Peter and Penny are approaching retirement and want to both downsize and build their dream retirement home in three years. They found the perfect lot for $100,000.
Fortunately, Peter and Penny have a $500,000 portfolio that was already set up as collateral, establishing a securities-based line of credit. They can use their line to act instantly without disrupting their investment portfolio, selling their investments, or accruing any tax consequences.
Peter and Penny are thrilled, because it will cost them only $250 per month
($100,000 x 3% = $3,000; $3,000/12 = $250/month) to pay for the lot. When they sell their current house, they anticipate they will have enough equity and plenty of money to pay off the line of credit, build their dream home, and perhaps have extra
for their portfolio.
Their biggest decision will be whether to get a mortgage on their new house or pay cash.7
“What is my return?” Financial advisors hear this question again and again because that's what people have been trained to watch. Regardless of your debt philosophy, I think we just proved that “what is my return?” might not be the most important question in determining whether you're on track for a successful retirement. It may be possible to create a lower risk—a more certain outcome—by using a combination of debt and a lower- volatility portfolio.
AHAS! ADVISOR HIGHLIGHT ANSWERS
Question #1: What is the right trade-off between risk and return, and what is the right leverage ratio to have the best outcome?
Answer #1: This is a very important question. It is perhaps the most important question. I generally outline a range of 15 percent to 35 percent adjusted up and down for your risk tolerance and cost of distress. This is a nice guideline, and we can make it better. What you really want to consider is the debt ratio relative to the
standard deviation of the portfolio. What I mean by this is that you may want to consider having more debt if the portfolio has a lower standard deviation and less debt if the portfolio has a higher standard deviation.
It is of course impossible to know future risk—future standard deviations—just as it is impossible to know future returns. My macro theme is that when you are in
retirement, you would take a 20 percent reduction in return for a 50 percent reduction in risk all day long.
My other theme is that if it were possible—and I am not saying that it is—to have a portfolio with a standard deviation of 8 with an expected return of 8, then a portfolio with those characteristics is much better suited to support a debt ratio up to 35
percent than a portfolio that has an expected return of 10 and a standard deviation of 20.
The key theme is that according to Modern Portfolio Theory, Figure 6.1, the trade-off in risk for the trade-off in return is not a linear relationship of 1:1. This is an essential point in developing your overall debt strategy!8
Figure 6.1 Modern Portfolio Theory, the Efficient Frontier
Notes
1. http://investopedia.com/terms/r/risktolerance.asp.
2. An excellent review of Modern Portfolio Theory, asset allocation, and diversification strategies can be found in R. J. Shook's The Winner's Circle: Asset Allocation
Strategies from America's Best Financial Advisors (Hammond, IN: Horizon Publishers Group, 2006).
3. http://investopedia.com/terms/s/standarddeviation.asp.
4. According to NYU's Stern School of Business, the geometric average is 9.55 percent for 1928 to 2013 and the arithmetic average is 11.50 percent over the same period. The difference between the two is not the point of this discussion but, for those who are curious, see
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html.
5. The Trinity Study used the monthly returns of the Salomon Brothers Long-Term High- Grade Corporate Bond Index, as well as the Standard & Poor's monthly high-grade corporate composite yield date. For my table, I have chosen to use the 10-year U.S.
Treasury Bond historic returns. See Appendix D for details.
6. One hundred percent bond portfolio tested at a 3 percent distribution rate to represent the low-risk portfolio.
7. Case studies are for educational and illustrative purposes only. They assume eligible assets and that funds are available on the facility. All client situations are unique, and all loans are subject to eligibility and approval by the lender. A lender may deny an advance on an ABLF, preventing the scenarios. Pledging assets reduces and may eliminate liquidity. A market correction could impact market values and/or security eligibility, which could impact the facility size and/or trigger a margin call and/or forced liquidations of assets. See complete disclosures and risks to using an ABLF in Appendix F.
8. Author's Note: The information in this chapter is to be considered in a holistic way as a part of the book and not to be considered on a stand-alone basis. This includes, but is not limited to, the discussion of risks of each of these ideas as well as all of the
disclaimers throughout the book. The material is presented with a goal of encouraging thoughtful conversation and rigorous debate on the risks and potential benefits of the concepts between you and your advisors based on your unique situation, risk
tolerance, and goals.
Part III