You will find no shortage of investment strategies in the world of finance. Some are more popular than others, but we can take comfort in the fact that we have a variety. Among them is ‘laddering’. The term refers to a method concerning staggering the maturity dates of various investments.
Is there a reason as to why someone would partake in this? As a matter of fact, there is; multiple reasons, in fact. This article will dive into what exactly this technique is and how to apply it to cryptocurrency.
What does it mean?
In the world of finance, the use of ‘laddering’ is applicable in a wide variety of ways. Ultimately, it all depends on what the industry is. It is a popular investment technique that requires investors to purchase numerous financial products with different maturity dates. By far its most common usages are in relation to retirement planning. Moreover, it comes in handy pertaining to the underwriting of new securities issues.
In the context of retirement planning (i.e. its most popular usage), it is in reference to buying multiple financial products of the same type. These include such things as bonds or certificates of deposit (CDs), and each one has a different maturity date. By spreading their investment across an array of maturities, investors aim to decrease their interest rate and reinvestment risks.
How it works
The process of laddering is capable of helping investors with their management of reinvestment risk. This is primarily because as one bond on the ladder matures, the cash undergoes reinvestment in the nearest bond. In a similar vein, the practice is also capable of reducing interest rate risk. Even if rates drop during one of the bonds the holding period, the smaller amount of reinvestment dollars mitigates risk. Specifically, the risk of needing to invest a plentiful amount of cash at a low return.
In addition, the term is applicable in the context of the underwriting of initial public offerings (IPOs). In this particular case, it refers to illegal activity in which underwriters offer a below-market price to investors before the IPO. That is if those same investors agree to purchase shares at a comparatively higher price following the IPO’s completion. This practice proves to be advantageous for insiders at the expense of regular investors. It is, therefore, illegal under U.S. securities law.
You will find that the term ‘laddering’ goes beyond the use cases already mentioned. There are plenty of others that it can apply to. Laddering comes in handy when describing different investing strategies hoping to generate steady cash flow. How does it plan to do this? Basically, by voluntarily planning investments or creating an influx of liquidity at a predetermined time. As an additional alternative, it can match the preferable risk profile.
Admittedly, these strategies have a tendency to vary substantially in their execution. However, they are not without their similarities. They have in common the practice of meticulously combining a series of investment choices to produce the desired outcome.
Laddering bypasses the potential risk of reinvesting a large portion of assets in a troublesome financial environment. Each one of the ladder’s rungs is a bond of a certain maturity date. The overall “height” of the ladder is the inherent difference between the shortest and the longest maturity bond. The more rungs in the ladder (10 or more is the recommendation), the better the diversification. Moreover, it means that there is more stability for the yield and a considerably higher average yield.
Suppose an individual has both a 2013 matured CD and a 2018 matured CD in their possession. True, the interest rate is low in 2013 when one certificate is due for renewal. However, half of the income is locked in until 2018.
Laddering is able to free up capital as needed. Someone may purchase a shorter-term bond in the event that they need the capital in order to fund something. An example would be their children’s tuition. All the while, they are purchasing other longer-term bonds that mature later as retirement spending with a more suitable rate. That is to say, assuming the economy is going through a normal yield curve during this period of time.
As mentioned before, laddering is useful as a retirement planning approach for all retirement investments. The idea is to separate CDs, cash, bonds, annuities, and others into different “ladders.” It all depends on when the asset plans to undergo liquidation to fund the retirement revenue stream. The use of low-risk assets is at the start of retirement. Generally speaking, they have a lower rate of return thanks to a complete lack of risk premium. Higher-risk assets, on the other hand, would be in a basket and only used at the retirement’s conclusion.
To provide an in-depth example of the laddering concept, let’s imagine a hypothetical scenario. There is an attentive investor who is saving money for their retirement. At the age of 55, they were successful enough to save roughly $800,000 in combined retirement assets. Moreover, they are gradually transferring those assets toward comparatively less fickle investments.
In this day and age, $500,000 of this investor’s assets are invested in an array of bonds. All of which they have carefully combined, or ‘laddered’. By doing this, they can effectively reduce their reinvestment, as well as their interest rate risks. To elaborate, this investor’s bond portfolio consists of the investments below:
- 1 year maturity of a bond consisting of $100,000
- 2 years maturity of a bond consisting of $100,000
- 3 years maturity of a bond consisting of $100,000
- 4 years maturity of a bond consisting of $100,000
- 5 years maturity of a bond consisting of $100,000
Each and every year, the investor will take the money from the bond that matures and reinvest it. They will reinvest it specifically in another bond that will mature in five years’ time. In doing so, they will guarantee that they have exposure to only one year’s worth of interest-rate risk at any given time. In contrast to this, if they invest $500,000 in a single five-year bond, they will risk a greater opportunity cost. Particularly, if the interest rates wind up increasing throughout those five years.
What about ‘bond laddering’?
There is another laddering technique that goes by the name of ‘bond laddering’. What’s the difference? Well, this kind of laddering is an investment strategy that involves buying bonds with different maturity dates. This way, the investor is able to respond very quickly to any changes occurring in interest rates.
A bond investor may purchase both short-term and long-term bonds if they want to distribute the risk along the interest rate curve. That is, of course, if the short-term bonds mature at a time when interest rates are on the rise. In this sense, it’s possible to reinvest in the principal in higher-yield bonds. If interest rates somehow hit a low point, then the investor will receive a lower yield on the reinvestment. Still, though, the investor will maintain a hold on the long-term bonds that are earning a considerably more favorable rate.
In essence, bond laddering is a strategy that focuses on the decrease of risk or the increase of money-making opportunities. Particularly on an upward swing concerning interest rates. During times of incredibly low-interest rates, this strategy proves to be very helpful. They aid investors in avoiding potential locking in a poor return for an extensive period of time.
Along with laddering, there are other simple strategies that are applicable to buy and sell orders. There is dollar-cost averaging, value cost averaging, and scaling in and out of positions. In each case, you could avoid going all-in or all-out, instead of scaling in and out of positions. While we have gone over laddering extensively, we will cover it again in the context of buy/sell orders.
- Laddering is moving in and out of positions incrementally. Rather than buying or selling at a single price, one would set incremental buy/sell limit orders up to and down the order book. Moreover, buying only when the price drops and selling when the price is one the rise.
- Averaging is creating an average position. Basically, you either buy the average price of an asset over time or sell the average price over time. In actuality, there are different versions of averaging into a position. In this case, we are mainly referring to any tactic that consists of scaling into a position. There are two notable examples of averaging techniques. First, there is dollar-cost averaging, where you purchase an equal dollar amount at regular intervals. Second, there is value cost averaging, where you buy/sell to ensure a target dollar amount.
- Scaling is when you gradually scale in or out. You do this instead of buying into a position or selling a position all at once. Averaging and laddering will both inevitably have you ‘scaling’ into positions.
All of these tactics – averaging, scaling, and laddering – are useful when it comes to buying and selling incrementally. This can also prove to be extremely helpful within a volatile asset class such as cryptocurrency.
How to do it
When you use averaging, you can do it in one of a few ways. Traditionally speaking, though, with dollar-cost averaging, you will want to spend the same dollar amount every X amount of time. Therefore, if you have $1.2k to spend, then you would spend $100 per month, every month. And on the same day of the month for a year, too. In the end, you would officially have an average price in an asset.
An alternative version of this strategy is breaking this up to weekly buys, daily buys, or bi-monthly buys. Moreover, you could aim to purchase only on the dips or to buy drawing from a careful reading of the charts. Or, perhaps, you can skip months when the price is rising very high. You could even weigh your buys toward lower prices and sell off a handful when prices are high. Doing so will provide balance for your position toward a target; in other words, value averaging.
This form of incremental buying is sufficient for constructing long positions in cryptocurrency. The main reason for this being the crypto markets’ volatile nature.
Now, with laddering, you have the ability to ladder any type of order. You can conduct either limit buys and sells or stop buys and sells. Laddering stops are able to help limit losses should you decide to open a position in another way. Laddering buy orders for lower prices can assist in buying the average price on a price dip. Lastly, laddering sell orders guarantee that you will receive profits as the price increases. And you can do so without needing to time the top.
There are disadvantages to this technique that you should be aware of along with the benefits. One of them is that you will need a substantial amount of capital invested this way in order to provide meaningful income The reason for this being that the yields are low. Let’s take use a $500,000 investment as an example. Specifically, in a series of CDs earning 4%. In this case, it would yield $20,000, which would decrease further by income taxes. If you opt to go after bonds that possess higher returns, then they will probably have higher risks, too.
Under previous tax policies, there could also be tax disadvantages to laddering. Especially when you compare it to investing in stock for capital gain. If you were to purchase stock, hold it for a year, and then sell it at a profit, the capital gains tax was either zero or 15%. It mostly depends on the tax bracket you were in. However, your income in the form of interest deriving from bonds and certificates of deposit would be taxed at conventional income tax rates. These could typically be as high as 35%.
Following the incorporation of the tax legislation into law in January of 2013, the capital gains tax could reach 20%. Moreover, there was an addition of a higher income tax rate – 39.6% – to the six existing tax rates for married couples. To elaborate, couples with adjusted gross income above $450,000. Likewise, it is applicable for singles who have AGI exceeding $400,000.
Due to tax policy changes, it’s reasonable to consider the tax consequences before including the laddering method to your portfolio.