Weekly Update 5/11/2018 The Question of Leverage and Risk

Weekly Update 5/11/2018 The Question of Leverage and Risk

by Zach Marsh on Jun 19, 2018

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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

                Choice 1                                                                                               Choice 2

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

                Choice 1                                                                                               Choice 2

Lost $1900 or 10%                                                                           Lost $5700 or 30%


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 Note

At 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.      
**All graphs courtesy of portfoliovisualizer.com
**Housing data courtesy of http://www.econ.yale.edu/~shiller/data.htm

Zach and Dave


Calibrate Wealth






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