Phantom Cash

[Gosso]

With negative real rates on cash, does it makes any sense to replace a portion of the "cash" section of the PP with available margin or line of credit (LOC)?  By this I mean not holding as much capital in cash, and instead allocate a portion of the margin account or LOC to the cash portion of the PP.  I'm not advocating using all of the available margin but maybe 25% of it...this would require a 75% drop of the margin account assets before a margin call (if margin was even ever required).

Advantages of margin/LOC:
- 0% real return (sure beats negative real rates)
- no interest payments and therefore no tax
- can act as dry powder when needed
- costs nothing to hold, except when needed as dry powder (hopefully only temporarily since stocks/gold/LTT should rebound...unless we turn Japanese and fail to grow M2)
- capital can be used for gold/stocks/LTT and more than likely earn a positive real return.
- can still be used as "Phantom Cash" to reduce volatility in annualized returns

Disadvantages:
- If interest rates increase (I don't see this happening for a long time) then we would miss out on short term increase in interest payments on cash, and be penalized for higher borrowing costs if the dry powder needs to be utilized.

So what this does is allow us to place more of our capital in Gold/Stock/LTT rather than earning a guaranteed negative real return.  If the Fed begins to signal that an increase in rates is approaching then it may make sense to rebuild the cash section of the PP.

Lets say negative real rates continue for another 10 years, ie inflation of 2% and 0% nominal return on cash.  That means for every $10,000 held in margin rather than cash would gain $10,000 x 1.02^10 = $12,200 ($2,200), and this is assuming we gain nothing from investing the capital in stocks/gold/LTT.

Maybe we can place this under "Advanced PP Strategies"...

Thoughts / Criticism?

[Bean]

Since cash is for the Recession scenario, you may not have credit when the cash position is most beneficial and 3 other components are on "sale."

[Gosso]

Since cash is for the Recession scenario, you may not have credit when the cash position is most beneficial and 3 other components are on "sale."

Well, margin is not based on credit worthiness, but rather the value of the assets in the margin account.  Plus I have already been approved for an unsecured LOC, and I'm pretty sure it doesn't go away...it was still there during the 2008 crisis. 

So during a crisis when everyone else is receiving margin calls we can use our untouched margin to buy depressed assets.  If the margin is included in the "cash" portion (it's a bit of an accounting trick, since the margin will act as a placeholder for cash) then we can continue to operate a normal PP with 15/35% bands on the 4x25 assets.

To me, it doesn't make any sense to place hard earned capital in cash, when we could instead just temporarily borrow the money from the broker when we need dry powder.  If the Fed ever decided to begin paying positive real rates then this strategy would have to be re-examined.

Another benefit is that the interest on any loan used to invest in stocks/bonds is tax deductible (at least in Canada it is).  So that would drop the interest rate from 4%, down to ~2.5%, depending on tax bracket.

[HB Reader]

Since cash is for the Recession scenario, you may not have credit when the cash position is most beneficial and 3 other components are on "sale."

To me, it doesn't make any sense to place hard earned capital in cash, when we could instead just temporarily borrow the money from the broker when we need dry powder.  If the Fed ever decided to begin paying positive real rates then this strategy would have to be re-examined.

I'd like to expand on what Bean said.  The problem would go far beyond merely still having margin credit.

The real problem would be that your re-examination would be occurring while the other three assets are falling.  And broker margin rates would be rising sharply.  You would be leveraging and buying into assets that are falling with borrowed money on which there is no limit on how high your interest costs could go or how long you would have to carry the loans.  It would look and feel like investment suicide (and would be, unless you happened to have impeccable timing and used the margin extremely conservatively).  Things in the financial markets look very different when they are happening than how they prospectively appear in your plans, or later in history books.    

I know this seems a little far-fetched in today's environment, but this is exactly what I experienced in the 1980-83 period.  Stocks, bonds, gold and real estate all went south while interest-rates rose sharply.  Even after Paul Volker's announcement in late 1979 of his intent to raise rates, most investors considered it "temporary" and then were constantly "re-examining" everything for the next two and a half years. By early 1981, books were being written about the wisdom of keeping all your money in the new money market funds.  Even after interest rates began moderating (fairly slowly) and the stock market began rising in the late summer of 1982, it was anything but clear that bonds and stocks were in a long-term bull market.

As many investors discovered in 1980-83, 1987, 1990-91, 2000-03 and 2007-09 you simply cannot forsee where things are going.  And even if you're lucky enough to make a correct call about the long-term trend, you have no idea how long it will take to come about.              

[Gosso]

HB Reader,

I guess it depends on what your goals are for the PP.  If it is to simply protect money that you cannot afford to lose, then the 4x25 is fine.  My goal is to maximize growth as safely as possible.  To do this I am willing to accept extra risk and volatility to hopefully receive a greater return...although the downside to this is the "PP-calm" is diminished since I need to pay more attention to the markets and Fed.  In the long run it might not even garner extra returns but I think it is worth a shot.  I am still under the (naive?) belief that the future is somewhat knowable -- I'll likely have to learn this lesson the hard way.

As for the margin, I'm talking about only using 25% of the available margin.  So for a total PP value of $100,000, with $50,000 in a margin account, and $30,000 in available margin, means that I would count only $7,500 towards the cash portion (so that would be 30% of the cash, or 7.5% of the total PP).  Also, this "phantom cash" would be based on the peak value of the margin account, so that when assets fall the phantom cash remains constant (the same as normal cash would).

So essentially all I have really done is dropped the cash down to 17.5%, while still maintaining the 25% of dry powder.

[stone]

Gosso, when I saw the title "phantom cash" I thought I knew what you were getting at but my notion of "phantom cash" doesn't seem to exactly tally with what you have written.

To my mind a phantom cash  strategy requires a preconceived expected growth rate for the gold+stocks+LTT portfolio. So you could draw a chart of say smooth 5% per year growth before dividends and then agressively dip into/replenish a small cash holding at every rebalancing point so as to try and stear the gold+stocks+LTT portfolio more smoothly along that preconceived expected growth rate curve. How big the cash holding would be a matter of taste. Only if you wanted to have a zero cash holding would it make any sense to use borrowed funds. There would never be any sense in simultaneously holding STT and borrowing funds at a higher interest rate.

As an example, imagine you were holding $33k of each of gold+stocks+LTT and were using a strategy where you rebalanced whenever one of those got to >40% or <25% of the gold+stocks+LTT. You also had a pot of about $20k cash that you put monthly savings and divends into. After 12 months you expect your gold+stocks+LTT to grow to $104k but instead stocks are at $24k, gold at $30k and LTT at $35k. So you rebalance out of cash topping stocks and gold up to $35k and so only have $4k in cash remaining. During the following year, the gold+stocks+LTT grow by %15 and stocks hit a >40% rebalancing point. You then take money out of the gold+stocks+LTT portfolio so as to trim it down to the "on trend" size and so hold more cash.
To my mind it gets complicated when you are paying in savings, taking money out etc. The projected growth curve is also an uncomfortable idea for me. It also all depends on the idea that cash is never going to be one of the best of the asset classes for an extended period.  I sort of think just keeping 25% cash probably is better all round.

[Gosso]

Stone,

My original thinking was would I be willing to use a small portion of the margin account if needed.  My answer is yes.  So I took the amount of margin I'm willing to use and subtracted it from the cash.

But this begs the question of how much cash do we really need?  I see talk of either 4x25 or 3x33, but how about 10/30/30/30.  I think this gives you enough cash to buy depressed assets, and if they continue to fall farther then margin can be used, and if they fall even farther then the financial system has collapsed and the gold coins will be the only thing that matters.

Personally I can handle a decent amount of volatility so I only need the cash to buy depressed assets.  The so called "Tight Money" recessions will suck, but I'm willing to take that pain for a greater long term return.  Hopefully I'm smart enough to foresee the increasing rates (don't fight the Fed), and add more protection to the portfolio.

As for cash being the best performing asset, well, it can happen over short periods (2-3 years).  But over 5-10 years I think it is very unlikely.

[stone]

Gosso, my understanding was that the HBPP cash didn't simply act as a reserve from which to buy distressed assets, it also acted to cause "sell high" selling of overpriced assets at rebalancing points. In fact, if we take it that cash is seldom a high performing asset; then that is the predominate role of the 25% cash

[Gosso]

Gosso, my understanding was that the HBPP cash didn't simply act as a reserve from which to buy distressed assets, it also acted to cause "sell high" selling of overpriced assets at rebalancing points. In fact, if we take it that cash is seldom a high performing asset; then that is the predominate role of the 25% cash

I probably haven't explained things very well (I'm still allowing this idea to ferment in my brain, and it's possible I'm missing something).  

Here's an example:

12.5% = Cash
12.5% = Margin (aka Phantom Cash)
25% = LTT
25% = Stocks
25% = Gold

This means that the standard 4x25 PP and the 15/35 rebalancing bands are maintained.  If cash+margin hits 35% then we take from the cash to buy distressed assets, and only use margin if cash is depleted.  If cash+margin hits 15%, then we can sell assets and place in cash.

The broker accepts the negative real rate and pays taxes on the interest, while we simply have a placeholder in our portfolio that will likely never be needed, but is there just in case.  This frees up precious capital to invest in more productive assets gold/stocks/LTT.  I suppose this could fail if the Fed decided to start paying 3-4% real rates on cash, but IMO this is extremely unlikely, and would be warned about it as a possibility.  If we see any kind of deflation then the Fed will increase monetization of the debt (and therefore increase M2), at least as long as Bernanke is there (which I think is a good thing).  Any deflation we see will likely be temporary, plus we still have LTT to help us out.

Another thing to consider is that available margin will grow as the assets increase in value.  It may make sense to set the margin at a fixed level...although I haven't thought this completely through yet.

[stone]

Gosso, so are you saying that you will start off with 12.5% cash and no borrowing? You only intend to have the possibility of borrowing as something up your sleeve in case your cash doesn't cover your rebalancing demands? I still think your "phantom cash" requires some sort of comparison to "expected performance" in order to know how much to dip into/replenish your actual cash when rebalancing. Imagine you start with $25k in each of LTT,stocks and gold and $12k in cash. If the LTT, stocks and gold do very well a HBPP would sell off to rebalance into cash. That amount of selling off would push the cash portion of your portfolio above 12.5%. Selling off less would mean that you were foregoing that "sell hight" volatility capture opportunity.

[Gosso]

Gosso, so are you saying that you will start off with 12.5% cash and no borrowing? You only intend to have the possibility of borrowing as something up your sleeve in case your cash doesn't cover your rebalancing demands?

Bingo!

I still think your "phantom cash" requires some sort of comparison to "expected performance" in order to know how much to dip into/replenish your actual cash when rebalancing. Imagine you start with $25k in each of LTT,stocks and gold and $12k in cash. If the LTT, stocks and gold do very well a HBPP would sell off to rebalance into cash. That amount of selling off would push the cash portion of your portfolio above 12.5%. Selling off less would mean that you were foregoing that "sell hight" volatility capture opportunity.

You are correct.  In a way the margin allows us to "double up" our rebalancing with the cash.  Here's an example of how the portfolio composition may change with a rise in Gold/Stocks/LTT (possibly from QE3):

Code: Select all

     Stocks     Gold	LTT	Cash	Margin	
1	25	25	25	12.5	12.5	   100
2	30	30	30	5	5	   100
3	25	25	25	20	5	   100

In this scenario gold/stocks/LTT have all gained 5% of portfolio weighting and now represent 90% of the portfolio.  We then have 5% in cash and 5% in potential margin.  We sell 5% from each of gold/stocks/LTT and then finish with a 20% weighting in cash, while margin has fallen to 5%.  I think this is a good thing since the asset prices have had a good run and now is probably a good time to get a little defensive with the extra cash.

Here is another example:

Code: Select all

     Stocks    Gold	LTT	Cash	Margin	
1	25	25	25	12.5	12.5	    100
2	20	20	20	20	20	    100
3	25	25	25	5	20	    100

Stocks/Gold/LTT have all fallen 5% in portfolio weighting and now only represent 60% of the portfolio.  Cash and margin have now increased to 40% of portfolio.  To rebalance we use 75% of the cash (15% of portfolio) to buy gold/stocks/LTT.  We are now overweight in margin compared to cash, but we have already fallen quite far and are unlikely to fall much farther, and if we do then we can tap some margin if needed.  And if things continue to fall then the financial system has failed, and our gold coins will be the only thing of any value.

In my mind the risks appear limited, while allowing us to move capital away from cash (negative real rates) and into more productive assets.

[stone]

Gosso, I got my head around your idea in the end then . I'm still thinking you will need a projected "expected growth curve" to discern how much cash to hold. In your example you transitioned between 12.5% cash and 20% cash. Presumably at some point you would intend to reverse that. Those kind of decisions implicitly require a comparison to an expected growth curve don't they?

[Gosso]

Gosso, I got my head around your idea in the end then . I'm still thinking you will need a projected "expected growth curve" to discern how much cash to hold. In your example you transitioned between 12.5% cash and 20% cash. Presumably at some point you would intend to reverse that. Those kind of decisions implicitly require a comparison to an expected growth curve don't they?

I kinda like the expected growth curve idea.  I do something similar and only add new funds when the PP is below its two year trendline. 

I did some backtesting with the phantom cash, and I'm not loving what I see (although it's possible I'm not factoring in all the variables).  It basically performed the same as a 30/30/30/10 PP.  So it would be easier to simply lower my weighting of cash.

If it ain't broke...