What's wrong with leverage?

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whitemiata
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What's wrong with leverage?

Post by whitemiata »

If I had $99100 (or so) I could:

1. Buy $99,100 worth of SPY

or

2. Deposit the 99,100 in a futures trading account and buy one e-mini SP500 contract

The two strategies should be essentially identical so I doubt that a lot of investors would advise strongly against the second.

Now if I reduced how much I deposit into the futures I would begin to introduce leverage into the equation

Now without doing crazy stuff like reducing the deposit to near minimums... Why is there so much resistance to thi?concept?
FrugalFrida
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Re: What's wrong with leverage?

Post by FrugalFrida »

If you are on track with your retirement savings you don't need to take more risk. And if you are behind with your retirement savings you can't afford to lose what's already saved.
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market timer
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Re: What's wrong with leverage?

Post by market timer »

This has been a popular question recently.
555
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Re: What's wrong with leverage?

Post by 555 »

If you understand the difference between arithmetic mean and geometric mean then you have your answer.
http://en.wikipedia.org/wiki/Kelly_criterion
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tadamsmar
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Re: What's wrong with leverage?

Post by tadamsmar »

There is nothing wrong with leverage.

There is something wrong with taking reckless risks as measured by the Kelly Criteria: this practice underperforms optimal strategies.

It's perhaps possible to use leverage without taking a reckless risks, but leverage may be a reliable indicator of overconfidence/recklessness. The data is somewhat ambiguous because of difficulty in stock marker prediction.

Read Fortune's Formula for a non-technical introduction to this stuff.
IlliniDave
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Re: What's wrong with leverage?

Post by IlliniDave »

whitemiata wrote:If I had $99100 (or so) I could:

1. Buy $99,100 worth of SPY

or

2. Deposit the 99,100 in a futures trading account and buy one e-mini SP500 contract

The two strategies should be essentially identical so I doubt that a lot of investors would advise strongly against the second.

Now if I reduced how much I deposit into the futures I would begin to introduce leverage into the equation

Now without doing crazy stuff like reducing the deposit to near minimums... Why is there so much resistance to thi?concept?
My guess would be that it is partly because leverage will multiply losses as readily as it will multiply gains, and many investors are understandably as much focused on capital preservation as "beating the market" going forward. Plus, many investors already have what I would call de facto leverage--carrying debt outside their investment accounts, so adding more within the investment accounts may be imprudent in the big picture. I don't invest in futures so I can't say whether by nature they would add to the risk of leverage, or mitigate it.

I think this is one of those things where for certain investors in certain situations at certain times an amount of direct leverage in their investments might be an acceptable strategy. For my temperament and at a time of relatively high asset prices (potentially more room for things on the downside than the upside), leverage would make me lose sleep.
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tadamsmar
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Re: What's wrong with leverage?

Post by tadamsmar »

Thorpe shows that 17% leverage is the optimal point for the SP500. But he assumed the cost of leverage was the T-bill rate and it's higher so that cuts into the modest leverage rate. Plus he assumed that SP500 future returns would have the past mean and variance and be year-wise independent. If you add a bit of prudence about these assumption, you will find that leverage is not warranted.

http://www.edwardothorp.com/sitebuilder ... Market.pdf

Also, he was optimizing very long term growth like at infinity. Your considerably shorter lifespan and consumption plans are not that long term and this implies yet more prudence needs to be applied. No room left for leverage.
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Re: What's wrong with leverage?

Post by nisiprius »

What's wrong with leverage is that a) it exceeds most ordinary retirement savers' risk tolerance, and that b) there's good anecdotal evidence that many people who think they can tolerate it are overconfident.

In order to use leverage, one must sign a legal agreement that typically says something like "I solemnly swear on the name of Jesse Livermore that I am a sophisticated investor, I totally understand that I can lose not only everything I have but more, and I am completely cool with that." What's wrong is that most people who sign that statement don't really mean it. They only sign it because they don't think it could actually happen. To others, sure, but not to them.

Rudyard Kipling presented the testicular aspect of risk in his poem, "If--"; among his criteria for manhood:

"If you can make one heap of all your winnings
And risk it on one turn of pitch-and-toss,
And lose, and start again at your beginnings
And never breathe a word about your loss..."

That's what leverage is, and I couldn't do it. Rudyard Kipling would not approve of me.

And that is what forum poster "market timer" describes in his long-running thread A Different Approach to Asset Allocation, and, most significantly, this is what he said about in a recent post
One thing that is worth emphasizing here is that I didn't initially set out to risk a large amount of money. The idea was born when I lost $5K in summer 2007 selling a few puts on financials. I gradually added more and more exposure as markets fell, hoping to break even on that $5K loss, and came up with MYR to rationalize what I was doing. That's another risk with leverage: it is a slippery slope. Don't underestimate the human tendency to average down or change course if markets do not cooperate. Don't underestimate how distracting a leveraged position can become. Don't rule out bad outcomes. Seven years ago, I would not have believed I was capable of such reckless behavior, nor could I have imagined how quickly my life would be uprooted. As I've opened up to friends over the years, I've been surprised how many of them have similar stories.
There is "survivorship bias" in the stories we hear from investors, and we are much more likely to hear from the winners than those who have suffered crushing losses. We are fortunate in this forum to have market timer and his frank account.

I guess the question I have is: why are you seeking validation? To borrow a book title, what do you care what other people think?
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JoMoney
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Re: What's wrong with leverage?

Post by JoMoney »

When people talk about prudent allocation to risky assets, they often bring up "need, ability, and willingness" to take on risk. I think leverage inherently fails the "ability" test. If you're borrowing money to buy the asset, whether it's synthetic leverage or more typical credit or margin, can you really say you have the "ability" to be buying it if you don't really have the money?
There's something about derivatives I just don't like as well. When you buy a stock you're buying ownership of something, it may be a trivial amount, with limited legal status, but it's still something. When you buy a futures contract you're just betting on the future price for some specific time frame and settling the bet in cash at some future date (and possibly rolling it forward). There may be some legitimate reason you need to use that futures contract to hedge or insure a portfolio rather than buying the actual asset, but if you're just doing it to make a bet that the price will be higher (or lower) in the future, and that the other side of the bet will make good on their promise, it seems like there's additional counterpart risks involved... and seems to epitomize the bad side of the casino that is Wall Street (or Chicago)... people ignoring the businesses, with no cares as to voting rights or management of the company, just wanting to bet on it because it tends to move around.
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VA_Gent
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Re: What's wrong with leverage?

Post by VA_Gent »

You are basically correct in your assumptions.
If you plan on doing this for the long term, you will be faced with "rolling over" your positions four times a year.
This adds costs. Eight commissions and four "spreads" (which are not constant)

Example:
Commissions- 8 x $4.76= $38.00
Spreads- 8 points x $50 x 4 = $1,600
Loss of margin opportunity cost - $5,500 x(risk free rate)
Costs -$1638 / $99,100 = 1.65%

Other factors:
Your labor/headaches to keep track of when to roll the contracts.
Remember the flash crash? That one contract actually went down like -$5,000+ and you would have gotten stopped out that day, at the bottom, if you had only put in the required margin.
You will be tempted to time the market due to the relative ease of getting in and out.
You could get "Corzined".
"In investing, what is comfortable is rarely profitable." - Robert Arnott
Dandy
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Re: What's wrong with leverage?

Post by Dandy »

There are many good answers to review. My view is leverage is great when it works and horrible when it doesn't. It seems to be best used by very sophisticated investors in a limited way. There are too many people who consider themselves sophisticated investors and those investors tend to over use leverage.

It is a higher form of investment gambling than frequent trading.
Caduceus
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Re: What's wrong with leverage?

Post by Caduceus »

"Leverage" by itself doesn't really mean anything because investors can lever up in different ways. The motivations might be different; the risk-return profile might be different; the effects on the portfolio might differ.

Ryan is sure that gold miners are going to go on an upward tear within the three months. Based on his gut feeling and two hours of research on the internet, he spends $10,000 on far out-of-the-money calls that expire in 90 days. When it doesn't work out, he swears never to believe those folks on SeekingAlpha and drowns his sorrow in a bar.

Adam doesn't know whether the emerging markets ETF he likes (VWO) is over-valued or under-valued. If given a choice, though, he would buy a lot more VWO than he currently could at the current price to hold for the very long term. He has a stable job and is saving aggressively. He buys deep in-the-money calls that expire in two years and has worked out the implied interest of those calls. He is happy with the total price indicated by the strike price + option price + carry cost. As it turns out, emerging markets hits a home run and Adam buys in at his intended price over the next two years. To celebrate, he goes to a bar.

Adam and Ryan meet in a bar, get married, and decide to buy a house, putting only 20% down. What they don't know is that after 3 years, their home value will have declined by 20%, wiping out the entirety of their equity, causing a 100% loss on the original investment. It's OK though, because everyone does it, it being the American dream and all.

Then, they go to Las Vegas for their honeymoon, and put all their money in ... ... ...
Johno
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Re: What's wrong with leverage?

Post by Johno »

VA_Gent wrote:You are basically correct in your assumptions.
If you plan on doing this for the long term, you will be faced with "rolling over" your positions four times a year.
This adds costs. Eight commissions and four "spreads" (which are not constant)

Example:
1. Commissions- 8 x $4.76= $38.00
2. Spreads- 8 points x $50 x 4 = $1,600
4. Loss of margin opportunity cost - $5,500 x(risk free rate)
3. Costs -$1638 / $99,100 = 1.65%

Other factors:
5. Your labor/headaches to keep track of when to roll the contracts.
6. Remember the flash crash? That one contract actually went down like -$5,000+ and you would have gotten stopped out that day, at the bottom, if you had only put in the required margin.
7. You will be tempted to time the market due to the relative ease of getting in and out.
8. You could get "Corzined".
Note: the following is all with respect to the net unleveraged case of a long position in one ES contract and investing $99,100 (assumes a contract price of 1982), rather than holding $99,100 in an S&P ETF. I am not considering the case of actual leverage. Also I assume it's done in tax advantaged account,

1. Interactive Brokers charges $2.02 per ES contract trade rather than $4.76.
2. Much bigger overstatement here. The bid-offer on the ES is not fixed but it's .25 tick on the lead contract the great majority of the time, and .25 on the first two for at least a week or two every cycle when the second contract is the lead but front one hasn't expired yet (eg. the week or two up to Sep 17 the Dec was trading at .25 bid-offer when Sep hadn't expired yet and was also trading at .25 bid offer). And the loss in trading, assuming you come in place market orders to buy and sell, is generally then bid-mid and mid-offer, so 1/8 tick per trade. So the 8 trades per year (buy and sell each of the 4 quarterly contracts) would be 1 whole tick per year; you're assuming it's 32 ticks! :shock:

One might quibble with my assumption and say 'sometimes when you put in the buy and sell market orders the market will move a 1/4 tick, or more, against you between the executions so it's more than a 1/8 loss on average', to which I would counter-quibble that if you go in eg. on the bid on the contract you want to buy, you can usually hit the bid on the contract you need to sell when your bid gets hit, and therefore not pay any bid-offer. It usually comes out that way for me, though sometimes I'll have to improve a 1/4 on the second trade, and occasionally it will come out worse than that, but IME 1/8 per trade is not grossly optimistic, and 1/4 per trade is conservative (you can even program IB's thing to do stuff like like, sell at market on one if hit on limit order on the other, and not even rely on a quick click :D ).

3. So at 1/8 tick a trade the 'expense ratio' would (2.02+1/8*50)*8/99,100=6.7bps, at 1/4: (2.02+1/4*50)*8/99,100=11.7bps

4. This is incomplete in a major respect. Holding the contract is equivalent to borrowing at the implied financing rate to buy the index. See link for recent implied financing rates on the ES
http://www.cmegroup.com/trading/equity- ... /main.html
Most recent data point is 0.43%. So there's is a loss of 43bps for any portion of the $99,100 which is held in the futures account at 0% interest. And much more than the initial $5,750 (on IB now) margin has to be held that way in case the market suddenly drops (see 6). But any portion of the $99k not held in the futures account can be held in an FDIC money market account yielding up to 0.95%. Say we hold 26% in the futures account and 74% in the bank account. Then the net interest cost is .26*.43%-.74*(.95%-.43%)=-.27%. IOW there's an 'expense ratio' of around *minus* 20 bps overall assuming 1/8 bid-mid on the trades. This arbitrage can persist because institutions can't invest in FDIC deposits at 0.95%, and most individual investors who can invest in those deposits don't choose to hold their long S&P positions in futures.

5. Yes there is a labor input by the investor, which makes this unattractive for investors who highly value low labor input in their portfolio's.
6. In the wake of the 'flash crash' the ES contract became subject to a market wide 'level 3 circuit breaker' wherein trading halts till the next business day if the S&P (index) falls 20%. Therefore around 26% (6% initial plus 20% one day drop) kept in margin is enough, as long as additional money is wired from the bank account before the next day's trading. Again this is a labor input though.
7. I'd separate purely psychological aspects like this from physical, so to speak, facts which apply generally or even to particular individuals.
8. I assume you mean if the futures broker goes bust, but if you're long the ES contract you owe *them* money when the stock market crashes, That said, one should choose a futures broker carefully.

IMO this strategy (or a further variation, selling puts on the ES contract) is the way to go with marginal additions to the equity portfolio, as by rebalancing for example, in an IRA. The arbitrage is real. It's even more compelling if one would buy treasuries (since the implied financing rate on treasury futures is lower than on equity index contracts).
Whether to have *net* leverage in a portfolio is a different question, empirical as well as individual. But there's no axiom by which there's a bright line at 100% equity, which many people on this forum say they have (though perhaps don't really if you count everything), and anything past that must be wrong. Personally I'm not near 100% equity.
Rob Bertram
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Re: What's wrong with leverage?

Post by Rob Bertram »

A leveraged portfolio when used responsibly can reduce your risk (standard deviation) while keeping the same expected return compared to an unleveraged portfolio. Or similarly, a leveraged portfolio could give you superior expected returns with equal risk. And, of course, leverage can increase your risk way beyond need. I have a feeling that leverage has a bad reputation because it has been used irresponsibly. There is nothing inherently wrong with leverage as other posters have already said.
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whitemiata
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Re: What's wrong with leverage?

Post by whitemiata »

Those were a LOT of great answers!!!! Thank you so much.

I've looked into the costs and I believe they're more along the lines of the latest poster said in terms of bid/ask.

I'm skeptical of the arugments that people think they'll hold on to a strategy but then will fall off the wagon. I'm sure that happens to a lot of people but I'm just Me, I'm not other people. I don't drink and drive, if I drink I then chill in my car for as many hours as it takes. I don't drive while I'm tired... have no problem pulling over and sleeping. I don't give answers when I don't know the answer, I say "I'll find out" and so far I've only enthusiastically bought every time the market has gone down and didn't blink when my investments' value dropped significantly after the bubble popped or after the financial crisis hit.

My plan would be for a very specific portion of my portfolio that actually doesn't currently exist.

I have a rental that's cash-flowing very nicely for me and I was considering picking another one up but decided against it right now as I'm probably late to the property buying game, plus yeah the work can be a pain.

The rental is fully paid off and it's worth about 100K

I called my mortgage broker and asked him about doing a cash-out refinance. He's looking into the possibility for me and so far he thinks he could get me somewhere near 80K out of the property and payments around $460 - $500 a month.

The cash flow from the rental could easily cover that and continue to give me some income, so I consider the 80K "Play money".

My thought was to buy two contracts, one for the S&P E-mini and one for the Russel 2000 and put the full 80K in the account to cover.

Doing so would mean that for say $475 a month I would control the equivalent of roughly $100K worth of S&P and about $110K worth of Russel2000.

Assuming I get the 80K loan and everything works out I would be pretty significantly leveraged on this play money however if worst came to worst I would have the ability to cover the additional $120k ... though realize that THAT would mean the market went to you know... ZERO. If that happened the loss in that one account would be the least of my problems.

With an 80K buffer I could sustain a drop of 38% in both indexes before my play pot is wiped out.

That said... if the world did NOT come to an end a combined growth of 3% in the two indexes would pay for the $475 a month.

Yes this doesn't account for the transaction fees but with two contracts getting rolled 4x a year this is pretty insignificant.

Of course the indexes could stagnate for a decade or two I guess... if that's the case, for one that would screw over my regular portfolio anyway, for two I consider this PLAY MONEY so as much as I certainly DON'T hope to lose it I am prepared to lose it... again... the rental is paying for it.

At the end of the day I'm comfortable with my retirement portfolio, I'm (supposedly) going to have a generous pension... so I'm not exactly playing with my nest egg.

The upside of course could be fantastic. I'm not banking on it but if the bet paid off and the indexes grew at a healthy rate.. the one we all hope for for our retirement portfolio and if I grew it keeping the same 38% safety by adding additional contracts as the income permits, this could eventually provide a significant boost for my retirement and/or help with some of the future education costs for my 4 children.

Now someone made a comment along the lines of "why are you asking?" or something like that.

Well... mostly I was wondering if I'm missing some significant hidden thing I don't understand or that is hidden from me. For instance I know people who don't understand how catastrophic a leveraged ETF could be for a long-term buy and hold investor (because of how they attempt to simulate 2x the index in a way that essentially guarantees a slow loss).

As to the labor... I already LOOK at my accounts quarterly (never more frequently) for rebalancing/tax loss harvesting opportunities (yeah I know... not much of that for the last few years) so I could just adjust the date I do that to be the appropriate time to shift to the next contract... once every four months isn't exactly a huge burden.

You guys are awesome! You have no idea how helpful reading your stuff for the last several years has been... my family owes a lot of you a big debt of gratitude!!!!!!!

Oh and I WILL be following "naysayers" :) links later this evening once the kids are in bed. In a very real way while I certainly appreciate those who have indicated that what I was proposing wasn't completely nuts (we'll see once they see the full strategy laid out here LOL) I find the opposing position to be even more valuable. If I can't accept what they're saying or refute it (sometime just in terms of "it won't apply to me") then I'm not doing it right :)
Rob Bertram
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Re: What's wrong with leverage?

Post by Rob Bertram »

If you haven't done so, I suggest reading some of the discussion Should I use margin to buy a balanced fund?. It's a lot to read, so if you want to skim maybe read the first couple posts and the last 20.

My argument for using leverage on a balanced portfolio of stocks AND bonds is that it is more efficient than leveraging just stocks. If you want to play with leverage, I highly recommend doing the math to see if leveraging a balanced portfolio would be better than going 260% stocks.
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