But if we can all keep calm and stay rational, some really good insights drop out of a discussion about modeling financial leverage. So in this short post, I’m going to tell you how you model the impact of financial leverage on a portfolio. And then point out some of the interesting practical features of using financial leverage.
Modeling Portfolio Leverage with cFIREsim
You can model how leverage impacts your portfolio, roughly but also realistically, using either cFIREsim or FIRECalc. But let me start with cFIREsim since it does a better job, I think.
Here’s the trick. Enter your stock holding percentage as a value greater than 100% and then your bond holding percentage as a negative number. The fraction of the bond holding percentage to the stock holding percentage equals your leverage.
For example, to model a portfolio with 50% leverage, set the stock percentage to 200% and then set the bond percentage to -100%. This set of variables should let you mimic a portfolio with 50% leverage.
If these percentages seem odd, think about them this way. If you had $50,000 to invest, using 200% as the percentage you invest in stocks indicates that you’re going to invest 200% of $50,000 or $100,000 into the stock market. And then using -100% (minus 100%) as the percentage you invest in the bond market indicates that you’ll not actually going to put $50,000 into the bond market but rather take $50,000 out of the bond market.
Note: cFIREsim allows you to either annually rebalance or not annually rebalance. To model the scenario where you continue to rebalance, you leave the annual rebalancing “turned on.”
Modeling Portfolio Leverage with FIRECalc
Now that you know how to “trick” cFIREsim into estimating the impact of portfolio leverage, you can probably guess how to do the same thing with FIRECalc. You use a negative percentage as your bond allocation.
For example, if you set your stock holdings to 400% and your bond holdings to -300% (again, that’s minus 300%), you’re modeling a scenario with 75% leverage.
Tip: Use both cFIREsim and FIRECalc for any modeling you do. That way you can use each tool to test the other’s calculations—and your own data inputs. Note that they won’t exactly match. But they should deliver results that resemble each other.
cFIREsim Example Results: $50,000 Portfolio with 50% Leverage
The table below shows you how leverage impacts a 35-year, $50,000 investment in US stocks using 50% leverage. The first column shows the minimum, median and maximum ending portfolio values if you don’t use leverage. The second column shows the minimum, median and maximum if you do use leverage to double your invested amounts.
With these data points in front of us, let me share a short list of observations that I find interesting.
Portfolio Leverage Bumps Median
A first quick observation: Yes, leverage bumps your portfolio’s median return.
The unleveraged 100% stocks portfolio grows, on average, to roughly $446,000 over 35 years. The 50% leveraged portfolio, on average, grows to roughly $600,000 over 35 years.
In fact, that’s what people (including more than a few financial gurus) often focus on.
Portfolio Leverage May Produce Astronomical Results
A related thing people focus on: You can, if the timing works right, end up with astronomically good results. In theory.
You might, for example, start with a $50,000 leveraged stock portfolio and end up with more than $9,000,000 at the end of your 35-year accumulation phase.
A note about this best case scenario, though: The 35-year accumulation that produces this stellar result starts in 1933, a 35 year period when the stock market earned an astronomical 8% real rate of return. Interest rates, during this same period, ran about zero percent in real (inflation adjusted) terms—so basically free money.
In short, that 35 year time frame that started in 1933 was a weird interval. And one you or I would be unlikely to duplicate.
And then keep in this in mind about 1933, too. An investor needed to not just see opportunity but have the ability to invest spare funds at a point in history where a quarter of workers were unemployed and struggling to eat… and also the ability to borrow money in an economy where two banking panics and massive bank failures had probably eliminated any possibility to borrow the money from traditional sources.
Portfolio Leverage Jacks Financial Risk
One other observation: If you look at those minimums: $162,913 for an un-leveraged portfolio and then $34,033 for a leveraged portfolio, you see the risk of leverage.
You could, with leverage, find that you’d actually lost money even after 35 years of compounding. Which is tragic because the worst-case scenario had you not used leverage would have been that you more than tripled your money.
Four Final Random Thoughts About Financial Leverage
In closing, I want to draw four semi-random conclusions about using leverage:
First, when you or I look at investors who’ve used lots of leverage (like real estate investors whether that’s the guy down the street or some high-flying real estate developer), we want to remember that a lot of what’s going on is pure risk-taking that may or may not produce a good result.
Second, it seems reasonable to me to conclude that using leverage in a passive portfolio simply doesn’t make financial sense. Sure. The median return rises. But I think we maybe add too much risk for too little reward. And the really outstanding outcomes like the 1933 scenario seem, well, pretty implausible. (You may conclude differently of course.)
A third comment: Using leverage in an actively managed investment (and here I’m thinking of something like direct real estate investment or a small business that you or you and some partners own) seems to make more sense. Especially if you don’t continually borrow more to maintain a high state of leverage. (I would say leverage is a big part of the reason that competent real estate investors often end up wealthy.)
Fourth and final, this notion: We want to be alert to the possibility that when we invest passively some of the return we receive may just reflect financial leverage inside the active investment. In other words, the manager running the investment or business generating the fat returns may simply be using leverage rather than skill or expertise. That’s maybe okay… but there’s no free lunch.