Why consistent high returns are impossible without leverage

On the right-hand side of my bookmarks, I posted a 5-year performance of about 22% compounded annually. This is a high number, and as the years tack on, this will likely become lower. 2011 is going to likely be a low single digit percentage year.

The mean value theorem in mathematics can explain why such a level of return is not likely to continue. Let’s pretend that every company I put my money in will have a 15% earnings yield (either retained or given out in dividends; it does not matter). In the long run, my portfolio will be able to increase 15% a year. However, in order to achieve a 22% return, I must invest in something that has a greater than 22% return.

If I cannot find those investment candidates, then in order to achieve 22% on a 15% investment base, I need to borrow money at a rate less than 15% and put it into that 15% investment.

The risk of this is that my capital might “blow up” and I will be forced to liquidate my assets at precisely the wrong moment. Another way of thinking about this is that I want to be investing at precisely the moment that everybody else is forced to liquidate, rather than an arbitrary point in time such as now.

Unfortunately at present I am having grave difficulty identifying candidates that will give these types of returns. I also do not feel comfortable with employing leverage, so I will continue to twiddle my thumbs and wait for a better opportunity. I also do not think ploughing into commodities is any sort of “fix” to this problem – there are much better lower-variation equities out there that will give you a more stable return on investment and also be able to provide inflation-adjusted returns over the long run. Even though it is abundantly clear that commodities such as inexpensive-to-mine oil is rapidly depleting, it is still no reason why the price of such commodities at some point will not go to marginal cost of extraction, or even lower (e.g. natural gas). Commodity markets are cyclical and investors should never assume that the trend will be continuously straight-line up. There will be brutal price corrections in the interim – they are just very difficult to predict.

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“it is still no reason why the price of such commodities at some point will not go to marginal cost of extraction”
So simple and so true!