The Role of Leverage in Your Investment Strategy

Striking the Right Balance

Introduction

Leverage can be a powerful tool in an investor's arsenal, allowing them to amplify their investment returns by borrowing money to invest in various financial instruments. However, as with any financial tool, it comes with its own set of risks and should be used judiciously. This article will discuss the role of leverage in your investment strategy, particularly in the context of age, risk appetite, and diversification, to help you strike the right balance and optimize your returns.

The Connection Between Age and Risk Appetite

As a general rule, younger investors can afford to take on more risk in their investment portfolio, as they have a longer time horizon to recover from any potential losses. This is where leverage can play a crucial role by providing the opportunity for higher returns and wealth accumulation. However, it is essential to be prudent and avoid excessive leverage, which can lead to financial ruin in the event of a market downturn.

Leverage in Everyday Life: Mortgages and Car Loans

Leverage is not just limited to the world of investing; it is also present in everyday life through mortgages, car loans, credit cards and basically any time you borrow money. When you buy a house with a mortgage or finance a car, you are essentially using borrowed money to make an investment in an asset. They may be bad investments but you are borrowing future dollars and paying the borrowing cost today for that privilege. This can be a form of 'good' leverage, as long as the asset appreciates in value over time and generates a return greater than the cost of borrowing.

There is good leverage and bad leverage, I would much rather own a 3x leverage ETF than a loan on a car I cant afford.

Leveraged ETFs vs Margin Investing

Leveraged ETFs offer a more accessible and a lower-risk way to utilize leverage in your investment strategy compared to margin investing. With leveraged ETFs, you can gain exposure to major market indices such as the SP500 or NASDAQ, without the risk of margin calls or owing more money if the investment goes down. Additionally, investing in index-based ETFs mitigates the risk of individual company failures, further diversifying your portfolio. Leverage ETF’s handle the borrowing for you, you don’t have to do anything else! Buying $1,000 dollars of TQQQ or UPRO means these leveraged ETFs are buying $3,000 of NASDAQ or SP500 respectively for you. They can also do so at a lower lending rate than you, a retail investor can get.

Avoiding High-Risk, Small Sector Leveraged ETFs

While diversification is key, it is crucial to avoid high-risk, small sector leveraged ETFs, as they are akin to picking individual stocks and carry a higher chance of failure. Instead, focus on more stable, broad-market leveraged ETFs with lower leverage ratios, such as 1.5x or 2x, which are better suited for long-term investing.

Understanding Volatility Decay and Leverage Ratios

Volatility decay is a phenomenon that can effect leveraged ETFs, particularly those with higher leverage ratios like 3x. Essentially, the compounding of daily returns can erode the long-term performance of a leveraged ETF, making 3x leveraged ETFs more dangerous for long-term investors compared to 1.5x or 2x leveraged ETFs. We go over this in more detail in Dangers of Leveraged Investing

Lifecycle Investing and Leveraged Funds

The book "Lifecycle Investing" by Ian Ayres and Barry Nalebuff explores the concept of using leverage in a strategic manner throughout an individual's investment journey. While the authors propose using options, leveraged funds can be a simpler and more accessible way to implement this strategy. Leveraged ETF’s either just came out or had not yet been created when the book was published. Leveraged ETF's have now been around for ~12 years and have proven to be decent investments in a bull market.The book talks about using Options to use leverage, and while this is perfectly valid, it breaks our 80/20 rule by being complicated and time consuming.

Maintaining a Balanced Portfolio

Most importantly, it is vital to ensure that leveraged or risky investments make up only a small percentage of your overall portfolio, ideally between 5% to 20%. It is key to focus on well-diversified leveraged ETFs, such as those tracking the SP500, NASDAQ, or Dow Jones Industrial Average, to strike the right balance between risk and reward. Sector ETF's may look tempting but I only recommend them to seasoned investors who have gone through bear markets. A new investor is likely to buy at the high and sell at the low on something so volatile.

Why Opt for 1.5x, 2x and 3x Leveraged Investments?

Leveraged investments, specifically those at 1.5x, 2x and 3x, offer a unique opportunity to amplify returns for investors who understand and can bear the risks associated with them. They are tools designed to produce double or triple the daily return of an underlying index. Here's why you might consider using them:

Enhanced Returns

The primary draw of 1.5x, 2x and 3x leveraged ETFs is the potential for enhanced returns. If you have a strong conviction that a certain index will increase in value, a leveraged ETF can offer two or three times the daily return. This can significantly boost your portfolio's performance.

Diversification

While they should not make up the bulk of a portfolio, leveraged ETFs can contribute to diversification. They can offer exposure to different sectors, commodities, or indices, further spreading risk throughout the portfolio.

Investor Considerations

While leveraged ETFs can offer high returns, they come with a higher level of risk. It's essential for investors to understand that the double or triple return these ETFs aim to achieve is based on the daily performance of the underlying index. As a result, the compounding effect can lead to significant differences in performance over long periods. Therefore, regular monitoring and rebalancing of these investments is necessary.

Leverage investments are not a magic bullet
You should completely understand the risks and how they behave before investing

Leverage investments are not a magic bullet
You should completely understand the risks and how they behave before investing

Conclusion

Leverage can be a valuable component of your investment strategy toolbox, particularly when used judiciously and with a focus on diversification and risk management. By understanding the role of leverage in relation to age, risk appetite, and investment vehicles, you can optimize your returns and build a robust and resilient investment portfolio.