Housing, pt 10: Stress testing

I’m nearing the end of my Dream Home purchasing odyssey. In fact I have mustered the cash needed to buy the home, and wired it to my lawyer, in good time for completion.  Hooray!

What I haven’t quite found yet is the cash for the stamp duty, but I have another month to find that and think the market volatility could help. In any case you can see in my graph below that I have obtained over 100% of the purchase price – I am only a few % away from where I need to be including transaction fees etc.

This means that right now I am the proud owner of over £1m of new debt.

As I’ve recounted my progress in this journey, I’ve been extremely grateful for the comments and tweets I’ve had from readers.  But polite and intelligent though they are, it is clear that some of them regard me as Stark Raving Mad.  This has naturally had me wondering: am I Stark Raving Mad? So it’s time to share a stress test of my portfolio.

Apologies if this post gets rather dry and technical.  I haven’t found a more interesting way of considering my bonkers-ness.

A portfolio stress test looks at how a portfolio would perform in a stressful environment.  In this case, the stressful scenario is the Bear Market becoming really savage. We’ve already seen falls of over 20% from the peaks, and hence the journalists can roll out their “It’s official: we’re in a bear market” stories.  But as Black Rock’s Larry Fink said, there isn’t yet much blood in the water – not many investors would have invested much at the market peaks, and really we are down under 10% from the levels which people have been putting serious money to work.  At the time of writing FTSE-100 is at about 5900 and S&P-500 is at about 1900.  How bad could it get from here?

While past performance is no guide to future returns, blah de blah, the 2008/9 crisis is instructive. It was roughly as fierce as the previous 2000-2002 downturn and the 1987 one.  Equities fell by over 50%.  But balanced portfolios fared rather better, with Bonds providing a strong counterweight.  In fact a 60/40 portfolio fell by 32% (see Rick Ferri’s USA chart below; UK performance was similar) from peak. A 70/30 portfolio fell about 38%.  Given that we are already 10-20% down, I regard the worst that can plausibly happen to a 66:33 portfolio as a further 30% drop from where we are today.

Pause for a moment to consider what a 30% blended drop from today would feel like.  If it mirrored 2008/9, equities would fall almost twice this much.  So FTSE-100 would drop to 2700.   S&P500 would drop to 850.  I consider this to be a very implausible scenario; I think Ermine’s scenario of FTSE-100 dropping to 4400 far easier to imagine.  But we are talking Stress Test so let’s stress it.

The next question is what is the breaking point, at which point the portfolio fractures under stress?  There is some ambiguity about this.  But I consider the key requirement to be maintaining a total loan-to-portfolio-value fraction of no more than 50%.  So that for every £1 of loan, I have at least £2 of portfolio.  Ideally, I’d like to maintain this fraction for each currency I borrow in – i.e. for each $1 of loan I have at least $2 of portfolio too.  This whole business is complicated by the fact that not all of my portfolio is in marginable accounts, but equally some of those marginable holdings will not fracture until the loan-to-value fraction reaches 75%.  My astute readers will notice that relative to property mortgages, this is absurdly conservative, but that’s for another day.

I’ve had to update my target allocations slightly in the light of the margin loans I’ve received.  This new target allocation has 66:33 equity:bonds, a roughly equal UK:US equity bias, bonds being slightly UK weighted, and 25% being non-UK/US.

Target allocation from 23/1/16
	Aus	Int’l	UK	USA	Total
Equity	4%	16%	40%	40%	100%
Fixed income	1%	4%	30%	15%	50%
Cash/(loan)	0%	0%	-30%	-20%	-50%
Total	5%	20%	40%	35%	100%
Loan-to-value %			43%	36%	33%

At my target allocation, my net loan currently amounts to about 33% of my portfolio value; the UK loan comes to 43% of the UK portfolio. This gives me some wiggle room, but not too much.

If my portfolio drops 30%, what happens?  Without any changes, my portfolio fractures. Badly.   My overall loan-to-value rises to 48%, which is close to breaking point.  But the UK breaks – it reaches 61% loan-to-value.  Disaster, right?

-30% drop in portfolio, with no mitigation
Row Labels	Aus	Intl	UK	USA	Grand Total
Equity	5%	20%	51%	51%	127%
Fixed income	2%	5%	38%	19%	64%
Cash/(loan)	0%	0%	-55%	-36%	-91%
Grand Total	6%	25%	35%	34%	100%
Loan-to-value %			61%	52%	48%

Not so fast.  In practice I have various remedies I can take.  For instance if I convert some International and Australian holdings into UK holdings, I can mitigate the damage.  In fact if I am prepared to accept the UK becoming 51% of my total portfolio, I can keep its loan-to-value to 52% – which is uncomfortable but not a fatal fracture.

-30% drop in portfolio, with mitigation 45% drop in net value
Row Labels	Aus	Intl	UK	USA	Grand Total
Equity	1%	8%	64%	55%	127%
Fixed income	2%	1%	42%	19%	64%
Cash/(loan)	0%	0%	-55%	-36%	-91%
Grand Total	3%	9%	51%	37%	100%
Loan-to-value %			52%	49%	48%

So in theory under my target allocation my risks look manageable.  Unfortunately I’m not yet at my target allocation.  And under my current allocation, my risks are higher.  Right now my portfolio is slightly too large, funded by a slightly excessive loan, and within that I am overweight on equities and underweight bonds.  And my loan is disproportionately in pounds, not dollars.  My loan to value is 37%, not 33%.

Actual allocation, 23 Jan ’16
Row Labels	Aus	Intl	UK	USA	Grand Total
Equity	4%	19%	56%	42%	120%
Fixed income	0%	6%	19%	12%	38%
Cash/(loan)	-1%	1%	-50%	-8%	-59%
Grand Total	3%	26%	25%	47%	100%
Loan-to-value %			67%	15%	37%

What this means is that under a 30% fall in the portfolio, my total loan to value would reach 53%, and my UK loan to value would reach 96%.  Ouch!  I’d have as much debt as my portfolio, leaving my UK holdings practically wiped out. As above, I can take steps to ameliorate this, by raiding my International/Oz holdings I can keep my overall LTV to 51% and my UK/US ones at 53-54%.  This would be very hairy but is not out of the question.

-30% drop in actual portfolio, with mitigation 48% drop in net value
Row Labels	Aus	Intl	UK	USA	Grand Total
Equity	1%	8%	58%	61%	128%
Fixed income	1%	1%	46%	18%	65%
Cash/(loan)	-2%	2%	-55%	-42%	-98%
Grand Total	-1%	10%	49%	37%	95%
Loan-to-value %			53%	54%	51%

My conclusion from this is that my leveraged portfolio itself will, with care and attention, survive even a tough downturn.  But obviously its value would drop precipitously – I’d lose 48% of my current value. Am I prepared to take this risk?  Certifiably mad, surely?

For me the answer involves my overall balance sheet.  My investment portfolio is only part of my net worth.  Once I complete on the Dream Home, I will be extremely long on UK property.  In fact my properties will be worth over half of my net worth.  They aren’t liquid, they (mostly) don’t provide income, and in fact they cost me money to own.  But they are worth millions of pounds.  And in fact if we enter Savage Bear Market territory, and it looks anything like 2008/9, then the pound will fall, and there is a reasonable chance that London property will hold steady or even rise (it being priced, more than people realise, in Euros).  My properties could well amount to 75% of my net worth.

Even in a highly stressed environment, my loan might amount to about 50% of my investment portfolio. But if the investment portfolio is shrinking to, say, 25% of my net worth, then the loan is under 15% of my net worth.  I have two properties which would each more than pay off the loan. Even if the London property bubble bursts (it fell 16% in 2008, but rose 6% in 09) then I will still be able to get my overall LTV down under 25% in a doomsday scenario.

To summarise, while my loan is nervewracking, and I can foresee my liquid portfolio shrinking to amounts I will find distressing, I consider that I have lots of ways to manage the risk. It doesn’t seem feasible that I could be forced into making an unwanted disposal.  Famous last words?