BE MINDFUL OF THE LEVERAGE CLIFF
Whenever trades are on the favorable side, investors become more comfortable with their hedge fund managers and the leverage they employ although they do not fully understand the risks behind it especially when the going gets tough. Good thing investors can avoid financial disaster in times of difficulties by understanding horizon leverage and risk tolerance.
Many money managers, who are managing sophisticated funds, have led clients into financial ruin because they do not properly account for horizon leverage. Investors who do not have money to lose must not wage too much with their managers. It is advisable to plan for financial storms and modify the risk parameters for it.
Imagine you are in a casino where you have a greater chance of winning, but if you lose, you will face bankruptcy. You are asked to start with $10 bet and you win. Sounds like a good bet, right? So you keep playing and playing until the bet escalates to several million dollars. The bet will leave you with double or nothing. The consequences of losing changes while the odds of winning are still the same.
Beware of that! You are already trekking a leverage cliff and about to fall off.
Financial disaster can take place through sound strategies. A money manager solely focused on positive expected return will keep on playing the game, leveraging up bets. The technique may be reasonable, but that does not account the risk tolerance of investors. In the scenario above, an individual will lose the bet little by little. Money managers do not mind your risk tolerance like you do. They are only after expected return and get lost in it, not considering the horizon leverage. They are well compensated for earning high returns, but not much affected in times of the perfect storm, which eventually it will, since all of their money is likely not in the fund.
Things will be much different if these managers consider your risk tolerance. Take the game show Deal or No Deal for instance. The contestant guesses the briefcase containing one million dollar. Needless to say, the person does not know the content of each case. From time to time, the banker makes an offer to stop the contestant from playing the game before going through all the cases. The player either accepts or rejects the offer. Not all the time taking the offer is a good decision based on an expected return view, implying the player must keep on climbing up the cliff and never take the deal.
Breaking the above-mentioned example, the individual starts envisioning himself with the money offered, understanding the likelihood of losing it. Then they begin analyzing various factors including the time it will take them to earn the amount, to replace the said amount if lost, and savings goals, among others.
Better investing seems to rely on one’s willingness to make good bets, where the expected return is positive, but only wagering in an amount you can certainly afford to lose. So risk tolerance has to be matched with expected return. That way, investors can prepare for the perfect storm while making good investment decisions, just to a lower degree.
Rule of thumb: Do not stake more than what will affect your earnings power the following year. Take risk only to the extent of not making money for the year, but not permanently losing your principal, too. You may also reduce your risk capacity if you are near retirement.
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