An stock that is down 95%, is one that was down 90%, and then got cut in half.
The simplest way to lose your capital is to buy something and watch it go to zero. Whether it’s a bankrupt stock, or a swindled real estate deal, it’s relatively easy to understand how something becomes nothing.
Financial engineering has created dozens of more interesting ways to lose your money, and they all involve some form of leverage - implicit or explicit.
Leverage has an incredibly tempting value proposition. If the market goes up 8% a year on average, and I’m leveraged two times, can I make that 16%? What about 32% at four times leverage?
Leverage promises to take a good thing and make it even better. But it also brings the precipice of ruin that much closer. If you’re trading 2x the size, it takes a 50% dip to wipe out your stack. If you’re trading at 4x leverage it’s only a 25% drop.
What feels fantastic on the way up, rapidly turns miserable on the way down. The difference between losing 90% or 95% of your capital doesn’t sound like much, but on that road to ruin, there are increasingly gut wrenching days.
Volatility is the price that we pay for returns. It’s a big reason for why the equity risk premium exists. Over time stocks outperform the risk free interest rate because they embrace uncertainty.
Markets are first and foremost resource allocators. When there are opportunities with a greater certainty of returns, more capital will flow there, and ultimately drive down those returns. If everyone thinks that a stock will rise in the future, its price will float up and reduce future return potential.
Most investments lack that certainty however. Every day that the exchange servers fire up is another debate amongst trillions of dollars over what the correct prices for securities are. There are ebbs and flows as news percolates into the system and gets swirled with human emotion.
Long term returns come from being willing and able to hold positions as they appreciate in value. Investors that demand liquidity and valuation certainty will find themselves in safe but low yielding positions.
Leverage promises to accelerate time. It magnifies the investing experience, and makes every tick and dip feel like a rollercoaster ride. When you’re speeding along in an F1 race car, a pebble is a jolt and a pothole is a tragedy.
For most of us, it’s far more important to arrive in one piece than to get there first. That’s risk management 101. Having enough capital to stay in the game, is what keeps you positioned for long term success. Without capital, there’s no investing.
Time and patience are an investors best friend. They unlock the premiums found in illiquid and volatile investments. While there may be premiums in the long term, the path is not straight, and they only come from enduring choppiness. If you’re forced to sell when things are low, you’ve crippled your long term potential.
The right amount of leverage might not always be 0. But any amount of leverage that forces you to sell before you’re ready is too much.