Using Leverage

Hi,


I was just after some comments/advice about this idea.


Say the average market return is 13% for the purpose of this description (8% growth 5% yeild).


Seeing as Margin lendings rates are around 7 or 8% I would obviously be doing very well if I could borrow at 7% and make %13. The only obstical is volitility even something like a managed or index fund can fluctuate around enough to make this a risky exercise.


I was wondering if it would some how be possible to diversify my holdings to such an extent (overseas index funds, property trusts etc) that I can be almost assured that my yearly returns end up with in a narrow range, say between 11% and 15% and have minimal fluctuations. Mabey I have to settle for a slightly lower return to achive this say 9%-11% but as long as its above the margin lending rate and there are only small fluctuations then the principle is good.


If I could achive this then I could confidently use insane levels of leverage and do very well. I could for instance borrow money off one source and then put this up for 80/20 lending with a margin lender. So I end up putting up no money and then taking the difference between the market and the lending rate.


This brings me to my next question. If the market averages x% and it's really hard to beat the market then couldn't somebody beat x% quit consistantly over time by just using conservate leveraging.


Shouldn't it just be a walk in the park to beat a figure like 13% ??


Comments ?

Wow! where to begin... Diversification can be used pretty easily to increase returns, given a certain level of risk, or to reduce risk, given a certain level of return. The problem, though, is that designing a diversified portfolio depends on the assumption that past returns and correlations will hold in the future. Lacking a crystal ball, all we can do is try to guess well when diversifying. Crazy things happen to markets, and there's no way to smooth it out so that your envisioned money machine will be a lock.


You might want to go to the library and read some stuff about portfolio theory/index funds, etc. I also just read "Dumb Money", written by an erstwhile daytrader, and it's pretty funny. Good luck.

Your basic idea is sound but numbers are off. There is a maximum amount of diversification you can achieve with a fully-invested equity portfolio. If you hold the "market portfolio", e.g., S&P500, then you will still have at least 16% standard deviation. Note you actual fluctuations might be 1 or 2 standard deviations below expectation. The historically lucky return on the market has been around 8% above Treasury bills since 1926. That gives you optimistically an information (Sharpe) ratio of 8%/16% = .5. That's pretty good; with a normal distribution it would give you a 69% chance of beating the Treasury bills each year. I've been levered for years, and the 90's were great for me. Certainly levering the market gets you more compensation for risk than most active investment managers.


But margin doesn't change the information ratio or increase your chances of winning, it merely amplifies the risk and return. In other words do you want an 8% return premium with fluctations (around T-bills) between -24% and 40%, or do you want a levered return premium of 16% with fluctations between -40% and 72%? Frankly it sounds like you would prefer a balanced fund with a return premium of 4% and fluctuations between -8% and 20%.


Over time your probability of "winning" will increase with reasonably conservative strategies. But with a proportional investment strategy your compound return will lie below the average return by around half the variance, around 2% for a fully invested strategy.


The initial equity margin requirement is 50%, but you can get more leverage with index options and futures (I doubt you want it).

This web site should give you some great insight on your question. For a simple answer though it must be no. Lower volatility (which is what you need to use your margin strategy) can be achieved by various means but only so much before affecting your return. It's not on the website but it's interesting to note that, using historical data to predict future performance which isn't necessarily accurate, the lowest volatility portfolio is 98% cash and 2% foreign stocks. Even though foreign stocks tend to fairly volatile the blending effect is smoother than 100% cash.