The Psychology of Leverage

Another Day, Another Question

Welcome back! Today I’m going to respond to the top question that I’ve received about lifecycle leverage: what if I wipe out?

That is, what if using leverage makes my portfolio go to $0?

This is a totally valid question, and top of mind as we experience a potential stock market correction. However, I think that most people with this concern focus on the wrong scenarios. We’ll see that as you increase leverage, your likelihood of going to $0 increases, and under certain situations, leverage constraints can force you out of the market involuntarily, which is quite bad.

The potential for forced selling is one of the most significant differences between investing with and without leverage, but when following the strategy outlined in my post about lifecycle leverage, we’ll find that it is a very uncommon scenario.

That said, even without forced selling you can wipe out!

How?

You just have to bail out when the market crashes. Leverage and volatility can make this bad outcome much more likely.

Let’s explore how your emotions can make you poor.

How Leverage Works

To better understand the issue, let’s talk about how leverage works.

The most straightforward way to achieve leverage is to use margin. You borrow money in order to purchase additional assets, using your existing assets as collateral. Your brokerage limits how much extra you can purchase based on how much collateral you have.

For example, a common arrangement is that by using N dollars you can purchase up to 2N dollars worth of assets (200% leverage). This limit is called your “initial margin requirement” and in this case it’s 50%. That is, 50% of the assets you purchase must be funded by you. Past that point, the brokerage will require you to add more money to buy more stock.

So far, so good.

Note however, that stocks go up and down, and leverage exacerbates this volatility. If the value of your assets goes down, you have less collateral to cover your loan.

To protect themselves, your brokerage establishes a “maintenance margin requirement” that is lower than your initial margin requirement.

A common value is 30%. This means that if you use N dollars to buy 2N dollars worth of stock as above, you can continue to hold that stock without adding more money until the total value drops to the point where your collateral only covers 30% of the assets.

Let’s do the math to see when this happens.

You start out with $100 funded and $100 borrowed for $200 total:

$100 owned + $100 borrowed = $200 total, 2× leverage, 50% margin covered

Now let’s assume that your stock goes down by 25% so that your portfolio is only worth $150. The amount you borrowed is still $100, so your account looks like this:

$50 owned + $100 borrowed = $150 total, 3× leverage, 33% margin covered

So if your stock value goes down 25%, you’re okay since you’re still over the 30% requirement.

Let’s say it goes down a bit more… such that you have only $142 in the account.

Now your situation is:

$42 owned + $100 borrowed = $142 total, ~3.4× leverage, < 30% margin covered

At a price between $143 and $142, you fail to pass the maintenance margin requirement. At this point your brokerage will ask you to add funding to get above 30% or they will liquidate some of your portfolio to get you above 30%.

This is forced selling. The world doesn’t end, but you are selling exactly when you don’t want to—when the value of your stock is low. If the portfolio’s value went all the way down to $100, a 50% drop, you would be completely wiped out by a margin call.

Note that leverage makes this scenario more likely because it increases volatility. Starting at 2× leverage, the stock only had to drop 29% to hit the margin requirement. At a 50% drop, you’re wiped out. This would take a 100% drop with an unlevered portfolio and even then you wouldn’t be forced to sell the stock, so you could maybe recover.

Psychologically, we are primed to worry about these worst cases based on how “representative” or “extreme” they are rather than how likely. This is one reason why people are uncomfortable with leverage.

Is It Avoidable?

But how likely is this, really? Let’s consider wipeouts from a few angles.

First, let’s look at margin calls. There are ways to get around them, but none are perfect. Leveraged ETFs don’t suffer from margin calls, but continued poor performance can get them liquidated, which is essentially the same thing. Here’s an example. Derivatives like LEAPS options also avoid margin calls, but they are time limited and can be thinly traded, so in a crisis there’s still no guarantee you can unload it for a reasonable price before it expires worthless. No free lunch here.

So how do we avoid margin calls? Easy-ish. Just don’t let your leverage get out of control.

We can ready stories about folks like this guy, who blew himself up with leverage way above 2×. Don’t do that.

Historically, if you rebalance monthly such that your leverage is always reset to 2× if it ends the month above that level, you would never receive a margin call. The closest was the crash of October 1987, where the Dow lost 22% in a day and ~29% for a month, which is admittedly very close to our hypothetical margin requirement.

These days, there are more mechanisms in place to prevent large single day moves, but of course, there are no guarantees. That said, by basically margin-calling yourself when you’re past 2×, you gain a reasonable level of control at the cost sometimes being forced to rebalance in the wrong direction.

Okay, so we don’t think we’ll get a margin call or if we do, it’s not the end of the world as long as we’re not wiped out. How likely is that? The truth is, we don’t really know. Back tests show that a leveraged, monthly reset approach would lose 73% of its value in 1931 during the Great Depression and 64% percent during the 2008 Financial Crisis.

Neither of these losses are a floor on what’s possible, however. While the U.S. has had an uninterrupted growth streak, a variety of global stock market indices have broken the 50% loss barrier, and some have gone all the way to zero.

“All the way to zero.” Avoiding leverage would not have helped you here. In fact, in the event of a hyper inflationary crisis, “safe” assets like bonds or even cash have a higher likelihood of going to zero than stocks.

Thus, it seems like nowhere is safe.

So What’s the Good News?

With prudent rebalancing to 2×, leveraged backtests in the U.S., U.K., and even perennial underperformer, Japan come out ahead of non-leveraged alternatives. Conversely, if you consider worst cases, non-leveraged asset allocations can and do go to zero.

The only indisputable fact is that leverage increases volatility within a time period. The market moves faster. It’s more scary. And your risk of abandoning the time series diversification that is theoretically a risk-reduction strategy is the biggest problem.

My Own Worst Enemy

Consider a simplified example, where our intrepid investor bails out of the market when volatility gets too high. For any given bail out point, increasing leverage increases the likelihood that they’ll abandon their plan.

To illustrate this simply, I took a look at the average 3-month trailing volatility of the S&P 500 month by month since 2008. It averages around 20. 43% of months have a volatility of more than 20, which isn’t that surprising… monthly volatility is somewhat skewed toward higher values. So if you bailed out when volatility was higher than average, you’d be doing it a lot.

If we double the volatility threshold to 40, only 5% of months exceed that number. While it’s still not a good idea to blindly take yourself out of the market just because volatility is high, hitting that threshold one in 20 times is much more reasonable than almost 1 in 2.

However, if you double the volatility of your investments with 2× leverage, the story is much different. Volatility that only would have occurred 5% of the time occurs 43% of the time. Because of the way that volatility is distributed, you need a much stronger stomach. Simply doubling leverage led to nearly a 10× increase in the uncomfortable situations.

So be careful: market downturns are reversible, but capital lost by selling at the bottom is much harder to recover from.

Take Care Out There

So there you have it. Wipe out is real and increases with leverage, but bail out is far more likely to damage you.

Is leveraged lifecycle investing right for you? Can you stay the course? Does this post change your point of view at all? Let me know about it.

The only way to know yourself is to experiment, which is why I recommend starting to increase your leverage above 1× and see how you respond. Only increase as you prove you can stay the course through ups and downs, and (if history is any guide) avoid going above 2× to avoid margin calls.

1× is not a magical cap, but you need to be ready and stay vigilant. Know what can go wrong.