Interest Deduction against FIF income

[Snoopy]

The other-way of thinking about it is that I am arbitraging the cost of debt and cost of equity. Since the cost of debt is < the cost of equity in the long run you should make a profit. The cavet to this is "Markets can remain irrational a lot longer than you and I can remain solvent."

With a well run company the cost of debt does tend to be less than the cost of equity - true. But this rule is not so black and white as you make it out to be. There are companies out there where the cost of equity is greater than the cost of debt.

You also should consider why using your logic a well run company has any equity, or in the extreme might run $1 of equity to $99 of debt. The answer is to deal with the unexpected. You need to plan for the unexpected too.

By running a 100% debt funded investment which nevertheless has a 90% chance of performing to plan (because you only invest in good companies, right?) then you might consider that you have a 90% chance of pulling your investment plan off. Unfortunately the actual answer is that if on an annual basis your investment plan has a 90% chance of success, the chances of you losing all of your investment capital over your investment timeframe (say 30 years) is virtually certain. The reason you are almost certain to do your dough is that each investment year viewed on its own is not what is called in statistical terms 'an independent trial'. Put simply the amount of capital you have to invest at the start of any investment year is fully dependent on the capital you have at the end of the previous investment year.

I personally find it quite frightening that there are a whole load of investors out there who do not understand the statistical mathematics of this.

SNOOPY

[lou]

Thanks Snoopy. They are some very good posts

[lou]

With a well run company the cost of debt does tend to be less than the cost of equity - true. But this rule is not so black and white as you make it out to be. There are companies out there where the cost of equity is greater than the cost of debt.

You also should consider why using your logic a well run company has any equity, or in the extreme might run $1 of equity to $99 of debt. The answer is to deal with the unexpected. You need to plan for the unexpected too.

By running a 100% debt funded investment which nevertheless has a 90% chance of performing to plan (because you only invest in good companies, right?) then you might consider that you have a 90% chance of pulling your investment plan off. Unfortunately the actual answer is that if on an annual basis your investment plan has a 90% chance of success, the chances of you losing all of your investment capital over your investment timeframe (say 30 years) is virtually certain. The reason you are almost certain to do your dough is that each investment year viewed on its own is not what is called in statistical terms 'an independent trial'. Put simply the amount of capital you have to invest at the start of any investment year is fully dependent on the capital you have at the end of the previous investment year.

I personally find it quite frightening that there are a whole load of investors out there who do not understand the statistical mathematics of this.

SNOOPY

Position sizing and risk management is one of the keys to a successful investing strategy and it is outstanding how many investors don't understand it.

[Snoopy]

Position sizing and risk management is one of the keys to a successful investing strategy and it is outstanding how many investors don't understand it.

I am not sure I quite got my point about risk of investment plan failure across, so here are the numbers I had in mind. Let's say you devised a leveraged investment strategy that delivered excellent growth per year every year, but with a one in ten chance every year of total capital loss.

The chances of you holding onto your nicely growing capital for one year is 90% (or a probability of 0.9). But to come out ahead you need to do this for ten years in a row. Because each year of investment is dependent on the results of the previous year (in probability theory this means they are what is termed 'dependent variables'), that means you have to multiply the probabilites together to garner the multi-year picture.

After one year the probability of holding onto your fast growing fortune is 0.9.

After two years the probability of holding onto your fast growing fortune is 0.9x0.9= 0.81 (or 81%)

After ten years the probility of you holding onto your fortune is:

0.9x 0.9x 0.9x 0.9x 0.9x 0.9x 0.9x 0.9x 0.9x 0.9= 0.349, or approximately 35%

Or looked at another way you have a 65% chance eventually of losing everything after ten years has elapsed, even though on a seductive one year basis you have a 90% chance of single year success.

SNOOPY

[lou]

I am not sure I quite got my point about risk of investment plan failure across, so here are the numbers I had in mind. Let's say you devised a leveraged investment strategy that delivered excellent growth per year every year, but with a one in ten chance every year of total capital loss.

The chances of you holding onto your nicely growing capital for one year is 90% (or a probability of 0.9). But to come out ahead you need to do this for ten years in a row. Because each year of investment is dependent on the results of the previous year (in probability theory this means they are what is termed 'dependent variables'), that means you have to multiply the probabilites together to garner the multi-year picture.

After one year the probability of holding onto your fast growing fortune is 0.9.

After two years the probability of holding onto your fast growing fortune is 0.9x0.9= 0.81 (or 81%)

After ten years the probility of you holding onto your fortune is:

0.9x 0.9x 0.9x 0.9x 0.9x 0.9x 0.9x 0.9x 0.9x 0.9= 0.349, or approximately 35%

Or looked at another way you have a 65% chance eventually of losing everything after ten years has elapsed, even though on a seductive one year basis you have a 90% chance of single year success.

SNOOPY

Hey Snoopy I did get your point but from a different angle. I was meaning position sizing and risk mangaement is crucial to increase your success rate from 90% to 99%. Therefore your sucess rate after 10 years would be 99%^10=90%.

[Stranger_Danger]

I personally find it quite frightening that there are a whole load of investors out there who do not understand the statistical mathematics of this.

SNOOPY

Frightening? I find it mouth watering and borderline arousing!