Friday, March 23, 2018
On the hypocrisy surrounding War-chests and Leverage investing
Not everyone is a big fan of leverage investing using a margin the account. It is probably not coincidental that some of these detractors of margin financing also tend to employ a war-chest when describing their investing strategy.
In my opinion, margin investing and the employment of a war-chest are two extremes in investing.
Much like Law and Chaos in Michael Moorcock fantasy novels.
When you invest using leverage, you are trying to magnify your returns by borrowing money. If the cost of borrowing runs below the rate of return of the unleveraged portfolio, you are likely to succeed in getting better returns provided if the underlying investments generate positive returns. The problem of a leveraged portfolio is that there is a chance of complete and utter ruin, which to me is the odds of a margin call. In essence, you are trying to get higher expected return by flirting with the odds of ruin.
A war-chest is the opposite of a margin account. You hold a portion of your portfolio in cash so you are not subject to market risk at all. The downside is that if you calculate your rate of return, your cash component of the portfolio returns 0%, worse than buying government bonds. You are trying to securing your portfolio from losses by lowering your expected returns.
Both camps harbor fantasies on investing outcomes.
Leverage investors harbor fantasies that they would be able to avoid ruin but the odds of ruin can be estimated if you use the right statistical model. I consider 1 in 40 odds to be generally acceptable in my margin account if I can extract 10% yields for my trouble.
War-chest investors also harbor fantasies. There is this belief that the investor can time the markets to produce returns that can overcome the deficiencies of cash drag that have been adopted by the investor. Right up till today, I have yet to see a modelling attempt to justify market timing using a war chest. All I see is a lot of chest thumping and vanity displays of personal results, very often in un-diversified portfolio which does not help readers who want to replicated the strategy.
As of now, I'm still waiting to back-test a model that incorporates market timing with a war-chest. I simply do not see leverage investing and having war-chest as something that mutually exclusive to each other.
If a good marketing timing strategy exists, a savvy investor can hold his portfolio in cash and make tactical leveraged bets in a margin account.