Timeless investing lesson

I usually don't share my thoughts about investment via the blog but thought it would be useful to record the most important investing lesson so that I can come back and refer to it.

The last few weeks have been interesting in the stocks investment world, some of the recent events reinforce timeless investment advice that people only learn by making mistakes.

In this post, I will share 2 such pieces of advice with very recent examples. 

Never trade on leverage

This is the number 1 reason why people lose money and also differentiate gambler(i.e trade) vs investor.

Archegos hedge fund took down 4 major investment banks on March 2021.

Let's try to understand leverage before we get into how Archegos crash and burned.

Meaning of leverage

"use borrowed capital for (an investment), expecting the profits made to be greater than the interest payable."

The first exposure of leverage everyone gets exposed to is via housing loans, banks will fund part of the house price and the borrower will pay interest over the amount that is borrowed.

I would say leverage via house loan is good leverage because it allows to get shelter overhead and also has a good chance of price appreciation. 

One of the most important things about a house loan is that tenor of payment is fixed and not linked to the underlying asset value.  

If house price falls by 50% then the borrower doesn't have to pay more to a bank but he can gain if the price goes up by 50%. I am not saying a house loan is a good leverage but it is on the fence type of thing. 

Lets see how leverage works in the investment world. 

In trading/investment world leverage is called a margin, the trading broker will allow x times of leverage to clients but with conditions that whenever they issue a margin call then the investor has to deposit more money or sell some securities.

 

Another example to understand this, assume we have 1 Million and we get 10X leverage, this means that we can buy securities worth of 10 million. 

Only 2 things can happen and each has the probability of 50-50 in short term.

The bet goes your way

This is the happy scenario where the market value of securities goes up by 20% and you are happy and also pay back some of the leverage and reduce risk.

The market is cruel to you

This is what happens in most of the scenarios and you loose 20%, in this scenario, you lose your 1 Million and an additional 1 Million since you will not have the cash to fulfill the margin call you will start selling securities or take more leverage. In whatever options are selected it will cause panic in the market and will cause more selloff. 

Now, this is exactly what happened with Archegos hedge fund because a bet on one of the Chinese company did not go their way. 

Archegos hedge fund is a family-run business and the owner has not so good reputation, they did few things very extreme to fail big.

- Took leverage of around 500 times.

- Used Contract for difference, which are very high leverage instruments and it is ban in many markets. Many individual investors are not allowed to trade in CFD by regulators. 

Now how does anyone gets 500 times leverage? 

They used a couple of brokers to get leverage and these are big names like Goldman Sachs, Morgon Stanley, Deutsche Bank, Credit Suisse, Nomura Holding.

None of these brokers were aware that Archegos is operating on such high margin and also to add that risk management process of these banks were not to the mark to issue some warning signal before it was too late.

Look at the stock prices of these brokers when this thing came out.

Goldman Sachs & morgan stanley was little smart enough to recover their loss but Credit Suisse and Nomura were caught off guard.

Billions of dollars were wiped up, some of the numbers that are coming in news are 10 Billion but many experts feel that it could be 100 Billion, many of these banks have already declared that they are going to report losses in the next quarter and will also result in some people losing jobs.

As I write this post, the stock price has dropped more :-(

This is not the only example where a big leverage bet has gone wrong, the 2008 subprime crisis was also due to leverage and the common man was directly impacted by that.

Keep eye on this news to understand the real impact.

As an individual investor never trade on leverage. 

Markets are efficient 

There are 2 popular styles of investing growth and value. Warren Buffett is a value investor and many companies and people try to follow him.

It is hard to achieve anything close to Mr Warren because to become Warren you need the temperament and patience of warren. 

Many investors try to pick stocks using value investing techniques and when they fail then they try to pick a fund manager that can do value investing for them.

Trust me that picking stock or fund management is like flipping a coin and the downside probability is very high. 

On March 10, 2021, International Value Advisers ( IVA) decided to liquidate the fund.

IVA was an esteem value shop and it has a sad and common end of actively managed funds.

IVA was sitting on cash for a very long time because they thought the market is expensive, there was a time when the fund had 50% cash waiting to be deployed.

They got asset allocation wrong and waited for the timing market. 

The efficient market hypothesis states that share prices reflect all information and consistent alpha generation is impossible.

Every now and then someone will come and tell the market is inefficient and will try to fight against it.

This has been proved multiple times and a nice article was posted on Forbes about it, it is called any monkey can beat the market.

IVA investors would have made lots of money by just investing in a broad market index fund. 

Morningstar has done a nice analysis of the IVA fund, read this to understand in detail what went wrong. 

If you can't beat the market then be the market, Index fund should be the core strategy. 

I will leave you with one more interesting read about Warren Buffett Just Won a 10-Year Million-Dollar Bet, where he challenges hedge fund managers to beat the market and they end up losing and have to close the fund.

I will wrap up now but if you want to remember one thing then it has to be "never trade on leverage"