What do “Black Swans” Mean for Investors?
Big economic events, popularized as “black swans”, are known to happen more often than standard economic theory predicts. However, it’s not easy for most investors to figure out what they should do with this information other than to be vaguely worried. One important implication is that leverage is more dangerous than it appears.
Leverage just means borrowing to invest. If you invest $50,000 and it goes up 10%, you make $5000. But if you had borrowed another $50,000 at 4% interest, you’d have made $10,000 less $2000 in interest for a profit of $8000. When investments are rising, leverage is a wonderful thing. However, when investments are dropping, leverage magnifies losses. There is even the possibility of going completely broke if the value of your investments drops below the amount you owe.
In most cases where investors use leverage, they can weather minor storms by paying off the leverage loan with employment income. This way they can wait out stock market tumbles until prices rebound. However, a big enough stock market crash might knock a leveraged investor out of the market completely leaving huge losses. It’s tough enough to watch a portfolio half in stocks get hammered, but it’s another thing to be 200% in stocks and watch them plummet.
Proponents of leverage often talk of Sharpe Ratios and the optimal amount of leverage. These formulas are based on the standard Bell curve and do not give results that are useful for most investors. Be very wary of leverage.
Leverage just means borrowing to invest. If you invest $50,000 and it goes up 10%, you make $5000. But if you had borrowed another $50,000 at 4% interest, you’d have made $10,000 less $2000 in interest for a profit of $8000. When investments are rising, leverage is a wonderful thing. However, when investments are dropping, leverage magnifies losses. There is even the possibility of going completely broke if the value of your investments drops below the amount you owe.
In most cases where investors use leverage, they can weather minor storms by paying off the leverage loan with employment income. This way they can wait out stock market tumbles until prices rebound. However, a big enough stock market crash might knock a leveraged investor out of the market completely leaving huge losses. It’s tough enough to watch a portfolio half in stocks get hammered, but it’s another thing to be 200% in stocks and watch them plummet.
Proponents of leverage often talk of Sharpe Ratios and the optimal amount of leverage. These formulas are based on the standard Bell curve and do not give results that are useful for most investors. Be very wary of leverage.
Good advice. Pessimists have lower expectations, but a more accurate view of life. I've heard enough of these "I used to be a millionaire, and then I had nothing" stories to know to avoid leverage.
ReplyDeleteWhen you get into 20:1 or 30:1 leverage, you're into Bear Stearns or MF Global's league, but 2:1 is enough to destroy an individual investor.
@Gene: Back in the dot-com era I worked with many people who were millionaires on paper but never cashed out. This is different from destroying your finances with leverage, but it is similar in that the problem was that they took on way too much risk.
ReplyDeleteI agree that 2:1 leverage is plenty to make the risk of ruin too high. The 20:1 or 30:1 range is best for gambling with other people's (taxpayers') money.
I don't think that leverage is inherently a bad idea. If someone has a stable income, has a reasonable knowledge of investing, has at least 20 years until retirement, and has been through a bear market without it bothering them, then leverage is an option to consider. However, I think the limit for most people, who meet the above criteria, should be 1.25:1 leverage. And getting information on leverage is not easy.
ReplyDelete@Anonymous: For the conditions you describe, a modest amount of leverage can make sense. I would add the condition that the person's income is enough to service the debt payments. This would usually be the case at 1.25:1, but not always.
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