Leverage: It’s Why Portfolios Blow Up

At less than a 20% drop in its portfolio, the hedge fund was basically out of business. From there, the banks were 100% on the hook, and they quickly sold the fund’s assets to protect themselves. As the stock prices fell due to the deleveraging, slower banks lost more money.

Why the bankers would allow Archegos to employ so much leverage (greed!) is a discussion for another day. Today, I want to emphasize two points.

First, that hedge fund returns are often a matter of luck. When you see the end-of-year average returns that look great, those returns were from the hedge funds that survived. The ones that went broke don’t show up in the yearly numbers. While not all hedge funds use excess leverage, it is a shortcut that works well when it works. And produced financial disaster when it doesn’t.

In your own investing, don’t get overleveraged. Your stock brokerage account will keep you from losing more than about 60% of your money. However, I suspect there are many “low information” traders taking out personal loans to buy bitcoin or trade on Robinhood. Odds are things will end badly for traders using unauthorized leverage.

If you want to use margin loans, do so in moderation. Use less than the broker maximum. Don’t borrow outside money to bet on a “sure thing.” It probably isn’t, and you could end up losing a lot more than your investment money.

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