Leverage is great – only when everything is appreciating. Indeed, if things appreciate, the leverage ratio goes down since the loan-to-equity ratio goes lower. A simple example is taking a $100 portfolio, borrowing $100, which gives you a 50% loan-to-equity ratio. If your portfolio appreciates 10%, the loan-to-equity goes down to 45%, and suddenly you’re feeling more comfortable again.
This basically explains the real estate market – you buy a house, take a mortgage for 80% of the house value (paying 20% down), and when the real estate market goes up 40% (like it has in the Vancouver area), suddenly your loan-to-value ratio goes down to 57% – let’s suck more money out of the house and get that back to 75%! This means borrowing another 25% of your original house value.
This all works, until the underlying asset value falls and you have to pay back your loans. In the instance of an initial 80% loan-to-value, a price drop of 10% means the loan-to-value goes up to 89%.
The same dynamics go for portfolio management – leverage is painful in the down direction because your loan-to-equity ratio becomes more concentrated.
Clearly, the best time to de-leverage is when you’ve made your anticipated gains.
I’ve started to take some money off the table. Specifically, Genworth (NYSE: GNW) and most US insurers have gotten hot because of the probability of the federal reserve increasing interest rates again.
After raising cash, the most difficult part of investing is to wait. The easiest way to lose money is to do something with cash just because it is earning zero yield in the brokerage account.