"Market returns are almost always going to be higher than the borrowing cost"
This sounds like perpetual motion to me. It's like Moore's law - no matter how long it's gone on for, it can't go on forever.
If everybody believes that, and people who actually control trillions of dollars do it on a massive enough scale, just borrow money and invest in stock, then it has to break things down at some point, doesn't it?
Due to volatility tax [1], there’s an upper limit on how much leverage you can assume. This amount is a function of forecasted returns and variance: r/var(r). The larger this ratio is, the more leverage you can take on. In general, just investing in the broad equity market with anything above 3-5x leverage over the long-term is probably unadvisable. So groups like hedge funds first reduce their volatility by going long and short, and then leveraging up afterwards. Even with market neutral funds (0 market exposure), the leverage applied rarely goes past 6x nowadays.
Banks are a little different and while the rules are complicated, big banks need to have around 3% of their total book at hand. Or in otherwords, they have around 33x leverage. Because of the leverage, banks need a very diversified uncorrelated portfolio in order to reduce volatility. No bank would stuff all of their money into equities, the risk of ruin is too high.
Also, there’s another perspective to look at your question: the efficient market hypothesis. In short, EMH states that in general, all investments have the same or trend toward the same risk/reward profile. That is, the ratio or slope of the returns vs volatility should be the same. With debt/credit, there are two primary options: you get paid back with interest or you don’t (let’s ignore bankruptcy). With equities you are assuming a lot more risk, the stock could go up or down or whatever. Since you are assuming more risk with equities than credit, it would violate EMH if you weren’t compensated for the extra risk.
This however, doesn’t explain why equities perform so much better than everything else. This is called the equity premium puzzle [2].
So maybe you’re right? No one really knows. Maybe the jig will eventually be up? Or maybe not, no one really knows.
I spent some time thinking about leverage and margin, and my thinking was
- I don't want to invest on margin unless the interest rate is significantly lower than stocks generally return
- as a rule of thumb, 7% is a conservative estimate for stocks in the long run, while a typical broker charges close to 10%. So it seemed like a non starter.
- however, it is possible to find rates as low as 3-4%, so then the question becomes how much leverage to use?
- my logic was, what kind of drawdown is plausible if you invest at a market peak? It appears based on known history that -70% could happen. Therefore it would be best to limit leverage so that more than a 70% decline would be needed to cause a margin call.
- which seems to lead to borrowing no more than 25-27% of one's equity.
for a large number of reasons it's hella hard to make money in finance. you can make whatever the vanguard index fund makes "for free" in your pajamas, so in order to justify your existence as an org within a financial institution you're going to need to put together some returns that are, obviously, way higher than that. so out come things like leverage and derivatives (=> hyper-leverage).
and yeah, there are failures, and they lose their shirts, and the beat goes on. but you're probably not going to make very much money (=> last very long) if your rate of return is the same order of magnitude as the collateral you're taking out. it's just not worth it from the POV of the bank.
This sounds like perpetual motion to me. It's like Moore's law - no matter how long it's gone on for, it can't go on forever.
If everybody believes that, and people who actually control trillions of dollars do it on a massive enough scale, just borrow money and invest in stock, then it has to break things down at some point, doesn't it?