Weekly Update (5/11) and Blog Post
by Zach Marsh on May 11, 2018
Calibrate Weekly Update
Our Weekly Recap
S&P 500 +2.37%
10 Year US Treasury -0.20%
Our Weekly Reading
The Question of Leverage and Risk
Continuing on a bit from last week, we wanted to take some time to address another question many people ask about our portfolio construction, which has been: Is leverage, or margin risky? It’s a good and valid question and one I’m very excited to talk about. As I thought about this question this week it aroused many interesting ideas and concepts, not just about leverage, but about risk and volatility. So, let’s get down to it. First, the short answer is yes, leverage does, by its nature add risk. Absolutely, if you take any asset and buy more than your cash position allows, you have naturally increased your exposure relative to the cash invested. Nominal risk is linearly increased with the amount of leverage you assume. Let's illustrate:
Scenario: You have $19,000 to invest
Purchase 100 shares of Apple stock for $190/share Purchase 300 shares of Apple on 3:1 margin
Outcome: Apple stock declines 10% from $190/share to $161/share
Lost $1900 or 10%
As you can see the loss increased incrementally with the leverage, but there is a flip side, obviously, and that is the possibility for greater return. Using the same example from above, if Apple stock increased in value by 10%, you would make 30% on our original investment. So, leverage certainly increases risk, while increasing reward if your investment pays off. That’s the clear and obvious answer. Now, where this discussion gets more intriguing is investigating the true nature of risk and determining when it can be appropriate lever investments.
Determining Your Risk Level
The above example illustrates that risk is increased when comparing one investment versus the same investment leveraged; Apple stock versus Apple stock purchased with leverage. But, what if we examined two different investments, consisting of a different mixture of non-risk-free assets, and compared the impact that leverage would have upon them. Risk in capital markets is typically defined as volatility, a measurement of how much returns vary or fluctuate. For example, an investment in the S&P 500 stock market index fund, the large-cap index has a long-term annual volatility of roughly 16% going back to 1970. Given an 8% average annual return this implies that 99.7% of the time returns will fall between -40% and +58% if returns will normally distributed. However, returns are not normally distributed, but are subject to what are called, “fat tails.” Since 1970 there have been 3 separate periods when the stock market has fallen by over 45%, or about 1/16 of time.
Levering an asset like this can obviously cause existential problems for an investment strategy. A 250% levered position would’ve led to terminal events in all three occasions. Therefore, the underlying risk of the investment is crucial to determining whether to use leverage or not.
Now consider a lower-risk investment using a risk balanced approach. The line in blue is a simple portfolio consisting of 40% S&P 500 and 60% Long-Term US Treasury Bonds, the red line is a 100% investment in the S&P 500. While both portfolios exhibited volatility over the years,
Portfolio 1 (stock and bond) was significantly lower risk. Adding leverage to Portfolio 1, at say 200%, would’ve removed the low risk componentry of the portfolio, but added greatly to the performance.
Here is another look at a more condensed time horizon (1987-Present) of the same portfolios with Portfolio 1 levered 200%.
You can see that both had drawdowns, but the unlevered, all stock portfolio had deeper drawdowns, dragging down its performance over the period as illustrated below.
When things were going well in the market both portfolios performed equally well, but when things got rough the balanced, levered portfolio withstood the turbulence better. Therefore, leverage adds risk to the portfolio in question, but the risk is relative. Depending upon what your overall target risk level is, leverage can be an effective way of seeking higher rewards while reducing your overall risk.
What is Risk
It is easy to simply look a variance of returns as a measurement of risk. In that context, cash is the lowest risk asset there is. But, money is only as good as what purchases. Inflation perpetually eats away at the purchasing power of cash. Below is a look at an investment in 3-month US Treasury Bills on an inflation adjusted basis. Notice that not only has it barely yielded an 11.5% total real return in 30+ years, it has actually lost value since the turn of the century, -10.14% to be precise. So, risk isn’t
simply volatility of returns, but it is also the erosion of purchasing power. The certainty of time’s erosion of money is one risk that must be avoided, as it is the most certain of all risks.
Final NoteAt Calibrate we seek to provide a solid, well-balanced, foundational portfolio for our clients. At its foundation our portfolio seeks an annualized volatility of roughly 6%, in contrast a standard 60/40 portfolio is roughly 9%. We add leverage according to risk tolerance and return requirements for each client, 150% leverage would equal the equivalent volatility of a 60/40 portfolio. The US housing market as measured from Robert Shiller’s data set has an annualized volatility of roughly 5.5%. Consider that most people purchase a house with 20% down payment, the US housing market is run on about 500% leverage. As home owners we are comfortable with this risk because, assuming we make our payments, we are not at risk of forced liquidation. But assuming we purchased a house and not a coffin, one day we will want to move. Until 2008, home owners, didn’t measure the volatility of the housing market, but the volatility was always there. The housing market volatility is, perhaps, like Schrodinger’s Cat, always present, but only exists when observed. Lehman Brother’s tried to leave it unobserved for as long as possible, but it eventually caught up with them. Stock markets don’t receive the same latitude as the housing market and always exist in the realm of the observed. While exhibiting roughly the same volatility as the housing market, we never assume the same leverage. As mentioned last week, observation has its downside, but volatility transparency is ultimately a good and valuable thing.
Zach and Dave
All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. Tax laws are complex and subject to change. Calibrate Wealth LLC, does not provide tax or legal advice and are not “fiduciaries” (under ERISA, the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise provided in writing by Calibrate Wealth. Individuals are encouraged to consult their tax and legal advisors (a) before establishing a retirement plan or account, and (b) regarding any potential tax, ERISA and related consequences of any investments made under such plan or account.
This material does not provide individually tailored investment advice. It has been prepared without
regard to the individual financial circumstances and objectives of persons who receive it. The strategies
and/or investments discussed in this material may not be suitable for all investors. Calibrate Wealth
recommends that investors independently evaluate particular investments and
strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a
particular investment or strategy will depend on an investor’s individual circumstances and objectives.
Investing in commodities entails significant risks. Commodity prices may be affected by a variety of
factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii)
governmental programs and policies, (iii) national and international political and economic events, war
and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities
and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other
disruptions due to various factors, including lack of liquidity, participation of speculators and
Foreign currencies may have significant price movements, even within the same day, and any currency
held in an account may lose value against other currencies. Foreign currency exchanges depend on the
relative values of two different currencies and are therefore subject to the risk of fluctuations caused by
a variety of economic and political factors in each of the two relevant countries, as well as global
pressures. These risks include national debt levels, trade deficits and balance of payments, domestic and
foreign interest rates and inflation, global, regional or national political and economic events, monetary
policies of governments and possible government intervention in the currency markets, or other
Transactions in options carry a high degree of risk. Purchasers and sellers of options should familiarize themselves with the type of option (i.e. put or call) which they contemplate trading and the associated risks. You should calculate the extent to which the value of the options must increase for your position to become profitable, taking into account the premium and all transaction costs.
The purchaser of options may offset or exercise the options or allow the options to expire. The exercise of an option results either in a cash settlement or in the purchaser acquiring or delivering the underlying interest. If the option is on a future, the purchaser will acquire a futures position with associated liabilities for margin (see the section on Futures above). If the purchased options expire worthless, you will suffer a total loss of your investment which will consist of the option premium plus transaction costs. If you are contemplating purchasing deep-out-of-
the-money options, you should be aware that the chance of such options becoming profitable ordinarily is remote. Selling ("writing" or "granting") an option generally entails considerably greater risk then purchasing options. Although the premium received by the seller is fixed, the seller may sustain a loss well in excess of that amount. The seller will be liable for additional margin to maintain the position if the market moves unfavorably. The seller will also be exposed to the risk of the purchaser exercising the option and the seller will be obligated to either settle the option in cash or to acquire or deliver the underlying interest. If the option is on a future, the seller will acquire a position in a future with associated liabilities for margin (see the section on Futures above). If the option is "covered" by the seller holding a corresponding position in the underlying interest or a future or another option, the risk may be reduced. If the option is not covered, the risk of loss can be unlimited. Certain exchanges in some jurisdictions permit deferred payment of the option premium, exposing the purchaser to liability for margin payments not exceeding the amount of the premium. The purchaser is still subject to the risk of losing the premium and transaction costs. When the option is exercised or expires, the purchaser is responsible for any unpaid premium outstanding at that time.