I am not smart enough to be a real rationalist, and I am really lazy. But I am smart enough to understand and implement rationalist advice and I suspect y'all are a better source of advice than normal investors. What is the highest level of returns I can achieve with a buy and hold strategy of some kind, across any asset class, and what is the empirical evidence for this? Also, I am self-employed, in a field where the 99th percentile earners make 7 figures per year and I make only low six figures. So how should I assess investment in an asset vs trying to invest in my career? I am not quite risk-neutral but pretty close to it. My expenses are well below my income; I'm done saving for retirement; further investing is just a game at this point. But I don't know how to play it.
For buy-and-hold strategies: leverage (borrowing to invest) can be used to increase returns. The Sharpe ratio of a portfolio is a measure of it's risk/reward trade-off; there's a theorem that given a set of assets with fixed known distributions and ability to borrow at the risk-free rate, the Kelly optimal allocation is a leveraged version of the portfolio with highest Sharpe ratio. You can calculate that optimal leverage in various ways.
In practice, we don't know future Sharpe ratios (only the past), we don't have assets with fixed known distributions (to the extent there is a distribution, it likely changes over time), and there's other idiosyncratic risks to leverage.
Using past data, however, is highly suggestive that at least some leverage is a great idea. For instance, a 40/60 stock/bond portfolio has higher Sharpe ratio than a 100% stock portfolio in almost all historical models since bonds and stocks have low correlation. It's not unreasonable to assume that low correlation will hold going forward. If I leverage up a stock/bond portfolio to the same volatility as the corresponding 100% stock portfolio, I see a 2-4% increase in yearly returns depending on time period. This is easily achievable by buying leveraged ETFs.
Naive Kelly models will usually recommend more risk than the stock market, so if your risk tolerance is even higher the (potentially naive and misleading) math is on your side. Be careful if you might need the money soon: these models assume you're never withdrawing!
My opinion: ~1.5-2.5x leverage on stock/bond portfolios looks reasonable for long-term investors, although it really depends on the assets -- short term treasuries for example are so stable that even 10x leveraging isn't crazy.
In the real world, you can leverage by:
- Buying leveraged ETFs. These work just like buying stocks or regular non-leveraged ETFs. Vanguard doesn't allow these, so I use Fidelity. I might recommend SSO and TMF, along with international + extended market diversification. Since the leverage on these is set daily, they eliminate some of the tail risk of leveraging. Downsides: volatility decay in sideways markets and ETFs can simply fail to track their (leveraged) index.
- Using margin accounts. This is where your broker lends you money, using your other investments as collateral. Rates are often really bad/not worth it -- be careful. Also they'll sell your other investments if you become overly leveraged due to a downturn (a "margin call") -- which means forced selling during a downturn, which can cause you to miss out on any recovery. I don't like this.
- Directly taking on debt / counter-factually not paying off debt. If you take out a mortgage instead of paying cash for a house, the money you saved can be considered to be "on loan" at the mortgage rate. Investing it is then a form of leveraging. This is bad if the rate is too high, but mortgage rates are really low right now.
- Futures. These allow higher leverage than ETFs and adoption of various strategies if you're willing to monitor them daily -- for instance, you can leverage/deleverage on a daily basis with no (additional) tax penalty. Great for getting really high leverage, e.g. for stable investments like treasuries. Downsides: your positions will be closed if you run out of margin -- which means you can be forced out of the market during a bad enough downturn, potentially missing the recovery. For high-leverage strategies, this means you probably need to monitor daily and de-lever as appropriate. Gains from futures are immediately taxed at 60% short-term 40% long-term capital gains, introducing tax drag that you wouldn't have with ETFs.
- Options. I don't know much about these. Here's a book talking about passive indexing approaches using options, which I haven't read: https://www.amazon.com/Enhanced-Indexing-Strategies-Utilizing-Performance/dp/0470259256.
- Other stuff (box spread financing?)
You can kind of backtest various strategies for yourself using e.g.:
- https://www.portfoliovisualizer.com/backtest-portfolio#analysisResults. Entering a negative percent for CASHX until your portfolio adds up to 100% is an approximation for cost of borrowing at the risk-free rate. They also have ticker data for leveraged ETFs, although most have short histories.
- https://www.bogleheads.org/wiki/Simba%27s_backtesting_spreadsheet. Entering a negative percent for 3-month T-bill rate under "Compare Portfolios" until your portfolio adds up to 100% approximates the cost of borrowing at the risk-free rate.
Keep in mind that the past doesn't predict the future, and naive back-testing might not track historical reality perfectly or may be missing some idiosyncratic risks of leveraging certain ways.
For your maximal laziness, here's an ~1.9x leveraged ETF allocation I made up just now that's around 40/60 world stock market/long-term bonds: 36% TMF, 16% SSO, 8% VXF, 40% VXUS. Full disclosure: Lots of people would think this is a terrible allocation since "everyone knows" the bond market is due to crash due to current low interest rates.
For increasing salary vs investing: do these really funge against each other? Why not both? Generically I'd think income should dominate before you have a lot invested, and then investment strategy becomes important once your yearly average investment returns become similar in scale to your yearly income.
Hmmm in order of certainty
1. Save and invest more = more total returns.
2. Diversification is the only free lunch in finance.
3. A cautious approach to tilting investments in favour of various factors has a lot of evidence around it. See e.g. this blog https://alphaarchitect.com/alpha-architect-white-papers/
4. Strict adherence to dollar cost averaging. Much harder to do than it looks.
Also all the personal finance rules apply - avoid unprofitable debt, take out insurance. avoid financial catastrophes like divorce, maximize marketable job skills, save hard.
In order of certainty, here are the bad ideas
1. Thinking that you can easily beat the market. Maybe with 70 hour weeks for many years... read hundreds of books and papers... otherwise assume you have negative skill to the tune of 4-6% per annum. Also going into the markets with psychological weaknesses unresolved and/or cognitive and emotional biases not dealt with - the markets have ways to find and exploit them all.
2. Investing in high cost funds based on recent outperformance.
3. Suddenly deciding to invest it all on stocks "for the long run" after a period of outperformance.
Leverage can give arbitrarily high returns at arbitrarily high risk. With things easily available at a brokerage, this goes up to very high returns with insane risk. See St. Petersburg paradox for an illustration of what insane risk means. I like the variant where you continually bet everything on heads in an infinite series of fair coin tosses, doubling the bet if you win, so that for the originally invested $100 you get back the same $100 in expectation at each step (at first step, $200 with probability 1/2 and $0 with probability 1/2; by the third step, $800 with probability 1/8 and $0 with probability 7/8), yet you are guaranteed to eventually lose everything.
Diversification, if done correctly, reduces risk at the expense of some reduction in returns. At which point increasing leverage to move the risk back up to where it was originally increases returns to a level above what they were originally. Diversification without leverage can make things worse, because it reduces returns.
Not making use of leverage is an arbitrary choice, it's unlikely to be optimal. For any given situation, there's almost certainly some level of leverage that's better than 1 (it might be higher or lower than 1). There are various heuristics for figuring out what to do, like Sharpe ratios and Kelly betting. As an outsider to finance, it was initially hard for me to make sense of this, as discussion of the heuristics is usually fairly unprincipled and relies on fluency with many finance-specific concepts. A math-heavy finance-agnostic path to this is to work out something along the lines of Black–Scholes model starting from expected utility maximization and geometric Brownian motion. For actual decisions, calculation through Monte Carlo simulations rather than analytical solutions lets utility functions, taxes, and other details be formulated more flexibly/straightforwardly.
Investing some money in Bitcoin would not be a bad idea. Bitcoin is both high-risk and high-potential.