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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 o

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).

kd5bjo 6y ago
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.
- fairity 6y ago
  > 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).
  - kd5bjo 6y ago
    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.
    - deleted 6y ago
      [deleted]
    - smabie 6y ago
      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.
      - kd5bjo 6y ago
        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.
        smabie 6y ago
        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.
        kd5bjo 6y ago
        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.
  - DamnYuppie 6y ago
    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.
- Moodles 6y ago
  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.
  - fairity 6y ago
    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.
    - Moodles 6y ago
      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.
- marcosdumay 6y ago
  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.
- karmakaze 6y ago
  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.
- smabie 6y ago
  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.
  - fairity 6y ago
    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?
    - smabie 6y ago
      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 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.
      - ptsneves 6y ago
        @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.
        smabie 6y ago
        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.
deleted 6y ago
[deleted]
marioletto 6y ago
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...
spekcular 6y ago
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).
- paulpauper 6y ago
  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.
  - xchaotic 6y ago
    If this is just retirement money, so what? It rebounded pretty well since.
    - paulpauper 6y ago
      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
smabie 6y ago
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.
- marvin 6y ago
  And certainly you are well protected against black swan type events, even at 10x leverage...?
  - paulpauper 6y ago
    it really depends on the underlying asset. short dates bond trading involves large leverage because short-term bonds tend to not move much
  - smabie 6y ago
    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.
    - marvin 6y ago
      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.
paulpauper 6y ago
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.
np_tedious 6y ago
Do you mean IBKR, Interactive Brokers? I looked up IBK and was surprised to st Industrial Bank of Korea
- fairity 6y ago
  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 https://www.interactivebrokers.com/en/index.php?f=46376

kd5bjo 6y ago

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.

fairity 6y ago
> 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).
- kd5bjo 6y ago
  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.
  - deleted 6y ago
    [deleted]
  - smabie 6y ago
    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.
    - kd5bjo 6y ago
      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.
      - smabie 6y ago
        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.
        kd5bjo 6y ago
        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.
- DamnYuppie 6y ago
  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.
Moodles 6y ago
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.
- fairity 6y ago
  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.
  - Moodles 6y ago
    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.
marcosdumay 6y ago
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.
karmakaze 6y ago
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.
smabie 6y ago
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.
- fairity 6y ago
  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?
  - smabie 6y ago
    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 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.
    - ptsneves 6y ago
      @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.
      - smabie 6y ago
        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.

deleted 6y ago

[deleted]

marioletto 6y ago

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...

spekcular 6y ago

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).

paulpauper 6y ago
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.
- xchaotic 6y ago
  If this is just retirement money, so what? It rebounded pretty well since.
  - paulpauper 6y ago
    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

smabie 6y ago

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.

marvin 6y ago
And certainly you are well protected against black swan type events, even at 10x leverage...?
- paulpauper 6y ago
  it really depends on the underlying asset. short dates bond trading involves large leverage because short-term bonds tend to not move much
- smabie 6y ago
  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.
  - marvin 6y ago
    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.

paulpauper 6y ago

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.

np_tedious 6y ago

Do you mean IBKR, Interactive Brokers? I looked up IBK and was surprised to st Industrial Bank of Korea

fairity 6y ago
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 https://www.interactivebrokers.com/en/index.php?f=46376