The Power (and Pitfall) of leverage kcchongnz

kcchongnz

Publish date: Sun, 05 Jan 2014, 07:22 AM

The power (and pitfall) of leverage

“The most dramatic way we protect ourselves is we don’t use leverage. We believe almost anything can happen in financial markets… [so] even smart people can get clobbered with leverage. It’s the one thing that can prevent you from playing out your hand.” Warren Buffett

During the US subprime crisis at the end of 2008 when investor sentiment was extremely low, the stock markets worldwide, including the KLSE, fell to a ridiculously low level. I refinance my house and borrow RM200,000 to add to my RM100,000 cash I have and invested in some stocks in Bursa. Note the amount of money is hypothetical but the leverage ratio is true and extremely high at 3 to 1.

At that time, market valuations were incredibly low, and stocks offered wonderful returns looking forward. Unfortunately, stocks first fell much further from the already low levels before they eventually turned around in March 2009. At the end of the year, my stock portfolio made 30%. And what is the return of my investment of RM100,000? It was RM80,000, or 80%. Yes 267% more than if I were to just use my own money (refer to scenario 1 in Table 1 below). I actually wanted to use the gain of my investments then to pay back my loan to the bank to be debt free but they wanted to impose a penalty on me for early pay back. So I discarded that idea and continued to use the money for investment. Thank God, the stock market continues to go up until to date.

It really seems smart or sophisticated to invest using OPM (other people’s money). No doubt about it, borrowing money to enhance the profits has tremendous appeal, only when everything is going correctly. That sounds great. Where can you sign up? But before that, beware of an alternate history. How would you know everything will be going correctly before the fact? You are encouraged to read the book “Fooled by Randomness” by Nassim Taleb.

But there’s a dark side…

But wait a minute. What if I was not that lucky? Yes, luck plays a part in all investments besides skill. What if the market, instead of making a upturn in March 2009, the whole world were to go into a deep recession and the stock markets continue to slide? Not possible? Again you are encouraged to read Nassim Taleb’s book about the black swan.

Table 1 below shows the returns of your equity with different scenarios of total returns with a leverage ratio of 3 to 1, the same leverage as mine. The interest rate is assumed to be 5%.

Table 1: Returns with leverage

Scenario	1	2	3	4	5	6
Equity	100000	100000	100000	100000	100000	100000
Debt	200000	200000	200000	200000	200000	200000
Total investment	300000	300000	300000	300000	300000	300000
Total return, %	30%	15%	4%	-10%	-20%	-30%
Profit	90000	45000	12000	-30000	-60000	-90000
Interest at 5%	10000	10000	10000	10000	10000	10000
Net profit	80000	35000	2000	-40000	-70000	-100000
% profit	80%	35%	2%	-40%	-70%	-100%

Yes, you make 80% if your stocks go up by 30% as shown in scenario 1. But if the return of total investment is 4% (scenario 3), or below the cost of borrowing, the return of equity is only 2%, half of the return of 4% if one uses his own money alone. However, if the return of total investment is minus 10%, the investor’s loss will be amplified to minus 40%, 4 times more (scenario 4). The investor would have lost all his money if the return of total investment is minus 30% as shown in scenario 6!

It’s great to borrow a cow and selling the milk, but not until the cow runs off. Now you’re stuck. You owe a cow and don’t have one to return, and no milk. The risk of leverage is investing that debt and losing what you borrowed, which can wipe out any profits, or even your entire capital.

This thing won’t happen as you have done thorough due diligence? Have you heard of the US subprime crisis I have just mentioned at the beginning? Just how long ago this thing happened when the liquidity in the market just dried up completely? Hack, even banks won’t want to lent to each other! The two very established investment banks in US, Bear Stearns and Lehman Brothers just went kaput because nobody was willing to provide credit and liquidity to them.

Not convinced of the pitfall of leverage? Wait till you hear this story, a true one too.

The infamous Dominion Funds

I went back to Malaysia in 2008 and joined a financial advisory company as a registered representative. One of the investment products the company pitched a lot is a PX2 USD Dominion fund (Yes, you got it right. The commissions were very high). PX2 is a leverage fund using twice the amount more of borrowings (exactly the same leverage as the above example) for investing in with profit funds of insurance companies. The sales pitch of Dominion fund is consistent high return of investment using leverage with low volatility using some kind of smoothening effect. Yeah, a high Sharpe ratio, very low volatility because of the “smoothening”, even though the absolute return is not that great. It was supposed to be for sophisticated investors with the advice of licensed and professional advisor. It was one of the top funds in the world then (They say so but I am not sure) because of the high but deceiving Sharpe ratio. In case you are interested in Sharpe ratio, please refer to the following link:

http://klse.i3investor.com/blogs/kcchongnz/44334.jsp

With the concept of amplification of returns by leverage above, we will examine the PX2 USD fund with the returns as compared to S&P 500 as shown in Table 2 below. The S&P indices and share prices of PX2 USD were extracted from Yahoo Finance and Dominion websites respectively.

Table 2: Return of PX2 USD Funds compared to S&P 500

Date	31/12/2004	31/08/2008	2/03/2009	30/06/2010	Since inception
S&P	1212	1300	700	1030	-15%
S&P Change	0%	7%	-46%	47%
PX2$	$100.00	$140.8	$121.5	$52.8	-47%
PX2$ Change	0%	41%	-14%	-57%

The four dates in the Table correspond approximately to the date of inception of PX2 funds, the high level for S&P 500, the lowest level of S&P 500 around that period and the last date (30/6/2010). From 31/12/2004 to 31/8/2008, S&P increased by 7% through this period and PX2 increased by 41% due to its leverage of 2X. This shows the ‘wonders’ of leverage and investors jumped with joy. From 31/8/08 to 2/3/09, S&P plunged from 1300 to 700, or 46% drop! However PX2 declined by a mere 14%. Fantastic, the magic of the so-called smoothening effect. Scenario 6 in Table 1 above shows that investors would have lost all their equity with that plunge of 46% in S&P. Look closely at the period from 2/3/09 to 30/6/2010. The S&P has recovered from 700 to 1030, or 47% but PX2 dropped further from $121.5 to $52.8, or 57%. Why the opposite? I could only guess that the heavy loss during the crisis was ‘smoothened’ again and it was not fully reflected in the share price. The fund had since been suspended a couple of years ago and my take is investors (sophisticated ones) have lost all their money there, while S&P is at its new peak now.

Look how leverage can cause devastating effect for investors. Hence from this experience, I personally don’t even advocate one should put all his money in equity, especially at this time when the stock market is not that convincingly low, not to say borrow and leverage to invest. It is a good practice to have a good assets allocation; some money in the stocks (and diversify the stock holding), some in fixed income, and some in properties etc. But never in gold, I mean like Genneva Gold.

Is the future knowable or unknowable? I feel I don’t know what the future holds and hence I will do differently; diversifying, not levering, staying high in the capital structure, and generally girding for a variety of possible outcomes.

KC Chong (5/1/2014)

Discussions

7 people like this. Showing 23 of 24 comments

houseofordos

This leverage method would work well if you can find an investment that guarantees returns above cost of debt.

2014-01-05 08:39

coolio

what a very informative artical! Thanks Kcchongnz

2014-01-05 09:31

kcchongnz

Is there such a thing as "guaranteed" in investing, especially you want to get a return higher than the cost of borrowings?

Posted by houseofordos > Jan 5, 2014 08:39 AM | Report Abuse
This leverage method would work well if you can find an investment that guarantees returns above cost of debt.

Posted by Tan KW > Jan 5, 2014 08:52 AM | Report Abuse
how if borrow $ to invest in good company that sell in great discount price (high MOS) like KFIMA and KUCHAI?
my own opinion, we have to ensure we have enough cash flow to cover the loan repayment but not hoping the equity investment will provide us the cash flow. we only able pick good company with huge MOS but we will not able to determine when the market will give a fair price to the selected stock.
kcchongnz, what is your view?

Tan KW, you have now become a great value investor. Buy them in loads if you find those value stocks as described by you. But with borrowed money for an ordinary investor like you and me, I am not sure. And bear in mind the followings:

The market’s not a very accommodating machine; it won’t provide high returns just because you need them. Peter Bernstein

There is a big difference between probability and outcome. Probable things fail to happen-and improbable things happen-all the time. Beware of fat tails.

2014-01-05 10:30

Ayoyo

Very informative article on the pitfalls of leverage, chong! I like your writings and generous sharing of your knowledge. I've just enquired on Mr koon's article on leverage and whether I should give it a go as a swing and momentum trader. I guess you have helped answer that niggling question for me.

2014-01-05 10:46

Chrollo

It's is always very nice to read kcc's writing.. It's true that during advantageous times, using OPM is a very good opportunity to increase your wealth.. Although the downfall, I believe can be compensated with a very large base of knowledge added with a proven system and also not to mention that one must not be greedy..
I deeply belive in MOS but however, we will not be able to know when the stock will go back to its expected intrinsic value as many stocks lay dormant for a long time before breakout.. I believe it is always the best to buy a breakout stock added along with good fundamentals..
And I would like to ask a question.. I am still learning so what I say may be wrong.. The question is that if we were to go on a value stock.. Will not our funds be held down for the dormant period until it flies? Overdiversifying will also actually bring you lesser return or maybe losses.. What is your opinion? Thank you

2014-01-05 11:43

kcchongnz

Posted by Chrollo > Jan 5, 2014 11:43 AM | Report Abuse

And I would like to ask a question.. I am still learning so what I say may be wrong.. The question is that if we were to go on a value stock.. 1) Will not our funds be held down for the dormant period until it flies? 2)Overdiversifying will also actually bring you lesser return or maybe losses.. What is your opinion? Thank you

Question 1: I will repeat the same response

"The market’s not a very accommodating machine; it won’t provide high returns just because you need them." Peter Bernstein.

"To be a value investor, you have to be willing and able to suffer pain:" The pain of waiting if you may say. Jean Marie Eveillard

But sometimes you may not necessarily have to wait too long, if you are lucky. And luck may not simply come to anybody. Please refer to the return of my two portfolios set up this year, both of them less than a year.

Question 2: Over-diversifying brings lesser return? Sure but have you thought of just having two stocks in your portfolio, or under-diversification, say Kumpulan Fima and SKP resources which fell in price albeit a little, while watching most other stocks went up in price a lot for the last one year?

I advocate diversification, not over-diversification. Please read this:

http://klse.i3investor.com/blogs/kianweiaritcles/43093.jsp

2014-01-05 12:33

JCool

Everyone shd try tis extreme leveraging...... at least once in ur lifetime..... for extreme rush....

1. Set aside say RM 100,000 hard cash... n ready urself for its total loss....

2. Search for a counter whc is a sure thing.... or at least u r cock sure is a sure thing...... n buy to d tune of RM 500,000..... without d intention of picking up....

3. Pray hard......

It may looks dangerous... but may b not....... since how likely is it tat u wil b surpried n screwed by a crash (by definition a drop of 20%) in d mkt/ur counter within d very short n managable period of T+3.... tat wil totally wipe ur RM 100,000.... as a black swan is a black swan simply bcos it happens so so rarely...

n hey for safety measure... u actually hv in place a cut loss point.. tat is d RM 100,000 refer 1 above

u want leverage... tis is leverage.... even whn u can't get a loan....

but WARNING.. tis is more akin to betting n is potentially suicidal... n if u found urself making a loss... jz blame urself for being cock sure of d counter u chose in d first place...

2014-01-05 12:41

Chrollo

Thanks kcc .. Appreciate your prompt reply.. Thank you very much.. I studied graham's book and Buffett book their waiting period is around 7-10 years..can we actually have their waiting patience? For me I definitely died as my holding longest was only a meager 1 month since I started two months which is damn sad..
Thanks a lot for your reply again.. I will read over your posting again and if you have any good websites or books or even writing, I would definitely love to hear it from you.. My patience is my downfall in investing.. I sold many only ended up going up because I can't hold them..

2014-01-05 12:43

houseofordos

kcchongnz Is there such a thing as "guaranteed" in investing, especially you want to get a return higher than the cost of borrowings

One example I can think of is like Amanah Saham schemes like ASB or ASM, these funds payout at least 6 pct annual returns even in bad times.... In fact banks used to provide loans just to buy ASB.

2014-01-05 13:56

houseofordos

KC, all studies have shown that stocks generally go up in the long run. As long as we have cashflow to service the loan, just buying an index fund should give excess returns on the cost of debt in the long run as long as interest rates remain low . However if interest rates were to go up drastically like during the asian financial crisis, leveraging is definitely dangerous..

2014-01-05 14:14

Ayoyo

IMHO, I think kcc can benefit from some form of market timing tactics to complement his sound FA. Buffet was a market mover in that he can be buying at any stage and still the stock will move due to his brand name but mere mortals like us is hardly make a statistic at all.

I'm sure kcc has some simple entry rules in his arsenal and not just 'buy at any price point as long as it is value' approach. Ooi teik Bee may be a good in between for both camps of FA and TA

For me, I'm lousy (or just too lazy) at FA. My trades are 90% TA-based and just based on simple 'tape reading' techniques of price and volume action. No indicators whatsoever to cloud my judgement. If a a stock hits my filter, usually just 1 or 2 will catch my eye for a watch or trade Ina a day or sometimes, none at all. I'll then check the simple fundamentals like profit, NTA and PE. looks ok, I'll trade and then ride the momentum . I'm not good at (and no time since momentum trading is about seizing opportunities) using IV, DCF or other models to check.

Which is why I'm still riding trades in success, astino, MFCB, farlim, gmutual. Stocks that have good simple numbers but may be avoided by the pure fundamentalist for its inherent lack of solid foundation in the numbers.

As for leverage, I'm not convinced if I should take it on. My returns are good. The past year realized profit is 80% while if I'll add my running profits in(stocks not sold), it's about 130%. But this is achieved thru very high frequency of trades . If I use OPM, my statistic will look much better but to me, statistic is meaningless. In all practicality, if I can afford to buy cash, just use it otherwise it'll just lie idle in Fd earning 3% while margin will cost me 4,5%, thus net is still a negative 1.5%. Then I ask, what's the point then? KCC just vindicated this argument

2014-01-05 14:23

michael99

strictly not for beginner .

2014-01-05 15:22

kcchongnz

Posted by houseofordos > Jan 5, 2014 02:14 PM | Report Abuse

KC, all studies have shown that stocks generally go up in the long run. As long as we have cashflow to service the loan, just buying an index fund should give excess returns on the cost of debt in the long run as long as interest rates remain low . However if interest rates were to go up drastically like during the asian financial crisis, leveraging is definitely dangerous..

"all studies have shown that stocks generally go up in the long run", but in the long run, we are all dead.

Ever heard of the lost decade of DJIA? DJIA was above 11,000 in year 2000. 10 years latter, it even went down below 10,000. How many people can afford to have their borrowed fund tied up in the market and continuously paying interest? Yes, you said it right, what if interest rate goes up to above 10%, like what happen during the Asian financial crisis?

What about if in 1990s, you have bought MUI, PMCorp, MPCorp, KNM etc with borrowed fund and keep them until now?

What if you have dabbled in the second board counters in 1996 when most of the stocks are in their tenths and hundredths of dollar a piece?

What if you have borrowed money and invest in the internet companies in 2000 and kept them until now?

Yes, stock prices go up in the long run. Yes all studies show that. But that is history. The future is uncertain. Yes, I agree we should still invest in the long term; but should we leverage, knowing that a black swan can appear any time? Beware of the fat tail.

Even though you invest in good stocks with the borrowed money can be very dangerous when a black swan appears when you are forced to sell off because of banks calling back loan, or margin calls.

2014-01-05 16:29

edmundgooi

Buy within your means

2014-01-05 16:32

kcchongnz

Ayoyo, I have to say that you have done extremely well in your trading adventure last year. But I can't help saying some sincere words here.

The past year is a good market. The broad index KLCI went up 14%, which is much better than a normal year. You would have done much better if you have borrowed money and have heavier bets.

But every once a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not necessary skill. In the short run, a great deal of investment success can result from just being in the right place at the right time. The keys to profit are aggressiveness, timing and skill, and someone who has enough aggressiveness at the right time doesn’t need much skill. And that includes many people, and me too.

It is very good that you seem to recognize that too. Many don't. The killer will be if one doesn't appreciate the role of luck.

2014-01-05 16:40

Ayoyo

Kcc, thanks for the honest words. I have no regrets not borrowing to leverage on my speculations . It is precisely because of this that my line is not over extended and I'm able to control my emotions and trade objectively .

And I have no arguments with a kamikaze speculator who strikes it big in a fluke but as you are aware, a successful speculator is someone who is able to do it consistently.. That's why I'm resign to the fact that I'm never gonna get a multi bagger from a single stock holding, being a momentum trader. That's not my edge and I'm not sorry about it.

Yes, luck plays a role but to strike lottery , you will still need the effort to buy the ticket in the first place. Thus, in some ways, you make your own luck . If I may add, the keys to profit is to find your trading edge and have the discipline and conviction to stick to it.

And again, I thank you for your wonderful nuggets of wisdom

2014-01-05 17:08

Chrollo

Ayoyo and kcc, hope to hear more from u guys =) great writing..

2014-01-05 17:19

houseofordos

KC, you have presented all the key points and risks one should consider when leveraging. Yes I agree leveraging is doubled edge sword. I personally have been considering to refinance my home and use proceeds for investment. For now I still have high cash ratio to stocks so not planning on doing that yet.. But what you explained from your personal experience of leveraging is exactly what I hope to accomplish...

2014-01-05 17:37

Chrollo

This few weeks i am on a holiday and thinking that if one were to wish to be wealthy and rich in a fast manner, leveraging is the only way.. There is just so much cash for a person who is young like me.. without leveraging, even if i have 50% gain, it will only bring about few k or few hundred.. and we are talking bout a superior gain of 50%.
However, if one were to take on borrowings without knowledge , the bid farewell to the money.. Currently im doing trial and error to test a system to buy and sell before i take on borrowings.. Wish everyone good luck..

2014-01-05 17:45

Ayoyo

The difference between skill and luck

"When a trade stops out, was it because your original hypothesis was wrong or because you were unlucky with the timing? When a trade is successful, was it for the reason you expected or did you catch a lucky break? If you can’t tell if you're clever or lucky, then you are nothing more than a passenger. . For, useless statistics cloud judgements while useful ones are predictive and persistent. skill is controllable and repeatable, luck is not."
Mike mauboussin

Chrollo, it took me a long and painful journey to be able to trade profitably for a living. I wouldn't suggest you mortgage your home and plough it into the markets. You'll have to determine what your speculating personality is, trader or investor? Then hone your skills around these. Read lots of books and find out what works for you. For me, the defining moment came when I read 'reminiscences of a stock operator' and was amazed how the legendary speculator, jesse Livermore, traded simply on price and volume action. The book contains insights into how a stock operator manipulates the markets and is a mandatory read for all trading interns at the large broking houses in US. From therein, I just continued my study and research into it until my hone my skills.

Leverage featured heavily in Livermore's speculations and at his height, his worth was worth the equivalent of 100billion today. Alas, he died poor and probably from his losses compounded with over extended credit.

But, his teachings and quotes are as much gems and wisdom as they are buffet's.

Chief among which, a fool and his money will soon be parted

2014-01-05 18:59

Chrollo

Ayoyo, it is a deep honour to hear your past and also advice.. I will get the books u recommended and read it as i am reading and applying.. Thank you very much for the recommendation!

2014-01-05 23:09

DonnieYen

I am a new investor and I thinks it's good to have you folks give such pearls.

2014-04-26 00:22

SuperMan 99

Thank you for all your words & sharing, truly appreciate.

2015-12-08 01:20

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