A TRANSFORMATIVE TALE: "LIKE US, THERE'S MORE THAN MEETS THE EYE"

In A Practical Tale, we learned the importance of understanding the expected behavior of asset classes, which of course impacts the expected behavior of your portfolio.  We can be fairly certain that when it comes to asset class risk, which we define as how much money you can lose if you invested in an asset class at precisely the wrong time, asset classes will behave the same in the future as in the past.  In this tale, A Transformative Tale, we will learn how to transform one type of asset class return into another.  This is called a transformation and thus the name of this tale.  We will specifically look at transforming bond returns to stock returns.  Please note that I don’t recommend that you try this at home.  I would leave this type of transformation to professionals but I write this tale so that you can understand once again the importance of assessing risk by focusing on the maximum draw down.

When I first started out in this business I was told to never trade stocks on margin.  The reason I was told and I quote from the wiser more experienced brokers “When you trade stocks on margin you will make spectacular returns 17 out of every 20 years and your clients will love you.  Unfortunately in the other 3 years, you will have to find a whole new set of clients because you will wipe them out.”  This was, still is and will continue to be sound advice.  The numbers may be slightly off but the intention is correct.  If you trade stocks on margin, which means you borrow money to buy more shares than you could normally afford to buy, then when markets go up you make more than without borrowing.  However, when markets go down, you also lose more.  So in essence you are simply increasing the volatility of your portfolio when you trade on margin.  But what happens if you could find a strategy, approach, technique, asset class, trader or investor that can make more than stock market rates of return with the same risk as the stock market or even less risk?  This would be a superior investment and benefit most people.  It’s not that complicated.

Suppose we had two strategies or two types of predictable behavior.  In the first strategy or predictable behavior one we would make 7.5% per year annualized but during bad periods we might have a loss or maximum drawdown of 50%.  This is a fair representation of the stock market or SP500 and as we know, this strategy has a Mar Ratio of 7.5% divided by 50% or 0.15.  In the second strategy or predictable behavior, we would make 5% per year annualized but during bad periods we might have a loss or maximum drawdown of 16.5%.  This is a fair representation of the intermediate bond market or Aggregate Bond Index and as we know this strategy has a Mar Ratio of 5% divided by 16.5% or 0.30.  So given these two types of strategies, which one is better?

Given a choice between these two types of strategies some will go for strategy 1 while others for strategy 2.  Others might even put a portion of their money in one and a portion of their money in another thus creating a 3rd strategy.  But those types of choices aren’t the point of this tale.  This tale is meant to show you how to transform bond returns into stock returns by borrowing money to buy bonds.  You can then decide for yourself which one is better.  You see the wise fellows that first taught me never said to avoid trading bonds on margin.  So what do we need to make the transformation?  We need to determine what someone will charge us in order to lend us money to buy bonds.  For simplicity let’s assume that rate is zero and do the math.

If we could borrow money at a zero interest rate to invest in bonds, how much would we want to borrow to transform bond returns into stock returns?  Let’s suppose we borrowed 1 times our investment.  In this case we would make 5% on our original investment and 5% on our borrowed investment.  This would mean a 10% rate of return but would also cause our maximum drawdown to increase from 16.5% to 33%.  Upon inspection, borrowing just 1 times our initial capital to buy bonds is a far better strategy than buying stocks.  Our return on the transformed bond strategy exceeds that of the stock market and it also has a lower maximum drawdown.  Given this set of circumstances, I suspect very few would chose to invest in an unleveraged stock portfolio compared to a leveraged or transformed bond portfolio.

What if we borrowed 2 times our capital?  Then our original capital would make us 5%, and our borrowed capital would make us 10% for a total of 15%.  Of course our maximum drawdown would increase to 49.5%.  Upon examination, this maximum drawdown of 49.5% is almost identical to the maximum drawdown of the SP500 with no borrowing.  Yet while this strategy produces a 15% return, stocks only produce 7.5%.  This too is clearly superior.

What does this mean to us as investors?  It means the next time someone tells you that stocks make more money than bonds what they are really saying is that stocks make more money than bonds under the assumption that you don’t borrow any money to buy bonds.

Unfortunately, being able to borrow money at a zero interest rate isn’t the real world.  In the real world you will have to pay to borrow.  The math doesn’t get much more complicated however.  If the rate they lend is at 1% then the transformation at 1 times capital is 5% on the original plus (5%-1%) on the borrowed or a total of 9%.  The maximum drawdown is 16.5% on the original plus 16.5% on the borrowed or a total of 33%.  This is still a superior investment than the stock market.  At a rate of 2% then we are looking at an 8% return with a maximum drawdown of 33%.  Once again this is a superior investment.  At 3% we are looking at a 7% return with a 33% maximum drawdown.  Once again, this is a superior investment because though the 7% return in the transformed bond strategy is slightly less than the 7.5% return from the unleveraged stock strategy, because the maximum drawdown is so much lower, there is room for additional borrowing.  Let’s see what happens if we borrow more.

What if you wanted to borrow 2 times your capital?  At a 1% borrowing rate then you would make 5% on your original investment plus 4% on the 2 times your investment that you borrowed or 8% for a total of 13%.  Your maximum drawdown would increase to 16.5% plus 16.5% plus 16.5% or 49.5%.  Once again, this is a superior investment to buying stocks on an unleveraged basis.  At 2% the return drops to 11% with a maximum drawdown of 49.5%.  At 3% it drops to 9% with a maximum drawdown of 49.5%.  These are also superior to investing in the stock market.  However, at a 4% rate, the stock market is a better investment than transforming the bond market on a 2 times basis.  In this case the return drops to 7% and the maximum drawdown is 49.5%.  This tells us there is a level where it makes no sense to borrow money to buy bonds and why earlier I suggested you leave this type of investment approach to the professionals.

So what have we learned?  There are countless ways to transform bond returns into stock returns.  But the two keys are to borrow cheaply and to make sure your assumptions on maximum drawdown are correct.  If one were to borrow money to buy stocks we can see how with a maximum drawdown of 50%, your capital could be wiped out very quickly and will be if you use margin to buy socks into perpetuity.  So if you want to trade stocks on margin make sure it is situational such as those times when markets are so low and beat up that you can’t help but make money.  If you want to trade less volatile asset classes on margin, make sure your assessment of maximum drawdown is correct.

As an aside, how does our understanding of transforming one asset class into another by understanding its predictability of return and maximum drawdown relate to understanding how banks operate?  We learned that during the 2008 financial crash many banks had capitalization ratios of 30-40 and that as of today, many European banks have capitalizations that are still in the 30 to 40 range.  What does this mean?  A capitalization of 30 translates to an investment portfolio that for every dollar that you earned and put into your portfolio, there is someone willing to lend you $29 dollars to buy whatever you want.  So, this by definition means that when banks assess their maximum drawdown they better have a very small expectation of potential losses if they are going to have 30 or 40 to 1 capitalization ratios.

Of course we all know the result here in the USA and can easily predict what will happen to the European banks.  What was the result and what can we predict?  Of course the result was that many US banks failed and had to be bailed out.  Their assessment of risk was wrong and their incentive to speculate was not adequately regulated.  In the US the capitalization rate is now 12.  This translates to a maximum drawdown of 8.33% which is derived by dividing 100 by 12.  What will happen in Europe?  European banks will also have to be bailed out since many of their largest banks still have capitalization rates over 30.  It doesn’t take a rocket scientist to understand how maximum draw down is the key measure to determine risk.