Kurt Johnson

Or, what’s an individual’s optimal investment leverage?

I’ve been thinking about this for a while and finally got around to doing it. The results are posted here because they’re too verbose for the blog. Formatting sucks because the only HTML editor I have on my travel computer is Notepad or MS Word and neither is very fun to work with….I’ll re-post a cleaner version when I get back home.

The bottom line is that I validated conventional wisdom; wealthier individuals should take less risk and asset-poor individuals should take more risk. My contribution is adding a quantitative toolset that lets any moderately sophisticated Excel user model how their savings might play out in retirement at a given risk level.

As always I welcome positive or negative feedback.

Update: I forgot to mention the original reason I built this, which was basically to see how likely I was to acheive my investment goals (10% likely, 50% likely, etc.). In the writeup I’m mostly discussing relative outcomes but for a lot of folks the most interesting part of the model will be to plug in where they are today, where they want to be, and what they expect the market parameters to be in order to see how likely they are to meet their goals.

During my test prep procrastination today I talked about investing with a friend who’s still in college and not finance saavy. I started thinking about what individuals should focus on when doing their own investing. For example, my view is that individuals should not try to pick stocks unless they really enjoy the process of stock selection per se (or see the choosing as entertainment, like a horse race). There is a mountain of empirical evidence that stock picking is hard to do well; individuals are statistically unlikely to beat a passive index investment. Thus a new investor should focus their learning on things that have guaranteed values (such as tax and liquidity planning) rather than stock picking. Note that this is probably not as fun to execute, resulting in several cable channels devoted to stock picking and none that I know of devoted to tax planning or asset allocation. Nevertheless I think the dollar return on time invested will be infinitely higher for structural investment planning than stock picking.

Now that 99% of my readers have stopped reading this post*, here’s my point: the biggest decision a novice investor needs to make is how much to save. This is much more important than stock picking and significantly more important than asset allocation or tax planning. It’s obviously possible to save too little; it’s also possible to save too much – deferring too much gratification. For example, delaying graification in college might mean postponing a trip around the world; unfortunately ten years later this trip may not be an option because of more commitments, disability, or other unforseen constraints – the deferral backfired and the savings can not be used.

There’s a basic level of savings that everyone should have; as in Maslow’s hierarchy there is a foundation level of savings necessary for people to feel secure; the cushion to handle car repairs, minor medical expense, or property disaster without resorting to outside assistance. Once this is established, why should you save? Owning Microsoft vs. GE is not as important as understanding whether one is saving for early retirement, preserving a windfall, funding a child’s education, or enabling philanthropy. It’s tough to make the right decision about how much gratification to defer until you understand what you’re saving for.

Obviously this is oversimplified. If an investor is saavy and dedicated enough the problem becomes more nuanced. The degree of gratification to defer becomes a question of probabilities; what is the probability I will get to spend these reserves while I can still enjoy them (i.e., before unexpected death or disability). How long and expensive a life do I need to plan for? Although I probably shouldn’t admit it I’ve actually nerded out to the point of writing a Monte Carlo simulation to vary life expectancy and annual rates of return on a portfolio (annual timesteps for 100 years) to build a distribution of required capital at a certain age. For example, based on a consumption forecast of $X/year (2005 real dollars) starting at age Y, what is level of savings required at age 30 to be 95% confident that I will not run out of money before dying? Assign probability distributions to the portfolio return and chance of death in each timestep and let 10,000 trials run to get the answer…..Note though that I did this as a fun/intellectual exercise; I’m not actually that obsessive about financial planning.

*Rhetorically speaking. 99% isn’t a possible outcome since it’s not a divisor of 2 readers.

I’ve thought a lot about how US government deficits are going to affect financial markets in the future, specifically the money my wife and I put aside to retire on. Here’s my basic fear/expectation: the US government will be unable to control entitlement spending and the commercial sector unable to control balance of trade, leading to more USD denominated bonds and currency being held by foreign investors. Simultaneously we’ll see a growing disparity between Americans who save and those who don’t – savers will have lots of money and non-savers won’t have much at all or have negative worth. What we’re left with is a narrow class of asset holders (foreign investors and a minority of Americans) and a large group of non-asset or net liability holders (the US government and the general public).

Since the US government controls how much currency is printed it’s pretty easy to think that they’d be willing to print more to control deficits. If the majority of voters are not asset holders, the treasury can get away with this since they’re basically ripping off foreigners and the minority of “wealthy” Americans to dig the government out of it’s spending hole (in other words, playing by the rules of a democracy).

What should you/I do to profit if this scenario makes sense? I’m kind of exploring a practical way to short-sell long dated treasury bonds (basically putting me in the same economic position as the US Government). If nothing else I’m trying to stay invested in diversified equities, which will hopefully hedge against inflation much better than holding cash or bonds.

What’s keeping this from coming to fruition? Maybe political pressure in the US to keep nominal interest rates down, which you can’t do if you’re inflating the currency printing more money. Most consumers aren’t going to be happy when mortgage and credit card rates jump, even if they profit on balance from the reduced value of their fixed rate liabilities. Another hindrance could be US political will to keep the dollar as a global benchmark currency, something it couldn’t do if it were to willfully inflate to avoid debt repayment. Finally, although probably least likely, we could see a new age of government fiscal responsibility and/or sharp organic growth in tax receipts from a strong domestic economy.

PS – if anyone has seen/done an analysis on how much of this year’s runup in stock prices is a factor of dollar devaluation I’d be interested in seeing it. I don’t know how much the S&P 500 companies hedge their forward foreign currency earnings, but assuming they’re generally unhedged (and assuming that they get 30% of their gross margin in foreign currency) it seems like 50% of the increase in large cap indexes could be from currency translation of future earnings per se rather than business fundamentals or the demand growth for dollar denominated exports.