This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on March 28 - April 3, 2016.

Thomas J Anderson says a successful debt strategy has the potential to increase your returns, reduce your taxes and lower your overall risk. In this excerpt, he looks at how to determine your optimal debt ratio.

The term “optimal debt ratio” is foreign to most people — naturally enough, as they have been trained to see it as a contradiction. In fact, however, both experience and theory have shown that there is indeed an optimal debt ratio — more properly, an optimal debt-to-assets ratio, that you should shoot for at any given point of time. Not surprisingly, many individuals and families are either too highly leveraged and have taken on way too much debt or have not taken advantage of their Indebted Strengths out of debt aversion. Like companies, individuals and families should aim for that middle ground, the not-too-much and not-too-little Goldilocks solution that will benefit them the greatest over the long run. 

The basic formula used to calculate your current debt ratio is easy: Debt-to-asset ratio = total debt/total assets.

Suppose your current debt ratio is 20%. Is that good? Bad? And how does that relate to the journey into and through retirement? Overall, a debt ratio of 15% to 35% is optimal for many people. Some commentators believe this is too conservative and that it should be between 25% and 45%, while others believe it is too aggressive and the ratio should be more like 5% to 25%. How does knowing that you are at 20% and have five years until you and your spouse retire help you?

Imagine an aircraft getting ready to descend at night. The pilot sees one row of lights shining on his left and another row shining on his right and a sweet-spot path — the glide path — guiding him to where he needs to land the plane. A good pilot will follow the illuminated glide path — not venturing too far to the left (too little debt) nor too far to the right (too much debt) — to bring the plane and its occupants to a safe, smooth landing. Figure 8.7 shows what this glide path could look like over time.

The term “glide path” is also used in a different way by the brokerage and investment industry, which may cause some confusion. Investopedia.com explains that a “glide path” …

... refers to a formula that defines the asset allocation mix of a target date fund, based on the number of years to the target date. The glide path creates an asset allocation that becomes more conservative (ie, includes more fixed-income assets and fewer equities) the closer a fund gets to the target date ... Target date funds have become very popular among those who are saving for retirement. They are based on the simple premise that the younger the investor, the longer the time horizon he or she has and the greater the risk he or she can take to potentially increase returns.

For our purposes, this specific notion of “glide path” is potentially misleading in a couple of ways. First, by continually replacing equities with fixed-income investments, it suggests an inevitable narrowing of the “safe down the Goldilocks middle” glide path over time — to a point when it will be just a straight line, not a path with easy-to-see left and right borders (“glide-lines”) guiding you to a safe, smooth landing. What was a path becomes narrowed to a line, incorrectly suggesting that such precision is both possible and as useful as a wide illuminated Goldilocks path.

Second, and more importantly, while it is true that investing assets more conservatively may make sense for some people over time, it is not at all clear that having less debt or a lower debt ratio over time also makes most sense. Strategically increasing your better debt — and consciously and wisely taking advantage of the Increased Liquidity, Increased Flexibility, Increased Leverage, Increased Survivability, and Increased Perspective that come with taking on such better debt — may be the more conservative move by nearly any definition of “conservative”.

It is important to consider the volatility of your asset portfolio when analysing your debt-to-asset ratio. Inherently, the more volatile your portfolio, the lower in the range your debt ratio should be. Conversely, the less volatile your portfolio, the higher your debt ratio can be. For example, if your investment portfolio is 100% in US stocks (think S&P 500) and your debt ratio is on the high side, around 35%, your portfolio might fall quite quickly in a major market correction similar to 2008. Depending on how your debt is structured, you might be exposed to a margin call, potentially forcing you to sell at the exact wrong time (at the low!). If, on the other hand, your portfolio is mostly conservatively allocated among global government bonds, you can likely have a debt ratio toward the high side with very limited odds of your portfolio falling to a level that would trigger a capital call.

It is important that you understand your own situation, including what you need and what you want, apply what you have learnt, and assess it against where you fall in the general optimal debt ratio glide path (which we continue to posit is, on average, between 15% and 35%). Assuming you have transcended (or never had) any problems with oppressive debt, if you see yourself moving too far to the left — to a debt ratio that is below 15% — as you approach retirement, you will probably want to make a course correction unless something in your Need-Want-Have Matrix, general circumstances, or psychological makeup indicates it makes sense to go lower than 15%. Similarly, if you find your debt ratio moving out of the glide path and substantially over the 35% level, you may want to rein it back in to the middle, or change your asset allocation, unless you have other information or advice that indicates it is all right for you to be that high.

I am against people making sudden and dramatic changes unless the full consequences are very well thought out and understood. I understand that mathematically moving to an optimal ratio can happen at any point in time, but it is easier psychologically if you move along a glide path — with gradual nudges that improve your overall outcomes rather than drastic changes. For example, if your debt ratio is not optimal, I am generally against a cash-out refinance against your house and reinvesting the difference. In many cases, this is restricted — or outright prohibited. More important, I worry that people will be tempted to do it at the exact wrong time. People will tend to take on more debt in good times and tend to pay off debt in bad times. It is my general belief that this practice is backwards. People should consider paying down debt when things are looking really good (or reallocating to other assets), and they may want to consider letting their debt ratio drift up a little higher if things are looking pretty bad.

How do you determine when are good and bad times? Unfortunately, there is no easy way. It is my experience that if you think the world is falling apart and three random people tell you that “the market” stinks, you may want to consider letting your debt ratio drift higher. If stocks are hitting new highs, or if three random people comment on how excited they are about “the market”, and especially if the media is excited, you may want to consider lowering your debt ratio.

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