The Leverage Cliff: Watch Your Step

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Due to positive experiences, many people grow comfortable with hedge fund managers and the leverage they use, even without fully understanding the dangers leverage can pose when times get tough. Understanding horizon leverage and risk tolerance can help the investor avoid financial ruin when the perfect storm hits.
Horizon Leverage and the Positive Return DilemmaMany smart people managing sophisticated funds have run clients into financial ruin. Why? Because money managers are not properly accounting for horizon leverage. Investors who don't have money to lose must not over-wager with these managers, hoping the perfect storm won't hit; it's better is to plan that it will, and adjust your risk parameters accordingly. (For more tips, check out 8 Ways To Survive A Market Downturn.)
Let's Play a GameFor instance, imagine you were to place a bet where the odds of you winning are great, but the consequence of losing is bankruptcy. To a person who understands positive expected return - defined loosely as the product of the probability of a positive outcome times the expected reward is greater than the product of the probability of a negative outcome times the expected loss - this seems like a good bet.
Now suppose you start with a bet of $10 and win! This game seems good, so you play again and again until you are now going double or nothing on several million dollars. While the odds of winning haven't changed, the disastrous consequences of losing have. Beware! You are going up a leverage cliff, and you are about fall off. After about twenty years into the game, the perfect storm hits and you are broke and despondent.
Financial Ruin Using Sound StrategiesA money manager who is myopically focused on positive expected return plays the game over and over again, leveraging up bets. The leverage investment strategy may be sound, but risk tolerance of constituent investors is not being factored in. It is a mathematically certainty that eventually you will lose the bet, and you'd better hope you are not betting all of your money when it happens.
This is a problem for many investors, since money managers often don't feel your risk tolerance like you do. Money managers only focus on expected return and get lost in it, not accounting for the horizon leverage. They are being well compensated for generating high returns, but do not suffer as much if the perfect storm hits, which eventually it will, since all of their money is likely not in the fund. (For more, read Use A Money Manager Or Go It Alone?)
Bankruptcy or No BankruptcyIf money managers did feel your risk tolerance, things would be much different. This can be readily witnessed on the game show Deal or No Deal, where the player guesses on which briefcase holds a million dollars, and is then made offers to stop playing before going through all the cases. The offer is rarely a good move based on an expected return standpoint, suggesting that you should keep climbing up the cliff and never take the "deal." However, some people do. Do they crunch numbers as they progress? No. Rather they go off their gut instincts.
Breaking this down a little further, they are starting to envision themselves with the money offered, understanding that they have a very real possibility of losing it. They then think about things like the time it would take them to earn the wagered amount, the time it would take them to replace the wagered amount if lost, and savings goals relative to their ages.
One step further, I would almost guarantee you that if Warren Buffet played the game, he would never make a deal due to it being negative expected return and his risk tolerance is way beyond a million dollars. (For more, read Personalizing Risk Tolerance.)
Real World ApplicationBetter investing seems to lie in the willingness to make good bets, where the expected return is positive, but only wagering in an amount you can certainly afford to lose. In the first example, $10 was definitely an amount most people could afford to lose; however, one million dollars is generally not. Thus, the risk tolerance needs to be coupled with expected return. This way, the investor can be prepared for the perfect storm while still making good investment decisions, just to a lesser degree.

Rule of ThumbA good rule for many might be to wager no more than would affect your earnings power the next year. Simply put, preserve principal, taking risk only to the extent of not making money for the year, but not permanently losing your principal either. If you are near retirement and need your investments to live off of, your risk capacity would be even lighter, suggesting ultra-conservative, non-leveraged investments.
ConclusionUnderstanding horizon leverage and risk tolerance can help the investor avoid financial ruin and the associated feelings when the perfect storm hits. Hired money managers can be useful in building wealth, by understanding what they are investing in and how much leverage they are using. Try to match your risk tolerance to your underlying investment strategy in order to mitigate the likelihood of financial ruin when you are several years down the road and your ability to play the investment game is hindered. Lastly, understand that the perfect storm will eventually happen; just be able to handle it - not by trying to miss the storm through luck, but by having the ability to weather it. (For more on risk tolerance, read Determining Risk And The Risk Pyramid and Risk Tolerance Only Tells Half The Story.)

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