Latest stock market news from Wall Street - CNNMoney.com

Saturday, January 14, 2012

Making the best of leveraged investing

Published January 14, 2012


A good trader minimises mistakes and if he does make a mistake, acts to minimise the damage by exiting from the situation quickly.

By WILLIAM CAI
GYC FINANCIAL ADVISORY

OPENING an account with a private bank can be a glamorous and exhilarating event. With a prestigiously branded partner to provide expert investment advice and solutions, investors feel confident, sophisticated and empowered to grow their wealth. Armed with this false sense of security, some investors welcome the idea of using leverage for exponential returns as a wealth creation strategy. They are comfortable with using leverage as it is akin to buying a property or running a business, which could have brought them much wealth in the past.

However, leveraged investing on securities, currencies and derivatives is a different business. Investors face market risks and other variables beyond their control. Without proper risk management and investment experience, leverage can lead a high-net-worth individual to financial ruin. In the accompanying table, an investor plans to invest in a basket of shares valued at $3.4 million, with a loan. The bank being prudent, determines that the portfolio has maximum lending ratio of 70 per cent. In other words, the maximum loan value it can provide would be 70 per cent of the portfolio's market value while the investor has to fund the other 30 per cent himself. The investor was prudent and took a smaller loan of 50 per cent and funded the rest with his cash.

Therefore, the portfolio was acquired with $1.7 million in cash and $1.7 million in borrowings with the portfolio itself as collateral.

When the market value of the unleveraged version of the portfolio rises by 25 per cent, the leveraged version would have a gain of 50 per cent on the investor's initial cash outlay.

Attractive as the scheme may sound, leverage cuts both ways. A 25 per cent fall in the unleveraged version would mean a huge 50 per cent loss for the leveraged investor.

The maximum loan value funded by the bank is limited by a lending ratio unique to the investment concerned. In this example, the new maximum lending value (NMLV) of 70 per cent on the portfolio after it has depreciated by 25 per cent is $1,785,000. (Lending ratio of 70 per cent X Portfolio Value). As long as the amount borrowed, at $1,700,000, is less than the new maximum lending value, a margin call would be avoided. The investor would still have a chance to recoup his losses.

If losses widen sharply to 40 per cent, the market value of the leveraged portfolio would fall to $2.04 million and its NMLV of 70 per cent would be reduced to $1,428,000. Since the existing $1.7 million loan has exceeded the NMLV, the bank would need to exercise a 'margin call' and the investor would need to pay $272,000 to reduce the loan to keep it within the NMLV rule.

If the investor is unable or chooses not to meet the margin call within the agreed time frame, part of his portfolio will be liquidated to pay for the outstanding loan.

By then, the investor would have lost 80 per cent and without the initial leveraged facility, it would be difficult to recoup the losses. On the other hand, the non-leveraged portfolio of shares has a good chance of recovering its value over time.

In a worst-case scenario, if a systemic tail-risk occurs, causing the leveraged portfolio to fall 60 per cent, the investor would have lost $2.04 million and now owes the bank $340,000!

Investors must always avoid a margin call and the best way is to avoid aggressive leverage. Between 2005 and 2007, it was easy for investors to profit from markets and they may have attributed their success to their superior investment ability. Those who used leverage could have been seduced to take up bigger positions as judgment gets clouded.

It is likely that they failed to recognise an overvalued market and a stock market bubble set to explode. Moreover, it only takes an unforeseen and rare outlier event to hit a highly leveraged portfolio badly enough to wipe out an account. Some investors end up in a sad state as they try hard to recoup earlier losses, only to repeat the same mistakes until they end up broke.

This is a classic case of the fate of gamblers, which an investor may refuse to admit. When systemic risks and market volatility increase, leverage should be reduced or used very carefully. If leveraged is kept low, margin calls are kept at bay and investors would be able to survive a few bad investment decisions. Investors have to carefully monitor their own leveraged positions to avoid margin calls. In a volatile market, loan value ratios can change widely. Leveraged investing is thus a risky proposition if not managed well. Investors can learn from investment legend Jesse Livermore who used leverage to amass a fortune in 1907 and famously made US$100 million (equivalent to US$1.26 billion) in 1929. His advice reflects the experience of making millions to becoming a bankrupt not once but a few times, and his views remain relevant today.

Firstly, always minimise mistakes. According to Livermore: 'Being wrong is acceptable; staying wrong is unacceptable.' A good trader minimises mistakes and, if he does make a mistake, acts to minimise the damage by exiting from the situation quickly. This means having a written plan for each trade entered, the most important element of which is the stop-loss.

For many investors, it is often easy to exit a profitable trade early but difficult to cut losses. People dislike being wrong and pride is one of the reasons. An investor holding on to a losing trade may cite the excuse that he is a long-term investor and not a trader or speculator, only to suffer the consequences. It is important to remain humble and admit to mistakes early.

However, most investors have a loss-adverse nature which makes them unable to adopt and execute a stop-loss rule early. A losing trade is usually held onto until the loss becomes unbearable or when an investor gets a margin call from the lender and is forced to close a position. Depending on the level of leverage used, a small 5 per cent loss can be swiftly magnified to 70 per cent or more. From a mathematical perspective, the bigger the loss, the harder it will be to recover. Therefore, mistakes must be acknowledged and stopped early.

Secondly, avoid the folly of trying to find a good reason to sell a leveraged investment. Answers take time to come and it would usually be too late to act profitably.

Livermore feels that 'the only reason an investor or speculator should ever want to have pointed out to him is the action of the market itself'. Investors are encouraged to use technical analysis to make trading decisions rather than rely on assumed market fundamentals.

Thirdly, it is important that an investor invest with leverage only when the risk-rewards ratio is great. As leveraged losses can be heavy, investors need to be patient and wait for potential returns that are large enough to make business sense and to cover interest costs.

Next, stick to liquid investments that you understand. In 2008, individuals and a few institutional investors especially in Hong Kong, were sold financial derivative products such as 'accumulator' notes which were leveraged. At the worst of the 2008 crisis, investors had difficulty unwinding their positions and suffered huge losses. One can appreciate how Livermore was fully aware of the risks involved in leverage investing when he set aside money in a trust to protect his family from his own trading activities.

Despite all the rules and dedication, he suffered from depression and lost all he had in 1934. In 1940, he published a book, How To Trade Stocks, where he described his experiences and techniques in trading in the stock and commodity markets. Shortly after, he shot himself in the head in the cloakroom of the Sherry Netherland Hotel in Manhattan.


The writer is vice-president & deputy investment head at GYC Financial Advisory

1 comment:

  1. What a rare and important view. Great article and I wished I have read this much earlier. I have lost so much money after being encouraged to leverage. Most bankers are useless sales people. Leverage increases their bonus and it hard to get good advice as the responsibility falls back to myself. But I only have myself to blame and its embarrassing....

    ReplyDelete