80% of this game is showing up. (That’s the Pareto principle, not an exact figure.) If you don’t have a better plan for your money and have the means to ride out a portfolio drawdown for a year or three, then by all means, invest some of it in index funds. But you can do a lot better than that with a little more effort.
If you’re concerned about a bubble, the correct move isn’t to get out (or not get in), but to diversify and leverage down. If you’re over-allocated when the bubble bursts, then you lose your shirt. Don’t bet the farm. But if you always avoid bubbles, you miss all the gains when they inflate. And sometimes they can keep inflating for decades.
Many of the best investments have a returns distribution with a negative skew. They go up in price precisely because they’re prone to crashing hard. That’s the risk premium.
Investing is not about avoiding risk. It’s about managing it. You want exposure to this skew risk so you can collect the premium for it. But you also have to be able to survive a drawdown. Kelly is the optimal balance, but it’s hard to use it directly.
In practice, this means leveraging up for index funds most of the time, and adjusting the amount of leverage based on its risk. This can be hard to quantify, however, the most important factor for index funds is their volatility. (Volatility is certainly not the only kind of investment risk.) Unlike asset prices themselves, volatility is much more predictable.
I personally (at present) have a portfolio of mainly TQQQ, UGL, and TMF, plus cash (among a few other things that take more effort and knowledge to manage), which are 3x-leveraged Nasdaq-100, 2x gold, and 3x long-term treasury bond ETFs, respectively, which I can leverage back down (when necessary) by allocating more of the balance to cash. I frequently (at least monthly) adjust their weights based on their recent volatility to maintain fairly constant and equal volatility exposure to each. That means, for example, that my allocation in terms of dollars to TMF is about double that of my allocation to TQQQ, even though my allocation in terms of volatility exposure is about the same.
[Epistemic status: I am not a financial advisor. I don’t know your financial situation. For informational purposes only. You are responsible for your own money. Invest with due diligence. Also, read my other posts about this stuff.]
Most of the 3x ETFs compound daily, it’s true. And there are costs to this—more from the fees than the compounding itself. But that doesn’t automatically make them a bad long-term investment (even though I’ve heard that said). 3x funds are much more accessible than other kinds of leverage. You don’t need a margin account. You don’t need options. You can even trade them in an IRA where you don’t have to pay taxes. That more than makes up for it.
Most brokers charge way too much to consider using margin loans long term. IB does happen to be more reasonable, but loans are still not for free. And to get the best rates, you need a big account. You can’t even get to 2x leverage on a Reg-T portfolio using margin loans. (On components sure, but not the whole portfolio, or you’ll get a margin call next dip.) For portfolio margin, you need at least $100,000 at most brokers, and preferably a lot more so you don’t get downgraded and margin called at the worst time. It’s great if you can afford it, but one should start investing long before saving up that much.
I’m 100% in unleveraged equity index funds. If I were to want to decrease how long I am I’d just hold some cash, right? If I wanted to go more long with leverage, would it make sense to preferentially do that in IRA accounts or in taxable?
If I were to want to decrease how long I am I’d just hold some cash, right?
Right, e.g. 50% cash and 50% index fund would be 0.5x leverage. But this isn’t once-and-done. You have to keep the ratio balanced as the index price changes, or you’re changing that leverage factor. Notice that you tend to buy low and sell high when maintaining balance this way: As the bubble inflates, you’re gradually pulling cash out of it, and when it finally crashes, you don’t lose what you’ve already pulled out. And then you have a lot of cash on hand during the crash to buy the index when it’s on sale. Had you not been maintaining the balance, all the gains from the inflation would be lost at the crash.
Rebalancing does have some transaction costs, so one shouldn’t do it too often. I do it about once a month or whenever volatility is dangerously high, but you’d get similar performance doing it once per quarter and when vol is high. The timing doesn’t have to be too exact. Some do it whenever the portfolio has deviated from the target ratio by a certain percentage.
And the balance doesn’t necessarily have to be in cash for you to get similar benefits. Some other mostly-uncorrelated asset can work. Cash is not exactly risk-free. The dollar’s performance has some amount of volatility relative to other currencies, and inflation means that you lose real value over time when holding cash. My portfolio balances the TQQQ against the anticorrelated TMF, with the mostly uncorrelated UGL as a ballast, and yes, some cash as well.
If I wanted to go more long with leverage, would it make sense to preferentially do that in IRA accounts or in taxable?
I’m less certain about this part. It really depends on your financial situation and goals. Probably preferentially IRA, because taxes add up a lot. There are limits to how much you can put into an IRA each year. If you’re balancing a portfolio distributed among multiple accounts, and one is an IRA then it can seem to be more tax-efficient to keep a portion of the cash you’re balancing against outside the IRA, but if you over-allocate and lose, then even if you have the money to make up for it, you can’t just replace your losses by depositing more money in the IRA due to the contribution limit, and you’ve lost the tax benefits since you’d have to do the balance in a taxable account instead. I’m not sure what to recommend here.
I’m putting the maximum amount in my Roth IRA every year, and it’s pretty small compared to what I can afford to invest. If you manage your investments well, then you might want to retire earlier than age 59 & 1⁄2, which might make one think twice about using an IRA. However, a Roth IRA allows you to withdraw your contributions at any time without penalty, so there’s little reason not to max it out. You can’t access its growth without penalty until 59 & 1⁄2 (with a few exceptions), however, so if you’re going to retire early, you still need to have a source of income to help make up the gap until age 59 & 1⁄2.
80% of this game is showing up. (That’s the Pareto principle, not an exact figure.) If you don’t have a better plan for your money and have the means to ride out a portfolio drawdown for a year or three, then by all means, invest some of it in index funds. But you can do a lot better than that with a little more effort.
If you’re concerned about a bubble, the correct move isn’t to get out (or not get in), but to diversify and leverage down. If you’re over-allocated when the bubble bursts, then you lose your shirt. Don’t bet the farm. But if you always avoid bubbles, you miss all the gains when they inflate. And sometimes they can keep inflating for decades.
Many of the best investments have a returns distribution with a negative skew. They go up in price precisely because they’re prone to crashing hard. That’s the risk premium.
Investing is not about avoiding risk. It’s about managing it. You want exposure to this skew risk so you can collect the premium for it. But you also have to be able to survive a drawdown. Kelly is the optimal balance, but it’s hard to use it directly.
In practice, this means leveraging up for index funds most of the time, and adjusting the amount of leverage based on its risk. This can be hard to quantify, however, the most important factor for index funds is their volatility. (Volatility is certainly not the only kind of investment risk.) Unlike asset prices themselves, volatility is much more predictable.
I personally (at present) have a portfolio of mainly TQQQ, UGL, and TMF, plus cash (among a few other things that take more effort and knowledge to manage), which are 3x-leveraged Nasdaq-100, 2x gold, and 3x long-term treasury bond ETFs, respectively, which I can leverage back down (when necessary) by allocating more of the balance to cash. I frequently (at least monthly) adjust their weights based on their recent volatility to maintain fairly constant and equal volatility exposure to each. That means, for example, that my allocation in terms of dollars to TMF is about double that of my allocation to TQQQ, even though my allocation in terms of volatility exposure is about the same.
[Epistemic status: I am not a financial advisor. I don’t know your financial situation. For informational purposes only. You are responsible for your own money. Invest with due diligence. Also, read my other posts about this stuff.]
3x funds track daily moves and thus underperform logterm. Better to use traditional leverage through Interactive Brokers.
Most of the 3x ETFs compound daily, it’s true. And there are costs to this—more from the fees than the compounding itself. But that doesn’t automatically make them a bad long-term investment (even though I’ve heard that said). 3x funds are much more accessible than other kinds of leverage. You don’t need a margin account. You don’t need options. You can even trade them in an IRA where you don’t have to pay taxes. That more than makes up for it.
Most brokers charge way too much to consider using margin loans long term. IB does happen to be more reasonable, but loans are still not for free. And to get the best rates, you need a big account. You can’t even get to 2x leverage on a Reg-T portfolio using margin loans. (On components sure, but not the whole portfolio, or you’ll get a margin call next dip.) For portfolio margin, you need at least $100,000 at most brokers, and preferably a lot more so you don’t get downgraded and margin called at the worst time. It’s great if you can afford it, but one should start investing long before saving up that much.
I’m 100% in unleveraged equity index funds. If I were to want to decrease how long I am I’d just hold some cash, right? If I wanted to go more long with leverage, would it make sense to preferentially do that in IRA accounts or in taxable?
Right, e.g. 50% cash and 50% index fund would be 0.5x leverage. But this isn’t once-and-done. You have to keep the ratio balanced as the index price changes, or you’re changing that leverage factor. Notice that you tend to buy low and sell high when maintaining balance this way: As the bubble inflates, you’re gradually pulling cash out of it, and when it finally crashes, you don’t lose what you’ve already pulled out. And then you have a lot of cash on hand during the crash to buy the index when it’s on sale. Had you not been maintaining the balance, all the gains from the inflation would be lost at the crash.
Rebalancing does have some transaction costs, so one shouldn’t do it too often. I do it about once a month or whenever volatility is dangerously high, but you’d get similar performance doing it once per quarter and when vol is high. The timing doesn’t have to be too exact. Some do it whenever the portfolio has deviated from the target ratio by a certain percentage.
And the balance doesn’t necessarily have to be in cash for you to get similar benefits. Some other mostly-uncorrelated asset can work. Cash is not exactly risk-free. The dollar’s performance has some amount of volatility relative to other currencies, and inflation means that you lose real value over time when holding cash. My portfolio balances the TQQQ against the anticorrelated TMF, with the mostly uncorrelated UGL as a ballast, and yes, some cash as well.
I’m less certain about this part. It really depends on your financial situation and goals. Probably preferentially IRA, because taxes add up a lot. There are limits to how much you can put into an IRA each year. If you’re balancing a portfolio distributed among multiple accounts, and one is an IRA then it can seem to be more tax-efficient to keep a portion of the cash you’re balancing against outside the IRA, but if you over-allocate and lose, then even if you have the money to make up for it, you can’t just replace your losses by depositing more money in the IRA due to the contribution limit, and you’ve lost the tax benefits since you’d have to do the balance in a taxable account instead. I’m not sure what to recommend here.
I’m putting the maximum amount in my Roth IRA every year, and it’s pretty small compared to what I can afford to invest. If you manage your investments well, then you might want to retire earlier than age 59 & 1⁄2, which might make one think twice about using an IRA. However, a Roth IRA allows you to withdraw your contributions at any time without penalty, so there’s little reason not to max it out. You can’t access its growth without penalty until 59 & 1⁄2 (with a few exceptions), however, so if you’re going to retire early, you still need to have a source of income to help make up the gap until age 59 & 1⁄2.