Tuesday, May 23, 2017

Equity Management #13 : How to think about leverage.

We are at Chapter 27 of the book even though this is the 13th installation of the series. For the reader's sanity (and mine), I have skipped over the mathematical components of the book to try to generalise some of the ideas on this blog.

Leverage is something I intend to try out over the next few weeks.

During my last talk, Maybank was kind enough to sponsor a room for BigScribe which would have the effect of improving our razor-thin seminar margins. In return, I signed up with Maybank for a brokerage account which allows me to leverage some of my REIT and business trust investments for a very low rate of 2.88%, in effect guaranteeing them at least one customer for that free room rental.

( I've been meaning to dabble with leverage since the 2009 recession but never had the guts to start until I learnt about the 2.88% interest rate. And this is not a sponsored post BTW. )

Once my account is opened, I will create a very small leveraged portfolio to experience what it is like to trade with leverage. It starts at a small size of $10,000, but I will buy about $20,000 worth of REITs and business trusts. This arrangement is expected to yield about 13%.

As I start my new career, I intend to farm my entire pay-check into this leveraged portfolio moving forward and see how long it will take for me to (a) Accumulate a pay-off high enough to off-set my mortgage payments, thus, giving my CPF-OA a well-deserved rest. (b) Actually pay off my remaining mortgage.

As I have a main portfolio of stocks feeding my family, this is still using money that I can afford to lose.

Back to equity management, the text-book has a few philosophical things to say about leverage.

There is an equation which measures an investor's utility function which incorporates leverage and volatility which I will not show on this blog.

In English, it basically means this :

An investor is always hunting for active returns but this greed is balanced by his fear of portfolio volatility and leverage. Because every investor has a different tolerance towards volatility and leverage, the optimal leverage and volatility of his or her portfolio is something unique to every investor. Traditional models employ only the investor's tolerance of volatility. Newer models incorporate someone's tolerance of volatility so an optimised portfolio may have a degree of leverage in them.

With this small portfolio of income investments, I hope to discover my own tolerance towards leverage. Of course, if my portfolio collapses within weeks or faces a margin call by the end of 2017, it might turn me off leverage for good !

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