Can leveraged investment really bring you superior returns?

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If you have entered the stock market sometime during the pandemic, there is a chance that you may have made a fortune with your “play-play” investment. To fuel your greedy mind, leveraging your investments is one of many popular alternatives.

Leveraging your investment means essentially that you borrow money from somebody else to buy more stocks than you can’t afford at the moment for a small fee.

For example, two times the leverage (2x) means that if the underlying stock goes up by 10%, your leveraged stock will increase by 20%. Of course, you will need to bear the risk of the lender and therefore, the losses will also be magnified.

Figure taken from London Stock Exchange

However, we tend to only focus on the situations when things go well and downplay the associated risk. We often oversee the fact that our capital even loses value if our stock goes up on the first day and then drops the same percentage on the second day.

Let me illustrate this with more examples. Suppose you start with $100 of a stock, which goes up 10% on one day and falls 10% on the second day. At the end day, you got $99 left. If you went for 2x leverage, you will end up with $96. With 4x leverage, you will have $84 left. 8x leverage brings you to $36.

What this shows is that a single spike in the stock market can erase your investment completely if your leverage is too high.

Let me illustrate this again with a real life example. Tesla is one of the most popular stock among the retail investors recently. 2020 was its best year yet with around 800% returns. The chart below shows what would happen to your Tesla investment with 2x and 5x leverages, if you invested $100.

Tesla’s share price in 2020 (black) compared with 2x (green) and 5x (red) leverages.

With 2x leverage, you would have enough money to go on a nice holiday. However, with 5x, you essentially would have lost everything by march. As soon as the market turns negative, even for a short period of time, highly leveraged stocks could send you back to zero in no time.

I could finish this article here with the following two key messages: 1) don’t hold your leveraged positions for too long. 2) Only go for higher leverages if you are confident about the trajectory of the stock.

If you are interested enough and have kept on reading, you might also have thought about the following interesting question:

Can you find an optimal level of leverage that consistently outperforms the underlying stock without any leverage for a given market condition?

Before I attempt to answer this question, let us define outperformance. For the sake of this exercise, we say the leveraged stock price needs to exceed the non-leveraged stock by at least 10%. For simplicity, let us also assume a stock that grows steadily at an annual rate of 10% with normally distributed daily returns. Since everything is so nicely set up, why don’t we also assume that the world is a nice place and nobody charges us any fees.

The figure below shows the probabilities for the leveraged stocks to outperform at different market uncertainty.

Monte-Carlo simulation shows the probability of outperformance for different stock volatilities (coloured lines)

Just as expected, at a stable market condition, when the volatility is at 0.5%, the trajectory of the stock is pretty certain, we can therefore confidently increase the level of leverage. As the market becomes more volatile, the leveraged stock is more likely to outperform the underlying stock at lower level of leverage.

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