No. of Recommendations: 15
you would have had to put up the cash to buy SPY. The futures contracts have a lot of built in leverage...
So you're seriously suggesting that people should have used leverage and made a risky bet buying a futures contract? Where that futures contract could have easily become a ticking time bomb and expired worthless? And you would recommend buying that contract (which could easily have gone to zero dollars) over simply buying and holding an S&P 500 index ETF?
Yup!
The thing about leverage is that it *really* depends what you're wagering on. Is the S&P 500 index going to be zero five years from now? Nope, except in scenarios so dire that no investment is safe (extinction level asteroid hit, for example). As a result, holding a futures contract with face value of $1000 does NOT require you to have $1000 to start with in order to have an essentially zero risk of wipeout.
I'm visiting Canada at the moment. The temperature here two weeks from now might be -45C or +25C. I wouldn't use leverage on a bet about that. But it's (to me) certain that the temperature will not be -200C. A wager like that with leverage isn't particularly risky, as it can't really go that low.
Similarly, this wager was about the likely total dividends paid by a bunch of European blue chips in a given calendar year. It might be a good year for dividends, or it might be a bad year, but the ending number certainly wasn't ever going to be zero in my view. Thus the nominal value of the contract (being the amount that you lose if it goes to zero) isn't really a very good yardstick of the size of the wager. If, for example, you consider a drop by half to be the absolute wildest worst case, then 2:1 leverage is perfectly reasonable. i.e., take a position on €1000 worth of dividends backed up by only €500 starting cash balance. Though it's not a precise comparison, the largest calendar-year to calendar-year drawdown of S&P Composite dividends since 1950 was -23% in the credit crunch.
Practically speaking, the more likely risk is that the future contract trades at a super low level for a few days during some kind of panic. Price can do *anything* in the short term. This is a very good reason NOT to hold a contract to expiry. Pick any calm day in the last several months, and close it early, or roll it out if you want the position longer. A "flash crash" kind of pricing situation can certainly happen on a given day, but it won't happen on every day for a year, so just pick a non-panic day to close or roll.
Not to mention that current S&P valuation levels would not have been predicted by any sane person. In the last few years almost any investment strategy looked dumb compared to holding the S&P. Sadly that wasn't knowable in advance.
...
Why do you constantly need to predict where the market will be next year or two years from now? Why not, instead, just dollar cost average into into it during your wealth building years?
That's a pretty wild change of subject.
A specific one-time investment was proposed a few years back, due to an apparently blatant market failure / mispricing. You proposed a hypothetical alternative one-time investment that would have been entered, fair enough. Neither of those alternatives has any applicability to the issue of continuous saving for retirement, nor does either of them assume that you are pre-retirement. (I'm not).
More specifically, the original wager was NOT trying to predict where the market would be in two years as a one time trade, it was placing a wager on where the level of *dividends* would be in two years as a one time trade, a wildly different thing. Your proposed alternative *would* have been a wager on where the market was in a couple of years, a very much more dangerous thing with or without leverage.
"I can't predict the short-term movements of the stock market. I haven't the faintest idea as to whether stocks will be higher or lower a month, or a year, from now."
Similarly, this quote is wildly off subject. Your suggestion of a one-time fixed-term investment in SPY instead of these future contracts would have been such a wager, but the bet on the dividends wasn't.
A much better example is the index put options that Mr Buffett wrote for Berkshire. They had a nominal value of about $37 billion, but that number was never particularly meaningful. His quote at the time:
"One point about our contracts that is sometimes not understood: For us to lose the full $37.1 billion we have at risk, all stocks in all four indices would have to go to zero on their various termination dates."
A wager on the level of dividends in some future date is extremely similar, in that a "zero" is wildly improbable. By extension, the nominal value is not the right way to measure the size of the position, and the ratio of that nominal contract value to the cash you start with is not a measure of the leverage in the deal in the sense of its real world risk. Unless you think dividends across all those companies will hit zero for a full year, of course.
But, to your first question, yes, leverage on this position would have been sensible. i.e., having cash backing it up which was much smaller than the nominal contract value.
Jim
