Monday, March 21, 2005

Unleveraged Portfolio Management

There are many ways to "leverage up" when investing. Stock investors can leverage their positions by buying on margin or buying options. Real estate investors can leverage up by financing and refinancing their properties at high loan-to-value ratios. When the market is going your way, leverage is a great way to produce spectacular returns.

However, as we know from hearing the stories of the likes of Donald Trump, Paul Reichmann, Long-Term Capital Management, Victor Niederhoffer and other prominent investors who have made money quickly on the way up through leverage, paper profits can disappear just as quickly on the way down when the markets reverse course. Some, like George Soros, have miraculously managed to cut losses early enough to avoid total ruin when markets have turned. Others, like Warren Buffett, avoid taking on extreme leverage from the outset, preferring a slower and more steady course to wealth-building.

Leverage is like a "throttle" that allows you to "dial in" the amount of risk you desire. Over the years I have used leverage as an income property real estate owner. However, in my stock investing I tend to operate unleveraged. Certainly, many of the stocks I own are shares of companies and financial institutions that employ moderate leverage on their balance sheets to realize higher return-on-equity. But I avoid buying on margin to leverage my own positions further.

In deciding whether or not to use leverage, I weigh "money management" issues as much as I do risk-return tradeoffs. Currently, I run a "safe," unleveraged portfolio. I find that having no loans makes things much simpler from a portfolio management point of view. I have no loan applications to fill out, no monthly payments to make, no margin calls to worry about, and neither banker nor broker to answer to. Without any debt, my personal balance sheet and tax returns are also simpler and, surely, it is impossible for me to go bankrupt. Psychologically, a tremendous amount of peace of mind comes from operating unleveraged.

While many might surmise that investing without leverage is boring, I contend that the level of excitement really is more dependent on how you play the underlying, unleveraged investing game. With the stock market being as volatile as it is and the companies with listed shares being as diverse as they are, there are plenty of opportunities to invest in high-risk, high-return companies with very substantial leverage in their businesses--even without invoking an additional layer of leverage in your portfolio.

I make one final comment on my attitude towards leverage: With interest rates still near historical lows, mortgages offer homeowners (who are also investors) the opportunity to leverage up their overall investment portfolios at an attractively low borrowing cost. However, here too, my preference is to manage my own portfolio without the complications that come from taking out a mortgage and working with other people's money.

I find that "keeping it simple"--unleveraged--works best for me.

11 Comments:

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