• Skip to primary navigation
  • Skip to main content
  • Skip to primary sidebar

Evergreen Small Business

Actionable Insights from Small Business CPAs

  • Home
  • Small Business FAQ
  • Monographs
    • Maximizing PPP Loan Forgiveness
    • Preparing U.S. Tax Returns for International Taxpayers
    • Maximizing Sec. 199A Deductions Monograph
    • Setting Low Salaries for S Corporations
    • Small Business Tax Deduction Secrets
    • Real Estate Tax Loopholes & Secrets
    • Preparing Form 3115 for the Tangible Property Regulations
    • Small Businesses and the Affordable Care Act (Obamacare)
    • Five Minute Payroll Monograph (2019 Edition)
    • Download Your Free Copy of the Thirteen Word Retirement Plan
    • Business Planning Workbook
    • Sample Corporate Bylaws
    • LLC Operating Agreement
    • Joining Our Affiliate Program
  • Our Bloggers
  • Free LLC Formation Kits
    • Alabama LLC
    • Alaska LLC
    • Arizona LLC
    • Arkansas LLC
    • California LLC
    • Colorado LLC
    • Connecticut LLC
    • Delaware LLC
    • Florida LLC
    • Georgia LLC
    • Hawaii LLC
    • Idaho LLC
    • Illinois LLC
    • Indiana LLC
    • Iowa LLC
    • Kansas LLC
    • Kentucky LLC
    • Louisiana LLC
    • Maine LLC
    • Maryland LLC
    • Massachusetts LLC
    • Michigan LLC
    • Minnesota LLC
    • Mississippi LLC
    • Missouri LLC
    • Montana LLC
    • Nebraska LLC
    • Nevada LLC
    • New Hampshire LLC
    • New Jersey LLC
    • New Mexico LLC
    • New York LLC
    • North Carolina LLC
    • North Dakota LLC
    • Ohio LLC
    • Oklahoma LLC
    • Oregon LLC
    • Pennsylvania LLC
    • Rhode Island LLC
    • South Carolina LLC
    • South Dakota LLC
    • Tennessee LLC
    • Texas LLC
    • Utah LLC
    • Vermont LLC
    • Virginia LLC
    • Washington LLC
    • West Virginia LLC
    • Wisconsin LLC
    • Wyoming LLC
  • S Corporation Kits
    • Alabama S Corporation
    • Alaska S Corporation
    • Arizona S Corporation
    • Arkansas S Corporation
    • California S Corporation
    • Colorado S Corporation
    • Connecticut S Corporation
    • Delaware S Corporation
    • Florida S Corporation
    • Georgia S Corporation
    • Hawaii S Corporation
    • Idaho S Corporation
    • Illinois S Corporation
    • Indiana S Corporation
    • Iowa S Corporation
    • Kansas S Corporation
    • Kentucky S Corporation
    • Louisiana S Corporation
    • Maine S Corporation
    • Maryland S Corporation
    • Massachusetts S Corporation
    • Michigan S Corporation
    • Minnesota S Corporation
    • Mississippi S Corporation
    • Missouri S Corporation
    • Montana S Corporation
    • Nebraska S Corporation
    • Nevada S Corporation
    • New Hampshire S Corporation
    • New Jersey S Corporation
    • New Mexico S Corporation
    • New York S Corporation
    • North Carolina S Corporation
    • North Dakota S Corporation
    • Ohio S Corporation
    • Oklahoma S Corporation
    • Oregon S Corporation
    • Pennsylvania S Corporation
    • Rhode Island S Corporation
    • South Carolina S Corporation
    • South Dakota S Corporation
    • Tennessee S Corporation
    • Texas S Corporation
    • Utah S Corporation
    • Vermont S Corporation
    • Virginia S Corporation
    • Washington S Corporation
    • West Virgina S Corporation
    • Wisconsin S Corporation
    • Wyoming S Corporation
  • Contact Nelson CPA
You are here: Home / investment / Portfolio Leverage Modeling with cFIREsim and FIRECalc

Portfolio Leverage Modeling with cFIREsim and FIRECalc

July 30, 2017 By Stephen Nelson CPA

Picture of man jumping for blog post about modeling portfolio risk with cFIREsim and FIRECalcI’m slightly hesitant to talk about modeling portfolio leverage. The topic, in terms of personal safety, sort of resembles a discussion about how to support your teenagers’ use of fireworks.

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.

No Leverage 50% Leveraged
Minimum $162,913 $34,033
Medium $445,809 $600,110
Maximum $1,460,421 $9,175,263

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.

Other Posts You May Find Interesting

Retirement Plan B: Why You Need One

Using cFIREsim to make Retirement Plan B Calculations

Using FIRECalc to make Retirement Plan B Calculations

Filed Under: investment, management, personal finance, retirement

Reader Interactions

Comments

  1. Brian says

    August 3, 2017 at 7:07 pm

    Steve,

    Interesting post and I generally agree with your conclusions. However, here is an interesting mind-trick I’ve observed related to your second conclusion. If you ask financially savvy people if they would willingly borrow money from the bank to invest in index funds, they would likely say no. If you ask the same people whether it makes sense to make additional payments on their mortgage, or invest those extra funds in the market, many would argue that investing those extra funds makes more sense since average market returns have historically exceeded recent mortgage interest rates. To me, these seem like the same situation but perhaps I am missing something.

    • Steve says

      August 4, 2017 at 11:39 am

      “To me, these seem like the same situation but perhaps I am missing something….”

      Brian, I agree. They seem like the same thing to me, too…

  2. DrF says

    September 12, 2017 at 12:24 pm

    This is just…wrong. Why would you leverage just the equity side? Possibly because there are no good calculators out there that will let you leverage equity and bond at the same time. That’s just lazy and poor advice. Why not at least model the leveraged equity and bond separately (yearly, rolling 10y, ???) and compile the data.

    • Steve says

      September 12, 2017 at 1:52 pm

      Gosh, sorry, I don’t understand your comment.

      The post–which is what I think you’re criticizing–discusses how to use cFIREsim and FIREcalc to understand how portfolio leverage impacts returns. I think it does that…

      • DrF says

        September 12, 2017 at 2:38 pm

        No worries. Yes, you proved that leverage is risky. But, it leaves readers scared and thinking there is never a scenario where you can harness leverage responsibly.
        Here’s a good writeup:
        https://earlyretirementnow.com/2016/07/20/lower-risk-through-leverage/

        • Steve says

          September 12, 2017 at 6:59 pm

          I don’t think I said there is never a scenario…

          Regarding passive investments in traditional asset classes, I said this:

          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.)

          Regarding the use of leverage in active managed alternative asset classes, I said this:

          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.)

Primary Sidebar

Welcome

Nelson CPA publishes this blog to help and encourage small business owners. Click here to learn more about our firm.

Need to help clients with their PPP loan forgiveness applications?

Updated for 2019 tax year changes and now available in print from Amazon!!

Maximizing Sec. 199A Deductions

International tax issues?

Preparing US tax returns for international taxpayers

Maximize S corporation tax savings

Setting Low S Corporation Salaries

Free retirement planning help

Picture of Thirteen Word Retirement Plan book

Featured Posts

How IRS audits work

How IRS Audits Work

Audit anxiety is something nearly every taxpayer has in common.  But, have you ever considered how IRS audits actually work? The IRS processes … [Read More...] about How IRS Audits Work

If you got caught in an ERC scam, take these steps to reduce the damage

If You Got Conned in ERC Scam

You wondered at the time whether it was a scam, right? And now you regularly see news reports about ERC scams. Employee retention credit scams, that … [Read More...] about If You Got Conned in ERC Scam

Lottery tax planning can save millions

Lottery Tax Planning for a Billion Dollar Drawing

Okay. This is silly. You’re probably not going to win. But just for fun, let’s talk about lottery tax planning for one of those giant Power Ball or … [Read More...] about Lottery Tax Planning for a Billion Dollar Drawing

Recent Comments

  • Stephen Nelson CPA on Lottery Tax Planning for a Billion Dollar Drawing
  • Morgan on Lottery Tax Planning for a Billion Dollar Drawing
  • Stephen Nelson CPA on Lottery Tax Planning for a Billion Dollar Drawing
  • Stephen Nelson CPA on Lottery Tax Planning for a Billion Dollar Drawing
  • Chanan Goldberg on Lottery Tax Planning for a Billion Dollar Drawing

Archives

Copyright © 2023 Stephen L. Nelson, Inc. · News Pro On Genesis Framework · WordPress