For buy-and-hold strategies: leverage (borrowing to invest) can be used to increase returns. The Sharpe ratio of a portfolio is a measure of it’s risk/reward trade-off; there’s a theorem that given a set of assets with fixed known distributions and ability to borrow at the risk-free rate, the Kelly optimal allocation is a leveraged version of the portfolio with highest Sharpe ratio. You can calculate that optimal leverage in various ways.
In practice, we don’t know future Sharpe ratios (only the past), we don’t have assets with fixed known distributions (to the extent there is a distribution, it likely changes over time), and there’s other idiosyncratic risks to leverage.
Using past data, however, is highly suggestive that at least some leverage is a great idea. For instance, a 40⁄60 stock/bond portfolio has higher Sharpe ratio than a 100% stock portfolio in almost all historical models since bonds and stocks have low correlation. It’s not unreasonable to assume that low correlation will hold going forward. If I leverage up a stock/bond portfolio to the same volatility as the corresponding 100% stock portfolio, I see a 2-4% increase in yearly returns depending on time period. This is easily achievable by buying leveraged ETFs.
Naive Kelly models will usually recommend more risk than the stock market, so if your risk tolerance is even higher the (potentially naive and misleading) math is on your side. Be careful if you might need the money soon: these models assume you’re never withdrawing!
My opinion: ~1.5-2.5x leverage on stock/bond portfolios looks reasonable for long-term investors, although it really depends on the assets—short term treasuries for example are so stable that even 10x leveraging isn’t crazy.
In the real world, you can leverage by:
Buying leveraged ETFs. These work just like buying stocks or regular non-leveraged ETFs. Vanguard doesn’t allow these, so I use Fidelity. I might recommend SSO and TMF, along with international + extended market diversification. Since the leverage on these is set daily, they eliminate some of the tail risk of leveraging. Downsides: volatility decay in sideways markets and ETFs can simply fail to track their (leveraged) index.
Using margin accounts. This is where your broker lends you money, using your other investments as collateral. Rates are often really bad/not worth it—be careful. Also they’ll sell your other investments if you become overly leveraged due to a downturn (a “margin call”) -- which means forced selling during a downturn, which can cause you to miss out on any recovery. I don’t like this.
Directly taking on debt / counter-factually not paying off debt. If you take out a mortgage instead of paying cash for a house, the money you saved can be considered to be “on loan” at the mortgage rate. Investing it is then a form of leveraging. This is bad if the rate is too high, but mortgage rates are really low right now.
Futures. These allow higher leverage than ETFs and adoption of various strategies if you’re willing to monitor them daily—for instance, you can leverage/deleverage on a daily basis with no (additional) tax penalty. Great for getting really high leverage, e.g. for stable investments like treasuries. Downsides: your positions will be closed if you run out of margin—which means you can be forced out of the market during a bad enough downturn, potentially missing the recovery. For high-leverage strategies, this means you probably need to monitor daily and de-lever as appropriate. Gains from futures are immediately taxed at 60% short-term 40% long-term capital gains, introducing tax drag that you wouldn’t have with ETFs.
You can kind of backtest various strategies for yourself using e.g.:
https://www.portfoliovisualizer.com/backtest-portfolio#analysisResults. Entering a negative percent for CASHX until your portfolio adds up to 100% is an approximation for cost of borrowing at the risk-free rate. They also have ticker data for leveraged ETFs, although most have short histories.
Keep in mind that the past doesn’t predict the future, and naive back-testing might not track historical reality perfectly or may be missing some idiosyncratic risks of leveraging certain ways.
For your maximal laziness, here’s an ~1.9x leveraged ETF allocation I made up just now that’s around 40⁄60 world stock market/long-term bonds: 36% TMF, 16% SSO, 8% VXF, 40% VXUS. Full disclosure: Lots of people would think this is a terrible allocation since “everyone knows” the bond market is due to crash due to current low interest rates.
For increasing salary vs investing: do these really funge against each other? Why not both? Generically I’d think income should dominate before you have a lot invested, and then investment strategy becomes important once your yearly average investment returns become similar in scale to your yearly income.
Increasing labor income vs investing is not 100% fungible but there are some tradeoffs, especially being self-employed. Any time I spend to learn or manage finance stuff is time I could have spent working. And at least in principle there should be opportunities to spend money to increase my income, but it’s a lot more unpredictable—I could advertise, in a non-pandemic environment I could join associations or go to events where I might meet lucrative clients, I could hire lower paid staff and take on clients who it is not worthwhile for me personally to perform services for due to opportunity cost, I could perhaps trade current income for prestige in some aspects of work hoping it will raise my stature and bring more money later, etc.
For buy-and-hold strategies: leverage (borrowing to invest) can be used to increase returns. The Sharpe ratio of a portfolio is a measure of it’s risk/reward trade-off; there’s a theorem that given a set of assets with fixed known distributions and ability to borrow at the risk-free rate, the Kelly optimal allocation is a leveraged version of the portfolio with highest Sharpe ratio. You can calculate that optimal leverage in various ways.
In practice, we don’t know future Sharpe ratios (only the past), we don’t have assets with fixed known distributions (to the extent there is a distribution, it likely changes over time), and there’s other idiosyncratic risks to leverage.
Using past data, however, is highly suggestive that at least some leverage is a great idea. For instance, a 40⁄60 stock/bond portfolio has higher Sharpe ratio than a 100% stock portfolio in almost all historical models since bonds and stocks have low correlation. It’s not unreasonable to assume that low correlation will hold going forward. If I leverage up a stock/bond portfolio to the same volatility as the corresponding 100% stock portfolio, I see a 2-4% increase in yearly returns depending on time period. This is easily achievable by buying leveraged ETFs.
Naive Kelly models will usually recommend more risk than the stock market, so if your risk tolerance is even higher the (potentially naive and misleading) math is on your side. Be careful if you might need the money soon: these models assume you’re never withdrawing!
My opinion: ~1.5-2.5x leverage on stock/bond portfolios looks reasonable for long-term investors, although it really depends on the assets—short term treasuries for example are so stable that even 10x leveraging isn’t crazy.
In the real world, you can leverage by:
Buying leveraged ETFs. These work just like buying stocks or regular non-leveraged ETFs. Vanguard doesn’t allow these, so I use Fidelity. I might recommend SSO and TMF, along with international + extended market diversification. Since the leverage on these is set daily, they eliminate some of the tail risk of leveraging. Downsides: volatility decay in sideways markets and ETFs can simply fail to track their (leveraged) index.
Using margin accounts. This is where your broker lends you money, using your other investments as collateral. Rates are often really bad/not worth it—be careful. Also they’ll sell your other investments if you become overly leveraged due to a downturn (a “margin call”) -- which means forced selling during a downturn, which can cause you to miss out on any recovery. I don’t like this.
Directly taking on debt / counter-factually not paying off debt. If you take out a mortgage instead of paying cash for a house, the money you saved can be considered to be “on loan” at the mortgage rate. Investing it is then a form of leveraging. This is bad if the rate is too high, but mortgage rates are really low right now.
Futures. These allow higher leverage than ETFs and adoption of various strategies if you’re willing to monitor them daily—for instance, you can leverage/deleverage on a daily basis with no (additional) tax penalty. Great for getting really high leverage, e.g. for stable investments like treasuries. Downsides: your positions will be closed if you run out of margin—which means you can be forced out of the market during a bad enough downturn, potentially missing the recovery. For high-leverage strategies, this means you probably need to monitor daily and de-lever as appropriate. Gains from futures are immediately taxed at 60% short-term 40% long-term capital gains, introducing tax drag that you wouldn’t have with ETFs.
Options. I don’t know much about these. Here’s a book talking about passive indexing approaches using options, which I haven’t read: https://www.amazon.com/Enhanced-Indexing-Strategies-Utilizing-Performance/dp/0470259256.
Other stuff (box spread financing?)
You can kind of backtest various strategies for yourself using e.g.:
https://www.portfoliovisualizer.com/backtest-portfolio#analysisResults. Entering a negative percent for CASHX until your portfolio adds up to 100% is an approximation for cost of borrowing at the risk-free rate. They also have ticker data for leveraged ETFs, although most have short histories.
https://www.bogleheads.org/wiki/Simba%27s_backtesting_spreadsheet. Entering a negative percent for 3-month T-bill rate under “Compare Portfolios” until your portfolio adds up to 100% approximates the cost of borrowing at the risk-free rate.
Keep in mind that the past doesn’t predict the future, and naive back-testing might not track historical reality perfectly or may be missing some idiosyncratic risks of leveraging certain ways.
For your maximal laziness, here’s an ~1.9x leveraged ETF allocation I made up just now that’s around 40⁄60 world stock market/long-term bonds: 36% TMF, 16% SSO, 8% VXF, 40% VXUS. Full disclosure: Lots of people would think this is a terrible allocation since “everyone knows” the bond market is due to crash due to current low interest rates.
For increasing salary vs investing: do these really funge against each other? Why not both? Generically I’d think income should dominate before you have a lot invested, and then investment strategy becomes important once your yearly average investment returns become similar in scale to your yearly income.
Increasing labor income vs investing is not 100% fungible but there are some tradeoffs, especially being self-employed. Any time I spend to learn or manage finance stuff is time I could have spent working. And at least in principle there should be opportunities to spend money to increase my income, but it’s a lot more unpredictable—I could advertise, in a non-pandemic environment I could join associations or go to events where I might meet lucrative clients, I could hire lower paid staff and take on clients who it is not worthwhile for me personally to perform services for due to opportunity cost, I could perhaps trade current income for prestige in some aspects of work hoping it will raise my stature and bring more money later, etc.