Friday, May 31, 2013

Leverage

I could have never stayed in the military for the simple reason that a functioning and competent military hierarchy has to be black and white.  You get orders and you carry them out, open and shut case.  But as I got older, my worldview has fundamentally changed to the point where right and wrong got too close together.  Protecting America's freedom and spreading democracy around the globe sound great, but it's naive.  The American government has done and will continue to do shady things to keep the #1 spot in the world.  In the Marines, it was drilled into every single one of us: do the right thing, and ironically for the branch that has seen the most combat and thus has most reason to be realistic, we are actually the most idealistic.  We like to believe that all our orders are moral directives from the divine and we are willing to die to carry them out.  So if any Marine starts doubting those orders, that just maybe we are not as good and those guys are not as bad, then it's over.  It's time to get out.

I told you that story to tell you this story: I used to fervently believe that leverage is always bad and using any type of leverage is never worth the risk.  This bias remained until I began to read about the low volatility phenomenon, which exhorted the outperformance of low volatility stocks, thus implying the lack of any meaningful risk premium.  Offhandedly, one of the passages talked about leveraging a low vol strategy and how it would greatly outperform benchmarks as doubling up on low beta provided superior returns without increasing downside risk, provided the vol remained low.  Then I suddenly realized what low vol actually meant--simply it was measuring the amount of time it took to make new highs.  That was ultimately the advantage of low vol over high vol.  Low vol required less time to consistently make new highs.  This allowed compounding to work its magic.  By applying leverage to this, it was the best of both worlds.  Thus the crux of the whole thing became clear: there is an inverse relationship between the effectiveness of leveraging and the magnitude of corrections before new highs.  The shorter the time between two new highs/the shallower the corrections, the more the strategy should be leveraged.  

Long story short, I have leverage into my strategy.  But in a meta sense, I am scared.  Even assuming my rational arguments for leverage make sense, I only came to such a decision because of the market's strong run.  If the markets weren't such a one way direction up, I would have never even thought about leverage; I would be content holding lots of cash to buy dips and sell rips.  It was only for the lack of vol that  that I began looking for reasons to stop holding cash.  But all in all, I am confident that this is a good decision in the long run.  In the short run, I expect a 5-10% correction, which means I bought a lot near a short term top.  If I had to do it again, perhaps I would phase it over a 1-2 month period, but that's another lesson learned.