What success story (or stories) did you have in mind when writing this?
Wei_Dai(Wei Dai)
Karma: 35,027
See also the bottom of this comment for a more complete record of my significant (non-EMH) investments.
Pay your monthly bills with margin loans
Instead of maintaining a positive balance in a bank checking account that pays virtually no interest and having to worry about overdrafts, switch your bill payment to a brokerage account that offers low margin rates, and pay your bills “on margin”. (Interactive Brokers currently offers 1.55% (for loans <$100k), or negotiate with your current broker (I got 0.75% starting at the first dollar)). Once a while, sell some securities, move money back from a high yield savings account or CD, or get cash from box spread financing, to zero out the margin balance.
There was a previous thread about this.
I kind of miss the days when I believed in the EMH… Denial of EMH, along with realizing that 100% and 0% are not practical upper and lower bounds for exposure to the market (i.e., there are very cheap ways to short and leverage the market), is making me a lot more anxious (and potentially regretful) about not making the best investment choices. Would be interested in coping tips/strategies from people who have been in this position longer.
(It seems that in general, fewer constraints means more room for regret. See https://www.wsj.com/articles/bill-gates-coronavirus-vaccine-covid-19-11589207803 for example.)
You don’t have to be smarter than them to exploit them, since they’re optimizing a different goal: keep their customers happy, instead of making maximum money for them.
What trades does this suggest?
such high variance looks much more obviously like ‘gambling’ or ‘taking on an enormous amount of risk’ than ‘it’s fun and easy to seek out alpha and beat the market’
I know someone else who made the opposite mistake as me and sold their coronavirus puts too early. If you only saw their record, there would be no “high variance”. They just made less money than they could have. It seems to me that the correct lesson from both outcomes is that it’s possible to beat the market (without putting in so much effort as to make it not worthwhile to try), but we haven’t figured out how to time the exits at exactly or very close to the best times.
Followup is important; I notice that Eliezer has not exactly gone around trumpeting Wei Dai’s followup comment where he mentions losing almost all of his coronavirus profits as evidence that maybe the EMH is right after all
When Eliezer posted about my bet, I had only gained 7x my initial bet (and that’s what he posted about), and although I ended up losing 80% of my paper profits (which were 50x at one point) I still gained 10x my initial bet. So him not posting further followup seems fine? And at least from my personal perspective (i.e., where selection bias isn’t an issue) the final outcome still seems to be strong evidence against EMH.
Can you go into more detail about this, or link to an article?
Yes, you can open accounts at multiple banks and use other tricks to get more insurance. See https://smartasset.com/checking-account/how-much-is-fdic-insurance
Both of these references fall under the “mean-variance” paradigm, but according to Strategic Asset Allocation: Determining the Optimal Portfolio with Ten Asset Classes:
Both academics and practitioners agree that the mean-variance analysis is extremely sensitive to small changes and errors in the assumptions. We therefore take another approach to the asset allocation problem, in which we estimate the weights of the asset classes in the market portfolio. The composition of the observed market portfolio embodies the aggregate return, risk, and correlation expectations of all market participants and is by definition the optimal portfolio.
I think “by definition” is wrong here, but there are strong theoretical reasons to think that the global market portfolio is the optimal portfolio for all investors (investors with different risk tolerance should differ only in how much exposure or leverage they use). However that theory makes some unrealistic assumptions, and here’s a fuller picture, from Q&A: Seeking the Optimal Country Weighting Scheme :
Financial theory suggests that a global value-weight market portfolio is the logical default position for an equity investor seeking the optimal allocation scheme across countries.
What are the implications for this approach if we take structural factors into account that encourage a home bias? Australia, for example, offers tax incentives applicable only to local investors, so their citizens earn higher returns than foreign investors do holding the same stocks. Brazil accomplishes the same thing by imposing additional taxes on foreign investors.
[...]
One can argue that asset pricing theory always makes unrealistic assumptions, which are irrelevant if a model does a good job describing observed average returns. True, if one is only concerned with describing average returns. But this argument does not imply that a simplified model can be used as a prescription for optimal portfolios. Here one must face the implications of real world frictions in international investment.
One might argue that the effects of all frictions are captured by the aggregate portfolio of local and foreign assets held by the investors of a country. This is, in a limited sense, true, and it is reasonable to argue that this portfolio is a starting point for investment decisions (perhaps the best we can do). But there are caveats. Within a country, there are taxable and non-taxable investors, and if the data are available, it makes more sense to start with separate aggregate portfolios for the two groups, which also seems a reasonable starting point. There are real problems, however, because not all taxable investors face the same tax rates. Etc. Etc.
So it seems like the default/optimal portfolio should be the average portfolio of investors like me, and not the global market portfolio. If that information is not directly available, we can try to infer it from other data, e.g., if some investors unlike me are known to overweight some asset class (e.g., treasury bonds) then I should underweight that asset class.
Negotiate with your brokers
A lot of brokerages will pay you cash bonuses to transfer your assets to them (and typically keep them there for a year) and this is another source of extra risk-free return. These public offers are usually capped at $2500 bonus for $1M of assets, but some places will give you $2500 per $1M of assets, plus deep discounts on futures/options commissions and margin rates. (You can PM or email me to get details and contact info of the brokerage representatives I’ve talked with.)
Bankruptcy risk for a leveraged portfolio
From Brian Tomasik’s Should Altruists Leverage Investments?
Also note that this continuous-time model doesn’t allow margin accounts to go bankrupt. Because a continuous-time margin account maintains constant leverage, if its assets fall, it rebalances immediately by selling some securities. In the real world, margin accounts can go bankrupt. This could, with low probability, even happen if the account rebalances daily. For instance, a 5X-leveraged margin account that rebalanced once per day might have been wiped out by 1987′s Black Monday. By not allowing for bankruptcy (and by ignoring black swans in general), continuous-time equations like those above may slightly overstate the expected value of leverage. In the extreme case, taking t = ∞, a margin investor who doesn’t rebalance continuously would go bankrupt with probability 1 (since eventually there would be a huge, near-instantaneous market downturn that destroys the account), while the leveraged mean equation concludes that the margin investor ends up with infinite expected wealth.
One might think that rebalancing more frequently than daily would help (perhaps with the help of an algorithm), but you can’t rebalance when markets are closed, e.g., during weekends. I haven’t figured out the best way to mitigate this risk yet (which isn’t really so much about bankruptcy as being over-leveraged when asset values fall too much before you’re able to rebalance), but two ideas are (1) keep some put options in one’s portfolio, and (2) have some assets that are protected during bankruptcy (e.g., retirement accounts, spendthrift trusts).
Farming capital losses by “pre-leveraging”
Suppose you plan to eventually have X exposure (e.g., 200% or 2x leveraged) to the stock market, but currently want Y<X exposure (e.g., 20%) due to market conditions. Instead of buying Y stocks, buy X and hedge it with a X-Y (e.g., 180%) short position (again not using the exact same underlying asset). This way, if the stock market has risen when you’re ready for X exposure, you can close the short position to realize a capital loss. Or if the stock market drops during this time, you can sell the long asset and replace it with a substitute (e.g., ITOT for VTI) and again realize a capital loss. The capital loss can be used to offset your current year capital gains, your future capital gains, or even your regular income (up to $3000 per year).
The flip side of this is that the asset you’ve bought will have a lower cost basis than it otherwise would, which means you’ll have a higher capital gain tax when you sell it, but you might never sell it (it might go into your estate or you might donate it) in which case no capital gains will be realized, and even if you do sell it, the IRS has essentially given you an interest-free loan for the intervening years.
You’re thinking of borrowing with margin loan, but with box spread financing (see my “answer” on that) you can lock in a borrowing rate for up to 3 years, so if you match that with the CD’s maturity you can cancel out the interest rate risk.
Using CDs / Savings Accounts for extra risk-free return
With portfolio margin, you can easily find yourself with more available leverage than you want to use, i.e., in the form of extra “buying power” or “equity”. Instead of letting that go to waste, you can withdraw some of your extra equity (and cover that with margin loan or box spread financing) and put that cash into an FDIC-insured savings account or CD, which currently yield 1% higher than the borrowing cost. Here’s my explanation of why this “free lunch” is possible:
I’ve been wondering why some banks (e.g., Goldman Sachs’s Marcus, Ally Bank) pay customers 1.5% interest on their savings account, when other interest rates are so much lower. (Withdrawing excess “equity” from my margin account and putting it into such a savings account is another way to make extra risk-free returns, currently 1% per year which seems amazing when you consider that 3-year treasuries are at .25%.) From Goldman Sachs’s annual report, “These deposits include savings and time deposits which provide us with a diversified source of funding that reduces our reliance on wholesale funding.” From other sources it seems that wholesale funding is less reliable in economic crashes, when wholesale interest rates could spike for banks that are deemed risky by the market, whereas retail customers are more likely to stick with banks they’re used to, since their deposits are insured.
So it seems like as long as the federal government continues to subsidize savers and banks (by implicitly backing the FDIC), this extra return should be available.
ETA: See also Are There Ways to Maximize FDIC Insurance Coverage?
References/tools for portfolio optimization
Leverage methods and their tax considerations
Portfolio margin
Portfolio margin allows higher leverage and lets you “net” positions against each other for the purposes of determining margin requirements. E.g., you can be 10x long VTI and 10x short SPX via options, and have only a small margin requirement. This allows some of the other tips/tricks to work.
Not all brokerages offer this, but I know E*TRADE, TD Ameritrade, and Interactive Brokers do. And you do have to apply for it and pass a test or interview to show that you understand what you’re getting into.
The reason I asked was that you talk about “safer” and “less safe” and I wasn’t sure if “safer” here should be interpreted as “more likely to let us eventually achieve some success story”, or “less likely to cause immediate catastrophe” (or something like that). Sounds like it’s the latter?
Maybe I should just ask directly, what you tend to mean when you say “safer”?