Taking Big Bets
A few years ago, a friend came to me for help. Her father had passed away years prior and had left a sizable estate for his children that was currently under the trustee of her uncle (we’ll call him Todd). Uncle Todd had a history of making large, concentrated bets with a few big wins and a handful of disastrous results. Fast forward to late 2019 and early 2020, when the COVID-19 virus had begun making news headlines as a potential threat; there was a great amount of uncertainty in the stock market about what would transpire in the coming months. At the time, there was little consensus among analysts, and views of how the growing spread could impact the US mostly stayed along the political party lines. Uncle Todd believed he knew how events would transpire. And so, with both his personal funds and the trust assets that were set aside for the children, he purchased stock investments in accordance with his conviction – as did many investors at that time. What made this bet different was not the stock pick itself but the leverage applied to it. In other words, if this particular stock investment moved by $1, then his balance would move by $3. The technical terminology is a triple-levered ETF.
As you may have guessed, Uncle Todd made the wrong bet. In the span of a few short months, the stock market moved quickly and viciously in a particular direction, and the portfolio assets fell from ~$3.5 million to just over $1 million over the course of about 4 months – an over 70% decline. After a few more conversations with my friend, it became clear that Uncle Todd held onto the investment for a few more months before locking in the losses.
News outlets often tout the success stories of investors who make high-conviction bets and enjoy wonderful upsides in their portfolios. For this article, I wanted to share my perspective on leverage (and what it isn’t) and highlight some helpful guardrails for applying it to your investment strategy.
Leverage as a Tool
In the context of financial services, Leverage is the use of debt to amplify an outcome.
Let’s take a simple $100 investment as an example. If you purchase an investment for $100, which grows to $110, you make a $10 profit or a 10% return on your original $100. Now, if you made that same investment, but this time put in $10 yourself and borrowed $90. When that same investment grows to $110, you would make the $10 profit, but it would be a 100% return since you only invested $10 yourself.
The use of debt as leverage has aided investors for generations. A common example is home purchases, where the family puts a cash down payment of around 20% and finances the remaining 80% to be paid back as a 30-year mortgage. For many homebuyers, the net result is they own an appreciating home that is growing faster than the interest paid on the mortgage – resulting in a net gain for family wealth. I often encourage investors not to think about debt in absolute moral terms of either “good” or “bad” but acknowledge that it’s a tool in their tool-bag to be used when appropriate. The key is understanding that using debt will unavoidably amplify the outcome – either for your benefit or detriment.
2008 Housing Crisis
Much has already been said about the 2008 crisis, not the least of which is David Bahnsen’s thorough critique in Crisis of Responsibility. One excerpt from his book is the plain truth that individuals purchased homes they could not afford, leading to their inability to pay off the mortgage debt and resulting in defaulting on their property. The irresponsible use of debt by homeowners and investors alike can cause systemic and permanent damage across the country when left unchecked.
Guardrails for Using Debt
Considering the risks associated with using debt as leverage, it may surprise readers to learn that I often encourage my clients to evaluate the use of loans for financial transactions. The caveat is that I follow a strict 3-Point rule for making this recommendation.
1. Income Production: The cost of debt will vary over time as interest rates fluctuate. This is both normal and expected. As such, when an investor uses debt to finance an acquisition, they have placed a headwind on their investment performance. For example, a 5% interest rate means the investment must grow by at least 5% yearly to break even. To accommodate this headwind, finding investment options that pay out regular cash distributions at a higher yield than the debt means the investor is net-positive before any appreciation of the underlying asset is accounted for. Commonly, using debt to purchase a franchise business can make a lot of sense.
2. Volatility (Risk): The value of the underlying investment must show meaningful stability in various economic environments. That is not to say the investment must be immune to market declines, but the daily fluctuations are within a range that would not cause the debt issuer to demand more collateral. Two examples where I’ve seen this played out. (a) The use of triple-levered ETFs in the opening paragraph, and (b) purchasing stocks using borrowed money. Both actions have a substantial risk of loss if markets turn downward because the asset’s value may go lower than the debt and put you underwater.
3. Timeframe: Investing is complex, and the future is uncertain. Statistics have shown that the longer an investor’s time horizon, the more likely they are to enjoy appreciation of their investments. In any given year, the S&P 500 has averaged a positive outcome 73% of the time. In comparison, when looking at a 10-year horizon, the S&P has averaged a positive outcome 94% of the time. The longer your investment window, the higher the likelihood of a positive result. This is well-known in the world of real estate, where landowners buy and hold for the long haul.
Many investors have used leverage to create enormous empires. When used prudently, the outcomes can be additive to your financial goals. My encouragement to our readers is to identify when you are using this as a short-term “bet” where greed and impatience may be a motivation or when the opportunity meets your criteria for a well-defined and prudent investment.
James Andrews
Private Wealth Advisor
jandrews@thebahnsengroup.com
Trevor Cummings
PWA Group Director, Partner
tcummings@thebahnsengroup.com
