions of capital, but maybe not hundreds of millions or billions. You probably haven't heard of most of these firms and they would prefer to keep it that way.

of course if you want a public example, look at RenTec. They are unique in generating eye popping returns with such a large amount of capital. This is extremely uncommon. However generating comparable returns on 500-1000x less capital is significantly more common. These returns often don't compound tho, as they are severely capacity constrained.

It sounds like people who invest the time to properly learn finance can make a pretty good living at it. If that’s you, I wish you the best of luck.

But I’m a retail investor, and will almost certainly remain one— Not only do I not have the training to come up with these strategies, I don’t have the knowledge to judge the veracity of anyone claiming to sell them to me either. I’m content with my suboptimal portfolio that I don’t have to think about more than once a year, and have more important things to spend my time on.

Few cryptocurrency holders are using it for payments or building anything that creates value. It’s just zero-sum speculation and FOMO.

Equities are different because their connection (however tenuous) to actual earnings gives them a very steady long-term uptrend. The hard part is just staying in during a crash so you don’t miss the recovery. Half of S&P 500 returns came on its ten best days.

I myself also don't trade on margin, but I don't disagree with it. An optimal trading strategy should be positive and often could include some amount of margin trading that beats interest rates as well as accounting for additional risk. The reason I don't trade on margin is that I don't put so much effort into it to optimize to such a level.

I imagine that if there are large transaction costs on moving money out of your main investment, a short term load would make sense.

I am personally too risk adverse to go taking loans all the time. But I can imagine it being a good option.

I think the answer is more philosophical than a formula that applies to everyone: in that sense i would say: save like your pessimist self would save and invest like your optimistic self would do. Like a grandpa would say, "To Each Their Own" My optimistic self will probably always invest way more conservatively than someone investing on margin...

Absolutely not because of risk of ruin owing to path dependency. I would recommend 2-3x ETFs instead because there is no risk of ruin but there are still possible path dependency issues.

Do you mean IBKR, Interactive Brokers?

I looked up IBK and was surprised to st Industrial Bank of Korea

Yea, typo. Interactive Brokers's margin loan rates are BM + 1% (or 1.09%, at present). https://www.interactivebrokers.com/en/index.php?f=46376

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