Leverage Can Kill

by: Cullen Roche

Back in 2011 I highlighted the three biggest risks to most portfolios:

  1. Leverage
  2. Concentration
  3. Illiquidity

With the SNB shocker this is a perfect time to revisit that thinking because we're seeing a lot of carnage out there as a result of these three factors.

Leverage multiplies the moves in assets. Borrow 100% and you've increased your beta or volatility by 2X. In volatile asset markets or markets that allow extreme leverage this can be particularly dangerous. FX and futures markets often allow much more than 2X leverage. $10 can be leveraged into $100 which means 100% of your capital can be wiped out by just a 10% move. In a market like the FX markets where 10% moves are uncommon, but not unheard of, this is a crazy way to try to generate returns. You're a gambler, not an investor. You have to understand how much more risk you're taking by leveraging something up. This is further multiplied when it's done in a concentrated portfolio position. You're narrowing all your risk down to a few assets and then leveraging. And as we now know, the SNB move resulted in widespread illiquidity which made the market losses that much worse.

I've talked about the dangers of trading leveraged ETFs in the past because they tend to result in volatility clusters and expose investors to tail risk. But this also extends to FX markets, futures markets as well as most other markets. You have to really know what you're doing when you engage in such a market. Leverage itself doesn't kill people, people kill people. And people who don't understand leverage or abuse it will inevitably get killed by it.

I think there's a good rule of thumb that comes from all of this. Most of us really don't need to use leverage in our portfolios. Yes, it can be a useful tool in the right hands, but what leverage does to most portfolios is increase the probability of a tail risk event thereby increasing the risk of permanent loss. So, when the SNB comes in and does something that no one expects then a 20% move turns into a 100% loss for a lot of leveraged asset holders. No one needs that sort of added risk in a portfolio. So, when in doubt, stick to the old Warren Buffet rule: "don't invest in what you don't understand." Odds are, you don't understand leverage and don't need to. For most of us, investing is actually just the act of allocating our savings. Unfortunately, the allure of "market beating returns" and the myth that we'll "get rich quick" in the markets is powerful and leads people to do things that are often irrational. When in doubt avoid leverage.