Podcast Summary
Understanding the Risks of Leverage: Leverage can amplify gains but also increases risks, especially in volatile markets. Use it cautiously and consider potential consequences, such as owing more than initial investment in a bear market.
While leverage can amplify investment gains in a rising market, it also comes with significant risks, especially for those who may not be able to handle the increased volatility and potential losses. Warren Buffett's famous quote, "only when the tide goes out do you discover who's been swimming naked," highlights the importance of being aware of these risks and only using leverage in a controlled and tactical manner. A margin loan from a broker is one form of leverage, but it's crucial to understand the potential consequences, such as owing more money than you initially invested in a bear market. Overall, leverage should be used with caution and only after careful consideration of the potential risks and rewards.
Investing on margin: Amplified gains and losses: Margin investing can amplify returns, but also comes with risks of margin calls and potential for significant losses. Consider the risks carefully before using it.
Investing on margin can amplify gains and losses, but it comes with risks such as margin calls and potential for significant losses. While it may seem appealing to double your potential returns with a smaller initial investment, the volatility of the market and potential for large margin calls can make it a risky proposition for many investors. It's important to consider the potential risks and limitations of using margin carefully and only when appropriate. Additionally, most investors may not need to use margin at all, and may find that a concentrated portfolio of stocks provides enough excitement and potential risk without the added leverage.
Margin loans and calls can cause stress and financial crises: Margin loans and calls require careful planning and quick action, and high levels of leverage in certain markets can pose risks for individuals and the economy.
Investments should ideally operate in the background of your life without causing undue stress or intrusion. However, margin loans and margin calls can be exceptions, as they require careful planning and quick action when triggered. These financial tools were a significant factor in past financial crises, including the 1929 stock market crash, and can lead to devastating consequences for individuals and the economy at large. Central banks closely monitor leverage, as it can amplify market downturns and lead to cascading failures. Current levels of leverage in certain markets, such as the leverage loan market in the US, are a cause for concern and may pose risks in the months ahead.
Understanding Leverage: Multiplying Returns and Risks: Leverage can enhance returns, but it also amplifies risks. Companies' balance sheets and financial instruments like ETFs offer leverage, but they come with additional costs and risks. Be aware of internal leverage to manage risks effectively.
Leverage, whether it's through a company's balance sheet or financial instruments like ETFs, can significantly increase returns, but it also comes with risks. When you buy a company, its balance sheet shows equity and liabilities, including bonds, which can multiply returns. Scottish Mortgage Investment Trust, for instance, has around 16% gearing, leading to larger returns than the market. However, the management fees don't include leverage costs. Leveraged ETFs, another form of leverage, can magnify daily returns, but they don't provide long-term multiples. For example, a 3 times daily leveraged ETF will go up or down 3% based on the closing price, but it doesn't guarantee 3 times the long-term return. In a volatile market, these funds can experience significant "leakage," where the gains and losses don't fully offset each other. While you can't lose more than your initial investment with leveraged ETFs, they can still result in substantial losses, especially in extreme market conditions. It's crucial to understand the internal leverage in investments to avoid unintended risks.
Leveraged Investments: High Rewards, High Risks: Leveraged investments offer potential for high returns but come with significant risks and high costs. Holding onto them during market downturns could lead to potential profits during recovery, but options involve the risk of becoming worthless and additional premium costs.
While leveraged investments such as margin loans, leveraged ETFs, and options offer potential for high returns, they also come with significant risks and high costs. The speaker shared his experience of the potential drawdown of up to 97.7% in a hypothetical 3 times levered fund during past financial crises. However, if one could psychologically hold onto such investments during market downturns, they could potentially benefit from the subsequent market recovery. Options, specifically call options, offer the potential to buy an asset at a future price, with the hope of making a profit if the asset's price rises above the strike price. However, this strategy comes with the risk of the option becoming worthless if the asset's price doesn't reach the strike price by the expiration date. Additionally, the premium paid for the option adds to the overall cost. The speaker noted that retail investors have increasingly turned to options and other derivatives, especially during the pandemic, but warned of the potential risks involved. The use of leverage in investments should be approached with caution and careful consideration of the associated risks and costs.
Understanding Options Trading Risks: Options trading involves significant risks, but professionals manage them by diversifying their options book or using return layering strategies. Buying call options can lead to potential losses, while selling options generates income but comes with risks. Naked call positions have unlimited downside potential.
Options trading, specifically buying call options, can be likened to gambling due to the potential for significant losses. However, professionals manage risk by having a diversified options book. A safer strategy, called return layering, involves combining leveraged investments with safe, income-generating assets. Options trading comes in two forms: buying and selling. Buying options gives the right to buy an asset at a fixed price, while selling options lets someone else buy from you at a fixed price. The latter can generate income through premiums but comes with risks, including the possibility of having to buy stocks at a loss if assigned on a call. A naked call, or short call position, has unlimited downside potential, meaning you could end up buying the stock at whatever price it's trading for if you don't already own it. While some compare options trading to "swimming naked" or "picking up nickels in front of a steamroller," others argue it's more akin to "surfing naked" or "riding the waves." Regardless, it's crucial to understand the risks involved and manage them effectively.
Leveraging young for higher returns and reduced risk: Young investors can use leverage to increase potential returns and reduce risk by starting with a leveraged position in equities and gradually reducing it over time, taking advantage of equities' historical outperformance.
Using leverage, particularly when young, can help retail investors increase their potential returns and reduce overall risk through a strategy called "temporal diversification." This strategy, also known as "life cycle investing with leverage," involves starting off with a leveraged position in equities and gradually reducing leverage over time. This approach allows investors to effectively compound their wealth for a longer period, taking advantage of the historical trend of equities outperforming other asset classes over time. However, it's crucial that the cost of borrowing (margin interest rate) is less than the expected return on equities for this strategy to be beneficial. This strategy, as proposed in the academic paper "Life Cycle Investing and Leverage" by Ayers and Nalebuff, has shown to be effective in historical backtests. Yet, it's important to note that the success of this strategy relies on the assumption that the cost of borrowing remains lower than the equity premium, which might not always be the case.
The emotional and psychological challenges of high-risk investing: High-risk leveraged investing, while theoretically sound, is emotionally and psychologically challenging for most individuals due to potential significant losses. A more conservative approach like buy-and-hold might be more practical.
While academic theories suggest that a high-risk investment strategy using leverage could potentially yield higher returns, the emotional and psychological aspects of losing significant portions of one's wealth make it a challenging choice for many individuals. The discussion highlighted that houses, despite their volatility in value, offer a sense of security and tangibility that stocks do not. Moreover, the risks involved in leveraged investing can lead to difficult conversations and potential financial hardships, especially during market downturns. The speakers agreed that while theoretically sound, such a strategy might not be practical for most people due to emotional and psychological factors. Instead, they suggested a more conservative approach to investing, such as the traditional buy-and-hold strategy advocated by Warren Buffett and John Bogle.
Leverage and Risk in Investing: Using leverage to increase returns and lower volatility can be risky and potentially lead to significant losses. Protective regulations exist, but investors should be aware of the potential consequences before using leverage.
Leveraging a diversified and safe investment portfolio to get higher returns with supposedly lower volatility may sound appealing in theory, but in practice, it can be risky and potentially lead to significant losses. This strategy, which involves borrowing money to buy more assets, has been used by hedge funds for years, but the risks were highlighted in the discussion when the speaker mentioned the potential for black swan events that can wipe out gains and even leave investors with negative balances. The EU has implemented rules to protect investors from such outcomes, but it's important to remember that leverage can still lead to significant financial losses, and it's generally not necessary for most individuals. As Buffett famously said, it's insane to risk what you have and need for something you don't really need. It's crucial to understand the risks involved with leverage and to be aware of the potential consequences before making investment decisions.
Understanding Negative Balance Protection in CFD Trading: Check with your broker if they offer negative balance protection and who regulates it before trading CFDs.
When trading with CFDs (Contracts for Difference), it's crucial to understand your broker's policy on negative balance protection. In the European Union, there is a regulation in place that limits traders' losses to their initial investment. However, this might not be the case in other parts of the world, including the US. Therefore, it's essential to check with your broker whether they offer negative balance protection and who regulates it. eToro, for instance, states on their website that they will absorb the loss and reset your equity to zero if market conditions cause your equity to become negative. However, it's essential to note that this policy might not be out of the broker's goodwill but rather a regulatory requirement. Always ensure you're aware of your potential risks before making significant trades.
