Intro To Margin Finance

snow_mtnBDC asked for an example for my post How Leverage Kills.

If you don’t understand debt then assume that the only time it might make sense to borrow is when your 30-year fixed-rate mortgage payment (including taxes & insurance) is less than your cost to rent. Assume that all other forms of debt will hold you back, prolong being a wage slave and reduce your retirement income.

The people that take issue with the generalizations above are probably trying to sell you something, and working on commission.

My family’s only borrowing is a 30-year fixed rate mortgage. Our mortgage payment is 60% of what it would cost us to rent. I made a calculated bet that our mortgage debt would provide a hedge against rental inflation.

Homeownership isn’t necessary for financial freedom. I bought the house because:

  • I have a young family
  • Don’t mind being geographically restricted
  • Live in a great public school district
  • My youngest won’t graduate high school until 2030
  • Our city is likely to experience above average real economic growth
  • I’m in a better part of town

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Let’s assume our investor has $100,000 and owns an asset that yields 2% after expenses ($2,000 net income).

  • Along comes her investment adviser and offers a portfolio loan – rates are low right now so the loan will cost her 3% per annum.
  • Our investor decides to borrow $50,000 and purchase more of the same type of asset.
  • Now she has $150,000 of assets, still yielding 2%, so $3,000 of income each year.
  • The loan is interest only and costs her $1,500 per annum (3% of $50,000).

Where things get wonky is if the asset’s yield disappears — for example if a rental property is vacant — OR — if the capital value drops significantly — for example if a portfolio of stocks falls 50% in a bear market.

Let’s look at the 50% asset value decline.

  • The value of the asset falls from $150,000 to $75,000.
  • The value of the debt stays the same $50,000.
  • Therefore the net equity value falls to $25,000.
  • The net cash flows stay the same $3,000 from the asset, $1,500 interest to pay, $1,500 net after interest.

If you generate enough cash to pay your interest then you can ride out the bear market and wait for asset values to return to pre-crash highs.

However… a common feature of margin lending is the bank can ask for their money back… ….and they have a habit of asking at the worst time.

Sometimes, they don’t ask, under the terms of your loan they have rights to sell you out of your position.

Let’s have a look at what happens if the bank asks for their money back at the bottom of the market.

In that case, you crystallize a 75% equity loss ($100,000 to $25,000). You are left with $25,000, which will be worth $50,000 (earning $1,000 per annum) when the market recovers to pre-crash levels.

If you didn’t borrow, you earn your 2% per annum through the bear market and end up with $100,000 (earning $2,000 per annum) when the market recovers.

Market Moves

The chart shows major bull and bear markets.

Using your own money, a habit of margin finance could wipe your investment out every 10-25 years.

Some risks aren’t worth taking, especially with money that you can’t afford to lose.


So Why Borrow?

In a bull market, it’s tempting to borrow a much higher percentage of the total investment. Hedge funds, and investment banks, can get over 90% leveraged, against shareholders funds (also known as other people’s money).

When you guess right with other people’s money, the “house” will get rich quick. I worked in a business that received 20% of the profits generated.

When you guess wrong, the clients take the losses.

More on leverage in Part Four of my free eBook Live Long & Prosper – specifically pages 46 to 51.

Structuring A Family Pension

Ax_iglooThree questions for your next family meeting, or your financial adviser:

  1. How long of a retirement should we plan to fund?
  2. As a couple, what is our joint life expectancy?
  3. As a family, how do we invest considering our collective life expectancy?

Today, I’m going to take you into the future of your retirement, your children’s retirement and your grandchildren’s retirement.

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Retirement

If I make it to 63 then my wife will be 55. At that point, there is a 50% chance that at least once of us will last another 31 years. Here’s a calculator that you can use.

It’s worth repeating – as a couple we have a joint life expectancy of 31 years when I reach 63 years old (17 years from now). Today, my wife and I have a joint life expectancy of 47 years.

That’s a heck of a long time for inflation to act on our cost of living.

Inflation of 2.5% for 47 years brings each $10,000 of current expenditure up to $31,917.

In other words, despite being middle aged, our core cost of living is likely to triple across our lifetime.

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Children

The joint life expectancy of my daughters (6 and 2) is 90 years. Their cost of living is going up 8-10x over their lives.

Can I insure against the risk that my surviving children run out of money late in life?

Let’s look at a case study.

At the end of last year, I was considering an expensive vacation. I couldn’t justify spending the money on myself and the calculation that follows is part of the reason.

As a family, we can make the decision to invest $10,000 per annum. There would be no impact on my quality of life.

What could it do for my children?

  • $10,000 per annum, invested for 47 years, 5% rate of return is $1,781,194
  • $1,781,194 invested for an additional 13 years at 5% is $3,358,707
  • Over $3 million in 60 years from redirecting my vacation budget

Let’s talk in 2015 dollars. I have no idea about future inflation, let’s assume 2.5%.

  • The $3.4 million will be worth a lot less in 2075 than today
  • $3,358,707 discounted back to 2015 at 2.5% is $763,379

In case I’ve lost you.

  • The cost is foregoing $10,000 of annual expenditure for the rest of my marriage.
  • The benefit is my survivors share a 30-year retirement income with a current purchasing power of $49,658 per annum.

The payment is calculated with 5% rate of return, over 30 years, with $763,379 starting value.

It’s never “too late” for compounding to work for your family. I’m closing in on 50 and can leave a valuable form of insurance to my children by changing my current habits.

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Grandkids

Run the exact same scenario except I have 85 years to grow the capital.

  • Invest $10,000 per annum for 47 years
  • Roll up for another 38 years (85 years total)
  • Discount back 85 years at 2.5%
  • How much income for the surviving grandkids (in retirement)?

30 years of $90,705 per annum in 2015 dollars ($1.4 million of present value, 5% rate of return).

It’s worth the effort to learn finance and tweak your wealth behaviors.

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This post inspired by Nick Murray’s book, Behavioral Investment Counseling

Link to a google doc that let’s you tinker with my assumptions. Make a copy before editing.

What I Wish I Knew Four Years Ago About Fatherhood

Lexi_2011I’m told that 2010-2013 were often awful. I wouldn’t know for sure because I have ZERO memory. It’s amazing. Aside from the photos, the early years of my kids are gone.

My wife carries emotional trauma from these years and will flashback when something triggers her. She tells me it’s a really unpleasant sensation.

The memory I have is wondering why I couldn’t transcend my daughter. I used to carry around the difficulties of parenthood. Even when I was away from her, I would hold the difficulties in my mind.

My wife’s the same way – both with her 2010-2013 experience of our daughter as well as with her own childhood memories.

I suspect we’re all prone to carrying around the past.

This might help.

The first step in letting go of an image isn’t letting go, snapping out of it, or moving on…

…my mind doesn’t work that way.

Lexi_CuteWhether you’re coping with an unpleasant emotion, an addiction or a compulsion…

…far better to give your mind something to grab on to.

Lexi_surfDecide on a series of images that you can feel in your body. The feeling you’re looking for is one that mimics joy and love – in my case the sensation in an opening of my heart.

Lexi_FlowerI walk in the forest and contemplate my favorite images.

When I started, I struggled to generate the feelings with the images of my daughter. I kept coming back to the pain image at the top of the page.

Ax_HippoSo I would start with images of my son and transfer the feelings over to my daughter.

It didn’t work well at first but I stuck with it.

I also spent a lot of time with the source of my discomfort.

Lexi_boom

…and my daughter grew up

…and I got better at it

Lexi_science

…and I realized that what I was doing was training my mind to be able to conjure up a sensation, a feeling, an emotion

…that was different to my prior habits of anger and frustration

Ax_scary

The difficult moments remained challenging but I was no longer carrying them around with me.

It was a form of freedom.

I found myself laughing more often and I had a bit more patience, which can be VERY useful when dealing with a cranky three-year old!

Anyhow, if you find seeking dominance to be an ineffective strategy then I hope you remember this post.

Replace your suffering by thinking about things that make you smile.

Bonus points for making the effort while walking in nature!

Lexi_Elsa

Quarterly Update – Q1 2015

winterFebruary contained the most (winter) laughter since my kids were born.

Much better than a gradual slump into seasonally-maladjusted depression!

Rebalancing & Asset Sales

  • No changes in asset allocation.
  • Small purchases to rebalance to target allocation.
  • No year-end tinkering for tax purposes.
  • Cash and short-term treasuries will fall to 6% of our family balance sheet once we make 2014 retirement purchases before April 15th.

We decided to take three non-yielding assets and put them on the market => a vacant lot, a piece of jewelry and a painting.

  • These sales could free 10-15% of the family balance sheet.
  • We expect to save 5-8% of our core cost of living by reducing taxes payable and insurance expenses.
  • A low tax basis on the vacant lot means there will be capital gains payable. However, we own the house next door and the capital increase on the house (as the neighborhood is upgraded) will mitigate the tax bill from the sale.

Simplification

The biggest change is with my working life. I’ve cut way back with non-family work.

Six years ago, I had over 60 third-party clients. Currently, I work with 3 families. The result is a significant change in weekly time allocation:

  • Kids/Spouse => 35 hours
  • Third-party Work => 5 hours
  • Family Work => 5 hours
  • House Work => 5 hours
  • Exercise => 15 hours
  • Open => 20 hours

The “open” time has been transformative.

I have time to read, write, think and unwind => none of these focus on external achievement, another change.

I also have a lot of flexibility for quick trips and short-term projects. My working life is bursts of focused effort with most projects being 2-10 days long.

Kids

2011-2013 were tough. I’ll write more in a separate post – 2014 was a transformative year for the family.