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June 10, 2015 at 12:04 PM
Have the 2%-and-change yields we’ve seen on 10-year Treasuries whetted your appetite?
If not — and yields were not even 2% as recently as April — then logic should dictate your desire to take the other side of the trade.
That is, you should want to borrow that money cheaply since you don’t want to lend it for such a pittance.
But that cold, hard logic does not always hold sway when it comes financial decisions is one of the key insights UBS offers in its new second-quarter client communique Your Wealth and Your Life, whose theme this quarter is how to properly leverage a balance sheet.
“Our brains are not wired to think optimally when it comes to decisions involving debt,” write UBS portfolio and planning experts Michael Crook, Brian Rose, Andrea Fisher and Matt Baredes.
Investment analysis is often dressed up in the guise of mathematical rigor. But, citing research by behavioral economist Richard Thaler, investor behavior lacks the predictability of physical forces such as gravity. A body in motion will fall, but a human being will fail … to rationally optimize his financial outcome, perhaps out of fear or shame.
Indeed, a university study cited by the UBS team attests that human beings are psychologically resistant to taking on debt even when borrowing would be the optimal behavior.
A second study — this one a UBS survey of investors — refines that view of debt aversion, showing that investors perceive “good debt” and “bad debt,” with a mortgage on a primary home and a student loan seen as the best kind of debt.
Even though people grasp that such borrowing is proper and prudent, such is our debt aversion that it still doesn’t “feel good.”
In contrast, borrowing from family and friends and credit card balances that are not paid off each month are seen as the worst on a menu of debt options.
Culturally, too, the subject of debt tends to be sidelined. Turn on CNBC and you’re far more likely to hear about assets such as stocks and bonds, commodities or real estate.
But as UBS frames the matter, debt is one of two co-equal sides of a balance sheet and as such merits a rational analysis as to its place in investors’ portfolio — all the more so at a time when the cost of borrowing is at historic lows.
UBS does not advocate using debt to live beyond one’s means, using margin to leverage an investment portfolio or taking on high-cost debt such as credit-card or car loans.
Rather, the wealth management firm says investors should leverage debt to diversify rather than amplify risk, particularly high-net-worth households whose balance sheets have the capacity to do so.
Modern portfolio theory, while based on rationalist rather than behavioralist assumptions, nevertheless provides a useful theoretical understanding of how this works as it is well established that diversification can bring higher risk-adjusted return.
“An aggressive investor can hold a portfolio concentrated in equity or hold a moderate portfolio that’s been leveraged to the same risk as the riskier option,” write the UBS authors, pointing out that investors would be better served with the leveraged moderate portfolio that can “increase return expectations without adding risk.”
