I first wrote about leverage more than one year ago, time flies!
It was a good introduction at the concept and what were my initial thoughts. I am not sure how I will ‘develop’ this series of post, maybe one day there will be an entire section of the blog, maybe this will be the last one. Leverage is quite a personal topic, how to handle it depends on your circumstances, financial knowledge, risk appetite, etc. Because of this, it is hard to write something that would be always valuable for an extended audience…so I will just talk about myself (like I normally do). What I write might not be right for you now but it can be in the future, or might offer you another point of view to challenge your ideas.
Confirmation bias
the tendency to interpret new evidence as confirmation of one’s existing beliefs or theories
From Warren Buffett to your personal finance guru, no one consider leverage as a good thing. That is why every time I stumble on an article or white paper that challenge than notion, as I did in my first post, I jump on my chair. Recently I found this (quite old) piece, Yale on leverage, that offers another interesting angle.
Your path to a successful retirement, in financial terms, depends on timing luck: if you have to experience a bear market in your saving career, you better choose to do it early…but unfortunately, you cannot plan your birthday based on market cycles or Central Banks chairs. This is called Sequence Risk.
If a bear market happens when you just started to save, a small part of your retirement pot will be affected by declining prices while you will have the opportunity to buy additional assets at a discount. On the contrary, if stocks drops 30% just before you retire…ouch! Your ENTIRE pot will be slashed, you sell assets on the cheap and those losses will be permanent. To counter this timing luck at the end of your working career, typical retirement portfolios gradually reduce the saver investments in stocks when they approach the retirement age and buy bonds, what is called the glide path; a useful patch but not a complete solution. The ugly reality is that your final retirement pot is path dependant and your saving decisions matter up to a certain point.
The idea proposed in the Yale paper is interesting but does not cover one crucial aspect. Months ago I found this blog written by a Canadian guy, which is a nice example on how you can find useful bits even in bad places. I read a couple of posts on how he managed to retire and…a lot of red flags: stock picking, market timing, maybe the guy is really good at that but is quite unlikely. What it was interesting for me was the fact that he is using Interactive Brokers to trade with margin and get cheap leverage. The solution to my problem was always there in front of my eyes and I never consider it! I am old enough that trading platforms had always a bad rep in my mind, partly BECAUSE they ruined so many clients giving them excessive leverage. I never did 1+1, I considered them scams for trading upstarts that did not know better.
So I opened my account on IB and started trading on margin. But how much margin is the right margin? The issue with margin trading is that you do not want losses to be greater than your collateral, otherwise what would normally be a market correction will morph into a permanent loss. The Yale paper suggest a 2 to 1 leverage but this means that if stocks loses 50% of more you might be wiped out. 50% is an infrequent but possible scenario (see 2008-09); on the other side, it is also true that you are dollar-cost averaging: if the market declines 50%, you will lose everything only if you invested exactly at the top and never do anything else, not realistic neither.
Your leverage also moves with your gains and losses: if the market goes up your leverage goes down and vice-versa. If you want to maintain a constant leverage of 2 to 1, you have to buy when the market goes up and sell when it goes down…not exactly the same as “buy low, sell high”. I was debating internally how to solve this and I think the paper offers the best solution: instead of considering the portfolio leverage, as I was doing, you have to constant-leverage your regular (monthly?) contributions. If you buy income generating assets, like ETFs that distribute dividends, your leverage also goes down because those distributions pay back part of your debt.
There is also the psychological aspect to consider. Around mid 2019 I was talking with a friend about NTSX, a new (at the time) ETF that offers some leverage. He commented “it is a nice product, but with stocks at such high valuations I do not feel comfortable to take a leveraged position on the S&P500”. Cannot argue with that logic but I bought it nonetheless:
It is the same dilemma for people that receive a large lump sum: should they invest it all immediately or dollar-cost average? If you are buying an asset that appreciate in the long term, investing it all is the optimal solution…but how would you feel in the above example in February 2020? Pretty f***ing stupid? The S&P500 is in a raging bull market since more than 10 years. It is easy to be complacent, thinking that buying every dip is the right strategy because anyway the market will recover and forget that a multi-year bear market is always a possibility. Introducing leverage in a gradual way is like dollar cost averaging, it is regret minimisation. I am also a noob with IB: for example I (think I) use limit orders but every time IB is telling me that no, that’s not a limit order…god knows…anyway, I started with a 25% leverage (or 1.25), let’s see how it goes.
The most annoying aspect of trading with leverage is that it is almost a taboo word. Tell your finance pal that you do cocaine and you get a shrug, tell them you use leverage and you become a clown. Maybe I am fooling myself like…people that snort coke when I say that I will stop once I get there, but I really believe it. I do not want to buy a bloody Lambo; I just want my (financial) independence and at 42 yes, I am in (kind of) a hurry.
What I am reading now:
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