Leverage & Wealth Creation

 

Leverage & Wealth Creation

How huge fortunes are made

This article will discuss the underlying theme of how most (all?) big fortunes were made. When I first discovered that there is something that most big and small fortunes have in common I was very amazed. Basically everyone that made a fortune used leverage in some form or the other. Leverage is commonly associated with risk, but when it is used consciously and prudently it is the most powerful tool available for wealth creation. What makes it even more important is the fact that leverage can be applied universally across all businesses, to investing in stocks and real estate, in your profession and even in day to day life. 

But what exactly is leverage? In finance leverage refers to the use of borrowed funds, which will result in a higher return on equity. But the concept of leverage can be understood more broadly. For example an entrepreneur can use leverage by employing people that work for him, which is actually why all of the richest men are entrepreneurs. Even with the highest paying job you could never earn as much, because without leverage you would have to put in all the hours by yourself. Leverage is also the reason why many people became rich by investing in real estate. In real estate it is easy to borrow money, because the property acts as security for the loan. Loan amounts of 80% are very common and can even be as high as 100% (or higher) were you only have to pay the closing costs. Another example of leverage from day to day life would be leveraging your time. This is achieved by hiring other people to do your less productive tasks, so that you free up time to focus on the more productive tasks yourself.  

Implications of Leverage for Investing

This article was meant to be a quick food for thought about leverage. It is really important to always keep this concept in mind, because it can be applied to so many different areas of life and business. In this last paragraph I want to briefly discuss what the implications of leverage are in the area of investing. Leverage can help you to drastically increase your returns. However it is important to be careful with it. When you invest in stocks you have to consider the high volatility and the high likelihood that the company you are buying is already levered. When the company has debt on its balance sheet they already use leverage so buying their stocks on margin can quickly increase leverage too much. The best piece of advice is to always protect the downside. Imagine the worst downside scenario and how your levered portfolio would react to it. If you keep in mind what could go wrong and rather use too little leverage than too much, it is a great tool to increase your returns. Even a small increase in returns can add up over time and make a huge difference when compounded. 

 

The Most Important Tool of Investing

The Most Important Tool of Investing

Diversification

Today I want to talk to you about what in my opinion is the most important tool an investor can use to his advantage. This tool is diversification. It is the only tool that allows you to reduce the risk in your portfolio, while at the same time not lowering the returns. Even though most people have heard of diversification and you will frequently hear phrases like: “Don’t put all your eggs in one basket!”, there are a lot of misconceptions out there. The concept of diversification appeals to many investors, but especially new ones think buying a lot of different stocks will sufficiently reduce the risk in their portfolios. However diversification can quickly lead to diminishing returns without lowering the overall risk. The biggest reduction in risk comes from the first 10 different stocks. After that, risk is only marginally reduced, while at the same time costs go up drastically. Because many investors don’t understand that, to gain all the upside from diversification, they only need have around 10 stocks they will buy many more thinking they are further reducing their risk. This will lead to a diminishing risk adjusted return, because increasing costs, lowering the return, outpace the marginally reduced risk. This phenomenon is known as over diversification. 

As we have seen in this first paragraph, diversification, if over diversification is avoided, can be a great tool. But there is a whole different level of diversification. Most people focus too much on diversifying across different stocks, sectors or regions. However in this digital age all stock markets around the world a highly correlated. The true power of diversification can be harnessed when diversifying across assets that have a low correlation. This is why it is necessary to diversify across different asset classes that have a low correlation. Diversification in the form of Asset Allocation becomes the most important tool of the investor.

Asset Allocation

Investopedia defines asset allocation as: “… an investment strategy  that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals,  risk tolerance , and  investment horizon . The three main  asset classes  –  equities, fixed-income, and cash and equivalents – have different levels of risk and return, so each will behave differently over time.”. In our case the most important factor in determining the portfolio structure will be correlation. I will show you how different types of asset allocation have played out over the last decades and we will see the power of a well structured portfolio. The tool I will use for backtesting is  www.portfoliovisualizer.com which is a free service.

All Stocks versus Stocks and Bonds

This first section is meant to illustrate to you how big of an impact diversification can have. The portfolios shown are kept really simple to make a point and are for demonstrative purposes only. We will compare a portfolio that consists of US stocks only to one that has an equal mix of US stocks and long term treasury bonds. Long term treasury bonds are a good asset to diversify, because they have a correlation to US stocks of only 0.04 and are therefore almost independent of the stock market. In the table below you can see the comparison of the two portfolios for a period from 1978 to 2019. What you can see is that by allocating 50% of your portfolio to long term treasury bonds it was possible to massively reduce the risk and only giving up very little upside. The risk in terms of the maximum drawdown more than halved from -50.89% to -20.39%. Also the worst year delivered a performance of -7.26% compared to an all stocks portfolio with a worst year of -37.04%. Contrary to this development the return, measured as the compound annual growth rate, only went down by 0.95%. (As a side note: You can see the power of compounding, because even though the return only went down by 0.95% it makes up roughly one third of the end balance over this long period of time.) In the last row of the table you can see that it was possible to generate an annual alpha of 4.33% simply by adding bonds and without any stock picking. That means the portfolio that mixed stocks and bonds was able to generate a risk adjusted excess return of 4.33% per years compared to the broad US stock market over the same period of time.

Examples of Asset Allocations

The purpose of this section is to introduce you to different types of asset allocations to give you an idea of how professional investors use this concept to their advantage. Below you can find a table that compares these allocations to each other as well as to US stocks. For each allocation there will be also a pie chart to show you how they allocate their capital.

All Seasons Portfolio

This asset allocation goes back to Ray Dalio the founder of Bridgewater Associates (see sources). The goal of this allocation is to invest in asset classes that thrive in complementary environments. For example during inflation bonds would suffer losses, but gold would perform well and during an economic downturn stocks would suffer, but bonds would perform well. You can find the exact allocation in the pie chart in the slider below.   The only change I made is to allocate 15% to gold as the original portfolio allocates 7.5% to gold and 7.5% to other commodities. However it doesn’t make a big difference as it is the same asset class and there is a lot more data on gold. The reason behind the high weighting of treasuries is their low volatility compared to stocks. The goal is to have an equal influence of all asset classes, so bonds have to be given a higher weight. The compound annual growth rate of this portfolio is 9.46% for the period from 1978 to 2019. However the really special characteristic are its low drawdowns. The maximum drawdown was only -13.06% and the worst year only -4.46%. Contrary to that the best year, with a performance of 31.9%, came close to the performance of an all stocks portfolio. Dangers to this allocation in the future could be high government debt and low yields of treasuries. 

 

Equal Weight Portfolio

This portfolio has the same goal as the all seasons portfolio, but allocates its capital equally among the asset classes and also includes cash. Because cash doesn’t generate income and the risk portion (stocks) only makes up 25% compared to 30% in the all seasons portfolio, the return is lower. The advantage of a cash position is the liquidity that goes with it. This liquidity can be really helpful. You can either sit out downturns without having to sell assets or you could even use low prices to buy more assets. This allocation would also offer more protection against a systemic crash with 50% either being allocated to gold or cash. Which asset allocation you prefer comes down to your personal preferences and expectations.

Conclusion

Asset Allocation is the most important decision an investor has to make. Combining multiple asset classes that preferably have a low correlation will tremendously reduce risk and therefore enable the investor to achieve a superior risk adjusted return. Inside the asset class of stocks further diversification can be obtained by selecting multiple companies to invest in. However it is imperative to limit oneself to roughly 10 stocks and thereby avoid over diversification. Further we have seen two examples of portfolios that both use asset allocation to massively reduce risk. These portfolios are an orientation for the reader and meant to give him a feeling for how an asset allocation could look like and what to expect from it. I hope I could provide some interesting insights and you enjoyed reading.

 

 

Sources:

https://www.investopedia.com/terms/a/assetallocation.asp

https://www.portfoliovisualizer.com

Ray Dalio Interview in: Money: Master the Game by Tony Robbins

What is Compound Investing?

Today we will briefly talk about what the term Compound Investing stands for, so that together with my first article on compound interest we will have a framework for the coming content. First of all I would like to think that I have coined the term Compound Investing myself as various searches on Google and Youtube have only come up with websites or videos that either talk about investing or compound interest, but not their combination in one single investment strategy. However I am not sure if that is really the case and provided you have heard it somewhere else please leave a comment correcting me on that. What I do know for sure is that I did not come up with the content of the strategy myself, but that it is a synthesis of what I have read about and learnt over the past years.
 

The Goal

At first let us talk about the goal of Compound Investing and the time horizon over which the strategy unfolds its power. The goal is finding companies to invest in that are able to deliver superior returns to the investor by compounding their earnings within the company. Basically this means they are using the exponential nature of compound interest to their advantage by adding their earnings back to the equity base so that given the same return on equity their earnings in the following period will be greater than before. This process makes a huge difference that will also show in the price of the company’s stock, but as we have seen in my previous article, the magic of compound interest needs time to work best. The biggest growth happens in the later phases. That is why we will look at a time horizon of around ten years. If possible we will hold the company even longer (given they still fulfill our requirements) and in some cases it might be necessary to sell after a shorter period of time.
 

The three Steps

Compound Investing consists of three separate steps. At first there will be a quantitative and qualitative analysis of a prospective investment. These steps will determine if a company meets our requirements. If that is the case the third step will be a projection of future earnings. The first step, the quantitative analysis, also acts as a filter, because if a company doesn’t fulfill our requirements in this section we will not look any further into it. This also allows us to quickly sort out most of the companies and therefore save a tremendous amount of time that we can then use to thoroughly research the companies that have a high likelihood of being a good investment. During this first step, the focal point will be looking at what the company earns and finding out if they have the ability to compound their earnings over long periods of time and at high rates of return. After that, in the qualitative analysis, we will take our time to really understand and get familiar with the company’s business model. At this point it will be important to determine if the company has a competitive advantage and some measures to shield themselves against possible future competition (i.e. a strong brand). Based on the results from these two steps we will be able to determine if we want to buy the company’s stock. In the last step we will estimate a price at which the stock becomes interesting to us. In order to do that we will be projecting the future earnings for the next ten years. 

 
This was meant to be an overview about Compound Investing. The exact process will be shown over the course of the following articles. I hope you enjoyed reading. See you soon!
 

What is compound interest?

In this first article we will discover what compound interest is and why it is very important for your investment success. We will also look at some examples to grasp the real power of compound interest and see which factors determine it.

The definition of compound interest

Basically compound interest is the term for additional interest you earn when you add the interest from one period to your principal investment in the next period instead of opting for a payout. So for example you start with 100$ at 5% interest rate and receive 5$ interest. In the next period your principal investment grows to 105$, so your interest at 5% would be 5.25$ (instead of 5$). The compound interest would be the 0.25$ that you only earnt because of adding your interest from the beginning back to the principal.
The key variables that determine compound interest are the principal investment, the interest rate, the compounding frequency and time. With interest rate and time being the most important ones.

This concept is one of the most important in finance, because it allows you to grow your investments exponentially (without having to do extra work). Even though exponential phenomena are difficult to comprehend for the human mind, there are multiple examples from other areas for example the growth of bacteria and nuclear chain reactions.

Visualization of the power of compound interest

In the graphic The Power of Compound Interest 1 you can see the exponential character of compound interest. You can also see how it unfolds over time and for different interest rates. Note the huge difference between an interest rate of 15% and 20% and that it is several times bigger than the same percentage difference between 10% and 15% interest. This means a small difference in interest rates can make a huge difference over a longer period of time. A return of 20% over the course many years was actually achieved by the world’s best investors and is not impossible. In the graphic The Power of Compound Interest 2 I zoomed in so you can better see the differences in interest rates and I also included the return of the S&P 500 for comparison.

The concept of compound interest is difficult to really understand, not intellectually, but to really get a feeling for its power and meaning. Hopefully I could convey its importance to you. If you liked the article or have some criticism feel free to leave a comment. Thank you for reading!