I'll use a modified version of my own personal situation as an example to see why I think Patri Friedman's argument may be a good one. The details of the example are as follows:
How should I save that extra $1000? The debate we have been having discusses many options - I will isolate three that I would be interested in:
The equity premium puzzle suggests that for people will average levels of risk aversion, their expected utility will be higher from purchasing stocks rather than bonds - that is, people are 'overcompensated' for the risk they take my purchasing equities. Now given the equity premium puzzle, the optimal portfolio might not be to spend $1000 on stocks - perhaps it is closer to $900 on stocks and $100 on paying down the line of credit. But I will take the extreme case.
Kling seemed to be arguing that option #3 makes more sense than option #2, which I cannot understand for the life of me. Since Kling is vastly more experienced in these matters, there is a good chance I am missing something. But I don't see what it is. For someone with the amount of money I have to invest, the margin interest rate I would have to pay would likely be between 9-10%. Even taking into account that the line of credit is variable rate and the margin interest is a fixed rate, why would I choose paying a 9.25% interest rate over a 6.25% interest rate? And if I lived in the United States, I would receive a tax credit for the interest I pay on the 6.25% rate but not the 9.25 rate (but since I don't live in the U.S., this is a moot point).
Now I am not suggesting these are the only three alternatives, but suppose they were. I cannot see how Kling can argue that option #2 is (weakly) dominated by option #1 and/or option #3.
- I have the amount outstanding on my house as a line of credit with a variable interest rate which is currently 6.25%. The line of credit does not require that I make regular monthly payments (or even pay interest for that matter, so long as the amount outstanding does not reach the upper bound of the credit limit.
- The line of credit is for $100,000, but the amount I am using is somewhat less than that (so I have paid off some of it).
- I have an average level of risk aversion, as judged by personal life decisions I make about things such as how much insurance to carry, etc.
How should I save that extra $1000? The debate we have been having discusses many options - I will isolate three that I would be interested in:
- I can take that $1000 and use it to reduce the amount outstanding on my line of credit.
- I can take that $1000 and buy an index fund.
- I can take $500 of that and use it to reduce the amount outstanding on my line of credit. I can then take the $500 and use it to buy $1000 worth of index funds by investing on margin.
The equity premium puzzle suggests that for people will average levels of risk aversion, their expected utility will be higher from purchasing stocks rather than bonds - that is, people are 'overcompensated' for the risk they take my purchasing equities. Now given the equity premium puzzle, the optimal portfolio might not be to spend $1000 on stocks - perhaps it is closer to $900 on stocks and $100 on paying down the line of credit. But I will take the extreme case.
Kling seemed to be arguing that option #3 makes more sense than option #2, which I cannot understand for the life of me. Since Kling is vastly more experienced in these matters, there is a good chance I am missing something. But I don't see what it is. For someone with the amount of money I have to invest, the margin interest rate I would have to pay would likely be between 9-10%. Even taking into account that the line of credit is variable rate and the margin interest is a fixed rate, why would I choose paying a 9.25% interest rate over a 6.25% interest rate? And if I lived in the United States, I would receive a tax credit for the interest I pay on the 6.25% rate but not the 9.25 rate (but since I don't live in the U.S., this is a moot point).
Now I am not suggesting these are the only three alternatives, but suppose they were. I cannot see how Kling can argue that option #2 is (weakly) dominated by option #1 and/or option #3.
Comments
How do you get the idea that Kling wants you to borrow at 9% instead of 6%? I think his point is that if you can’t borrow at 5% (the risk-free rate), you’re losing money after adjusting for risk.
Hi Phil,
I got that from this comment:
“You can do step 2 without doing step 1. For example, you can buy exchange-traded index mutual funds on margin.”
But then he goes on to say you would do it in the way with the lowest interest rate.
BTW, my broker’s margin rate is not much different from my mortgage rate.
“BTW, my broker’s margin rate is not much different from my mortgage rate. ”
How much are you investing, though? Given my example, I’m not investing huge sums of money, so naturally I’d pay a higher rate.
Are you in Canada too? I’d love to know where you’re getting such a good rate.
Cheers,
Mike
Mike,
to my understanding, Kling’s idea is that option #3 is the best, provided that instead of borrowing money at 9% from your broker you buy derivatives with the built-in interest rate close to risk free rate. The only example available to individual investors that I am aware of is to buy leveraged ETFs like Ultra QQQ ProShares. I have no idea how to sell a put option (buying a call at the same time, as one commenter at econlog suggested) if you are an individual investor. But well, I am from another continent
The equity premium puzzle is by no means strong evidence against EMH. We would have to be much more confident in the foundations of expected utility theory for that be the case. It is strong evidence against both EMH *and* our standard models of expected investment utility being true, but the problem could be anywhere in that chain.
It’s quite possible that equity premiums in the market *do* correctly mark an equilibrium trade-off of risk-return for aggressive well-capitalized investors, but that aggressive well capitalized investors are, on average, optimizing for a utility function that we do not really understand.
It’s also quite possible that standard expected utility theory is just broken. You might want to read up on an artefact of EUT known as the repugnant conclusion. That, among other oddities, leads me to feel only weak confidence in the theory. Not any more than I have in EMH.
Here’s my broker’s margin rates.
https://www.tdwaterhouse.ca/rates.jsp
If you have $300K in assets, and are borrowing $100K, the rate is 6%. I think the rate on my mortgage line of credit is somewhere in the sixes, so if you have a lot and are borrowing a lot, 6% sounds pretty cheap.