How much is a fixed rate of return worth to you?

Here’s one of my classic questions to advisors, and to arm chair advisors.  “Should I take out a Home Equity Loan to invest in stocks?”  My gut feeling is that most people would say that this was a bad idea because it is ‘risky’ and perhaps ‘gambling’.  But in the same breath, they’d have no problem recommending to people that have a mortgage that a brokerage account is a good idea.  It’s the same thing though, you’ve got a liability of X and an asset of Y in both cases.

What rate of return do you want?

This is a tricky question, you want the most right?  You’ve heard that long term it could be 10% from equities.  Therefore you’d like 10%. But you don’t know for sure that you’d get 10%, so what if we did a ‘deal or no deal’ game show?

How about I offer you 9% fixed rate of return vs plowing all in on the S&P500.  Would you take it?  Maybe you’re a ruthless negotiator and would hold out for 9.5%, but at some point, I think even the most bone headed of you would say that a guaranteed rate of return is better than a variable one.  To make it even more simple, if we offered you 10% fixed vs ‘what should average 10% most likely’ you’d see my point.. and all that fluff and haze about the averaging has to be discounted in.

The trick therefore is to be able to visualize what price is the risk that comes with a variable rate, and get paid a premium on it, by being offered the investment at a discount.

So what’s the number?

How do we get to the right place, throw around numbers until they stick? How about 3% guaranteed? Is that enough? If yes, great – go pay off your mortgage!  In finance there’s a term called the risk free rate of return.  In financial textbooks this may be said to be T Bills, but in reality, you’re mortgage, or other debt is the rate it should be.  Note that a mortgage has some taxable benefits to many people, so its better to work out your effective rate.

• Effective Rate = rate * (1-tax bracket impacted)
• EG 4% mortgage, 25% bracket = 4*0.75 for an effective rate of 3%.

So… your floor now is 3% on the risk free rate.  This means than an investment offering fixed returns less than 3% are a bad choice for you, as you’d be better off paying down your debt instead.

There are many forms of pricing model that come in now, many are based around the CAPM model, which is written as:

• Return of Investment = Risk Free Rate + (Market Return-Risk Free Rate)*Beta

It looks a bit weird, but basically its saying to you that the return of an investment should be worth at least the risk free rate (3% here) plus some upside that increases if the market is paying a lot, and the risk (Beta) is higher. In short.. more risk requires more reward.  The problem with these models though, is that they require us to speculate on what the market might be, and also don’t necessarily tell us when the market is better than not the market… because they are all about the market!

What do you need?

I like to think of this common approach to pricing as something of a top down approach.  You are told to ‘expect’ a certain return, and then you strive towards getting it.  The problem for me is twofold.  Firstly this doesn’t address your needs, you’re following blindly. And secondly, an average investor can’t really understand all the nuances of risk at play.  Certainly there is the approach to ‘buy the farm’ to reduce risk (IE buy broad index funds) but even then, is your return premium proper, or are you taking on too much risk, for too little benefit?

Instead, I like to work bottom up.

1. Sum up your needs, something of a budget, but not forgetting future obligations (such as college for kids or long term health care.  This is your liability.
2. Sum up your assets.
3. Determine how many years your assets can fund your liabilities when invested risk free.

If there is a shortfall, you need to start looking at blending varying degrees of risk into your plan.

Conclusion

Remember that fixed rates of return are inherently better than variable rates. Note that the amount you actually need may be less than you might be able to get.  If the rate is fixed and you get more than you need, super! But if the rate is variable and we talk of 40 year averages, if you don’t need the full rate from that, deleveraging risk brings you closer to the mean rate of return that you need. Personally, I don’t think you should just think to yourself ‘If the market’s go the way they should for the next 30 years I should be ahead by X’.  I think any money put into the market should be done so with reluctance, because a variable rate of return doesn’t mean you’ll make it.