With the amount of innovation in cryptocurrencies, it is time to review how portfolios can benefit from a small allocation into stablecoins.
A Model Retirement Portfolio
For illustrative purposes, the model portfolio we will be building is a simple portfolio of two ETFs that blend an a global equity fund and a global bond fund in a 50-50 ratio. This is something simple and can be executed by a retail investor with an Interactive Brokers account.
For the equity component, we will invest in the Vanguard Total World Stock Index Fund ETF (VT) which is a cheap way of buying stocks from around the world. The advantage comes from low expenses that cannot be matched by any unit trust offering or even robo-advisor in Singapore.
For the bond component, we will use the Vanguard Total World Bond Index Fund ETF (BNDW) which grants access to a portfolio of global bonds.
Combining these two ETFs will produce a portfolio that will generate modest returns when backtested over the past 10 years.
A return of 8.8% is not too shabby and the risk of 12.3% is quite low, it may even outperform many products sold by financial institutions due to a expense ratio of less than 0.1%.
If you perform 500 simulations of this retirement portfolio assuming that you will be consuming 4% of your existing portfolio every year, you will find that there will always be a possibility of retirement failure.
In this case, you will find that the rate of failure rate using this simple portfolio is 18.60%.
Leveraging our portfolio
In a book called Lifecycle Investing by Ian Ayres and Barry Nalebuff, authors considered the possibility of leveraging a retirement portfolio. We can borrow 20% of the portfolio from a broker, so that we can have $1.20 of stocks and bonds for each $1 that we own. This process is not free because the broker will charge 3% to loan the money to you.
Let’s see what happens when you leverage to x1.2 :
- Return = 1.2 x 8.8% – 0.2 x 3% or approximately 10%
- Standard deviation goes up according from 12.3% to 12.3% x 1.2 or 14.8%.
Using the same assumptions assuming a 4% withdrawal rate, the failure rate actually drops to to 13.2%.
As counter-intuitive as it is, leveraged portfolios improves the probability of successful retirement because it generates more upside from the equity portfolio.
But this is a controversial idea because when you have a leveraged portfolio, there is a chance that you might end up with a margin call which can lead to wealth destruction, this unnerves a lot of retail investors.
Introducing Stablecoins to a Leveraged Portfolio
One of the most consequential innovations in the crypto-space are stablecoins like Tether, USD Coin, or Terra USD. These are cryptocurrencies that are pegged 1:1 to the US dollar and designed not to fluctuate over time. On top of this development, various decentralised finance projects allow investors to lend out these stablecoins for high yields.
A portfolio that splits itself into different stablecoins and earning yields can generate dividends that go beyond 12%, and this can be really helpful in improving our retirement portfolio.
Suppose we supplement a leveraged portfolio with a further 10% of stablecoins:
- Returns = 0.9 x 10% + 0.1 x 12% or 10.2%
- Risk = 0.9 x 14.8% or approximate 13.3%
We have effectively increased our returns slightly, and reduced our risk further.
On top of superior outcomes, the 10% allotment into stablecoins do not fluctuate over time (in USD value) so this amount of money can be used to support margin calls which are the bane of leveraged investment investors.
How can you improve your retirement outcomes?
As we can demonstrate in our simulations, leveraging retirement portfolio can improve retirement outcomes but causes immense unease because the existence of margin calls can be terrifying to the retail investor. By introducing a small allocation into a stablecoin high-yield portfolio, a combination of leverage and stablecoins can reduce the retirement failure rate by about a third.
This manoeuvre has caveats:
- As regulation in the cryptos-pace is nascent, stablecoins has heightened regulatory risk.
- Investing in cryptocurrencies comes with new risks such as the risk of getting hacked, smart contracts risk and corruption of oracles (data sources), so the market risks has been transformed into something that is much harder to capture in statistics.
- Currently there aren’t enough DeFi projects to go beyond 3-4 different stablecoins over a similar number of platforms, if one project fails, you can lose a third of your stablecoin holdings.
- Stablecoins are not pegged in SGD so you will still be affected by fluctuations between USD and SGD.
As in all matters, for this to work in practice, leverage mutipliers need to be kept small and the allocation to stablecoins also need to be limited to 10%. However, there is a lot of financial innovation in the cyrptocurrency space and this limit can be removed as more viable stablecoins comes online in the future.
Finally, the question is whether a 12% probability of retirement failure is an issue for most Singaporeans. The good news is that most of us have CPF Life and our consumption of retirement portfolios can be kept much lower than 4% once we are over 65 years old and CPF Life comes online.
My Early Retirement Masterclass focuses on building the best in class leveraged portfolios designed to provide a stable flow of dividend income.
