TL;DR: Investing with leverage has the potential to blow you up. Back in the 2008/2009 financial crisis I managed to go from a net worth of several hundred thousand dollars all the way down to zero (even less, I was negative net worth for a while!). This is because I was using leverage to invest in high risk, speculative stocks. I was able to hang on through the trough and bounce back since. But for anyone who hasn’t lived through something like that, just know those kind of declines are real, and leverage will make you pay for it. Always remember the first rule of investing: never lose money. One of the best ways to ensure you never lost money is to make sure you never become a forced seller, which is why you also want to avoid leverage – particularly with publicly traded securities!
One of the investment rules I live by is to use leverage with care. I learned this lesson the hard way back in 2008. At the time, I had been out of school for a few years and was making pretty good money advising fortune 500 CEOs. Since my mid teens I had dabbled in stock market investing, and now I finally had the money to make some real bets. I remember actually thinking that if I invested well, I could make more money from my investments than from my day job. I was such a bozo!
From ~2006 to ~2008, I caught the last few innings of the 2000’s big bull run. From the depths of late 2002 the S&P bottomed at 815, and would almost double over that cycle peaking at ~1,550 in October 2007. Having really got into the market on Jan 2006, the S&P went from 1,280 to 1,550 over the course of a year and a half. That’s a solid 21% gain over that time – definitely well above the long term average, and in retrospect, particularly concerning given the market had basically doubled in the course of 5 years since 2002.
Of course, I wasn’t investing in the S&P – that was for suckers. I needed to make more than the measly 7% a year you can get from the S&P, so I was picking speculative stocks in businesses I knew nothing about. Speculative mining stocks. Speculative solar stocks. Speculative Chinese consumer stocks. But not only was I picking highly speculative, risky stocks – I was doing it with leverage. I had seen a few of my early picks gain 50-100% relatively quickly, and I got hooked on those types of returns. As mentioned above, my goal was to make more from my trading than I did from my day job, and to do that I needed to amplify my returns. I figured borrowing money from the brokerage at 5-7% interest was a steal when I was making 50-100% gains on those investments!
It was a crazy time, and for a while what I was doing actually worked… until it didn’t, in spectacular fashion. From 2006 to early 2008, I think my portfolio went up ~60-70%, so you can already tell that I had a more volatile mix than the S&P 500. Moreover, the closer we got to 2008, the more leverage I applied. I think I probably got to a point where I was 200% long on a pool of highly speculative stocks (i.e. I had borrowed an additional 100% of my equity value to invest). This was great when things were going up, but as things started to unwind in early 2008, it got ugly.
For context, from early 2008 to March 2009, the S&P 500 was cut in half, going from 1,550 back down to ~700. This was the Great Recession, or the Financial Crisis, or whatever you want to call it. It was bad. By March 2009, it felt like the entire financial system was on the verge of collapse. Nothing was safe. In times of market turmoil, speculative stocks, particularly ones that don’t have certain cashflow and staying power, get absolutely crushed. Those types of stocks made up a large part of my portfolio. In many cases, companies I owned lost more than 80% of value from Jan 2008 to March 2009. Remember, the S&P 500 lost 50% of value, and my portfolio was WAY riskier.
So not only did I have a mix of stocks that fared worse than the broader market during the worst downturn in decades, but I had added leverage to the mix. To help you understand the danger of leverage, consider this: If you are leveraged 200% and your portfolio loses 50% of its value, you are wiped out. There is no equity left. You are finished.
That is, effectively what happened to me from Jan 2008 to March 2009. As I watched the events unfold, I tried to stay ahead of the market. As things kept getting worse and worse, I was trying to unwind my positions and reduce my exposure. But I didn’t do it fast enough. I kept hoping the market would turn around. That word hope is the most dangerous word in investing. Don’t hope anything will happen. That’s not a strategy or a plan. It’s a hail mary. Expect and prepare for the worst, then appreciate the times when the worst doesn’t happen.
I can still remember when things hit rock bottom in March 2009. During that final precipitous drop, when it felt like things couldn’t fall any further, they did. I remember having to max out credit cards and lines of credit I had so that I could replenish my brokerage account and avoid the forced sale of the remaining stocks I still owned. At the very least, I knew intuitively that if I could hold on through the storm things would get better. Fortunately, they did. But… for a brief time in March 2009, I’m pretty sure my portfolio and net worth was negative. The value of my assets was less than the various lines of credit I had extended to hold on to them.
Of course, by mid to late 2009, the worst was over. My portfolio bounced back accordingly and my net worth saw the light of day again. But man, my psyche was forever changed. There is nothing like seeing all of your worldly wealth go up in flames to instill a healthy respect and fear for both the market and the use of leverage. Since that day, I’ve never considered using leverage for any sort of stock investment. It just doesn’t make sense. The only place I would consider using debt is with more stable, cash generating investments like real estate, or cash flowing businesses. If you’re using leverage on speculative investments you’re just waiting to get your ass handed to you.
So all of this talk of markets and cycles, brings me back to the present day, April 2018. From the depths of the March 2009 trough (S&P at ~750), we’ve crested at roughly 2,750. a 250% gain over that time frame. Put another way, we have had a ~100% gain since the 2007 peak around 1,500. That’s a ~7% annualized return, which would suggest we’ve matched the long term stock market performance since the last peak, and absolutely crushed it since the last trough. Does that mean we’re at another peak? I don’t know, but I can say things look expensive. I haven’t put much money in the public markets for a few years now, and I certainly wouldn’t put any money in these markets under leverage today. The potential for us to retrace back to 2,000, or 1,500 is very real, and the consequences to anyone who plays with that kind of fire are equally devastating.
For anyone starting out in their investment journey, if you’re going to consider public stocks, just remember that you need to plan for the long term, and you should never buy stocks on margin. Unless you’re a professional hedge fund trader playing with other people’s money, it’s just not worth it. Focus on your day job and increasing you earning power, and let your passive investments be passive and relatively low risk. While you’re at it, consider exploring some alternative investments like real estate and small businesses. They fly under the radar, but can offer compelling inflation protected returns, with the potential for cash flow generation today, which can help you start your journey toward Ramen Retirement.
Best of luck and enjoy the journey!