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The Downside of Doubling-Down

downside of doubling downLeverage. It can be a double-edged sword. On the one hand, it allows you to make lots of money using very little money. On the other hand, if you are not prudent enough, it can make you lose your pants.

200% Leverage

I just came across a book called Lifecycle Investing, co-authored by two Yale professors, Ian Ayres and Barry Nalebuff. The co-writers recommend that investors who are in their 20s use leverage to invest up to 200% of their assets by either purchasing long-term call options called LEAPs or by borrowing on margin. The reason they gave is that the standard retirement advice underexposes youngsters to stocks and thus needs them to take far too much equity risk later on in life, when they cannot really afford to lose much money. A typical retirement fund manager might advocate having about 90% of a 23-year-old’s savings in stocks, which might be pared down to around 50% at age 65. Here lies the problem, according to the professors. For the 23-year-old, the 90% allocation applies to a relatively minute amount of money, say, a few thousands of dollars while the 50% equity allocation at age 65 places hundreds of thousands of dollars at risk. A better strategy is to start with a 200% stock allocation at age 20 and scale down to 32% at age 65. This approach works as one is more evenly diversifying equity risk across his/her lifetime.

It might sound like a good idea, but there are downsides to such a strategy. By using flagrant leverage, one overexposes oneself to unnecessary risks? One, it will be emotionally draining when a black swan event roils the market. Two, with the markets so volatile for the past few years, how can one be emotionally unscathed after using 200% leverage? By using excessive leverage, seeing your portfolio being more than halved within a short span of time can become a common occurrence. You can call me a “dinosaur” for being so risk-averse, but I rather sleep like a baby at night than have sleepless nights. By staying away from leverage, you take care of the downside while the upside automatically takes care of itself.

Pristine Balance Sheet

Warren Buffett once proclaimed that, “Only when the tide goes out do you discover who’s been swimming naked.” What he means by that is that when the stock market is on a bull run, a business which is using excessive leverage may seem to be cruising along well. However, when a credit crunch happens and banks stop lending, heavily-levered businesses may go bankrupt instantaneously. On the other hand, there are companies like Vicom Limited (SGX: V01), SIA Engineering Company Limited (SGX: S59) and ARA Asset Management Limited (SGX: D1R) which have a pristine balance sheet, with little or no debt. This can be seen from the table below:

Company

Percentage of total debt-to-net profit

for latest Financial Year (FY)

Vicom

0%

SIA Engineering

2.1%

ARA Asset Management

29%

When a repeat of the 2008/2009 crisis were to happen, it is less likely that such businesses will go bankrupt. The cash flow generated will still provide dividends, while the market recovers.

Foolish Bottom-line

Don’t be caught swimming butt-naked as it might be a little too late. A good check to determine if you have been using excessive leverage or investing in businesses that over-leverage is the sleep test. If you can sleep well at night, you are doing fine. Otherwise, it is wise to re-look into your portfolio.