My first investment portfolio blew up due to excessive leverage when I was 19 years old. Having concluded that I was unlucky, I proceeded to blow up my second portfolio three years later
My first investment portfolio blew up due to excessive leverage when I was 19 years old. Having concluded that I was unlucky, I proceeded to blow up my second portfolio three years later
My first investment portfolio blew up due to excessive leverage when I was 19 years old. Having concluded that I was unlucky, I proceeded to blow up my second portfolio three years later
The second time more sophisticated leverage via options resulted in an even faster rate of loss.
These two events on their own are not unusual, happening often to investors who use leverage. After the second blow-up I underwent a long period of introspection, finally concluding that bad luck had nothing to do with the events. Too much leverage led to the inevitable result.
Since the 2008 financial crisis borrowing money has never been cheaper, and offers of cheap loans are unrelenting.
When investing without leverage an investor can hold if the price temporarily moves against them. With leverage there is always a price level at which the lender of the money will ask to either top up more cash, or force-sell the underlying assets to repay the loan. This is a margin call event. The ultimate decision on whether (and how much) leverage should be used depends on the investors’ confidence that this margin call price level will be avoided at all times. Being ‘eventually’ right is not good enough when using leverage, as you may be forced to sell if prices move against you in between.
This confidence level is more critical with speculations compared to real investments. Speculations are often called “investments” but they are not the same. Speculation is based on an expected rise (often in a short space of time) in the principal value of an investment. Investment consists on buying an acceptable and stable level of cash-flows (whether via coupons, dividends, or earnings growth) at an inexpensive price. The attractiveness of the investment increases when there is reasonable expectation for these cash-flows to increase over time. The probability of success is significantly higher in investments compared to speculations. Leveraged investments have lower risk than leveraged speculations.
Buying Microsoft shares in year 2000 at 35x earnings and no dividend was a speculation. The only way to show a profit was to have the next buyer pay an even higher price. Buying Microsoft shares now at 11.6x earnings and a 2.9% dividend is more like an investment.
Speculation is not inherently ‘bad’ and investment ‘good’. There are plenty of successful speculators who have devised trading strategies that earn consistent profits. However combining speculation with leverage needs extremely tight risk control at all times. Below are four common scenarios of leverage:
Taking a mortgage to buy a property for own use
As long as the monthly payments can still be made, usually the bank will not foreclose on the underlying property. Therefore avoiding margin calls rests on your ability to make these payments. This in turn is determined by your family’s monthly net surplus after expenses, and the risk of the monthly payments increasing in the future due to higher interest rates. Assuming you are confident in the security of your job, expenses vs. income can be modelled against the risk of higher mortgage rates in the future to make the final decision, also taking into account the projected future appreciation in the value of the property. It is important not to underestimate how fast interest rates can move up. For example, from mid-2004 Singapore rates rose from 0.6% to 3.5% in 18 months.
2. Taking on a mortgage to buy an additional property for investment
If the property in question has a projected rental yield of 3% p.a. before expenses, and the mortgage cost is 2% p.a., the net yield to the investor is less than 1% p.a. Obviously this kind of transaction only makes sense if there is an expectation of a future rise in the value of the underlying property, as a small move in interest rates will cause a negative cash-flow situation. When taking into account recent government measures to cool the local property market, the risk of higher mortgage rates in the next few years, and that property prices are at all-time highs, this is clearly more of a speculation than an investment. The only way to avoid the risk of foreclosure with certainty depends on the investors’ capability and willingness to finance the monthly payments from other available financial sources, once the rental does not cover the mortgage payments.
3. Leveraging an investment portfolio to buy bonds / high dividend stocks
This has been a favoured strategy over the last few years, but the good times are ending. The ‘spread’ (income earned less cost of leverage) has tightened consistently over the years, leading investors to take on more credit and duration risk, lowering the cushion for negative events such as defaults, price falls in the underlying investments, or higher interest rates. Similar past gains in bond prices will not happen in the future, leading to higher margin call risk. It is important to note that variants of this strategy, such as holding Australian Dollars leveraged in Singapore Dollars, are clearly speculative and under no circumstances an ‘investment’. At regular intervals the adverse currency movement will be far larger than any spread an investor can earn from the strategy. Investors should have learned that lesson during the 2008 crisis where 3 months erased six years’ worth of profits. History is repeating itself now with the Australian Dollar having fallen -10% in the last four months. Since there is no way to protect against such movements without giving up the spread that is the reason for doing this in the first place, there is no way to avoid the risk of a margin call with any degree of certainty.
4. Leveraging an investment portfolio to buy assets that are expected to gain in value
When the investment does not generate sufficient income to cover the costs of leverage with a sufficient spread, gains come solely from capital price appreciation. This strategy has the highest risk of failure, and therefore is not recommended for the majority of investors. It should only be employed by traders and speculators who have a clear strategy, and are able to define their risk on every trade and overall portfolio to minimise/eliminate margin call risk.
My less than stellar start in investing held an important lesson. Combining ignorance and leverage leads to interesting results. Recently I heard advice to leverage one’s home to buy stocks, just as both are trading near all-time highs. Thankfully I am not as ignorant as I was.
By LEONARDO DRAGO
Co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund management services to endowments and family offices, and wealth-advisory services to accredited individual investors.