Leverage is like fire. Use it to your advantage, but beware the burn
The most important lesson is to separate conviction from leverage
OVER the past few months, South Korea has provided investors with a remarkable real-time lesson in the dangers of leverage.
Single-stock leveraged products, introduced in South Korea in late May, gave investors magnified daily exposure to firms such as Samsung Electronics and SK Hynix, and they quickly became popular.
But the feature that made them attractive – the ability to magnify gains – also magnified losses; regulators intervened, suspending new listings and tightening requirements.
The lesson extends far beyond Korea. Leveraged investors elsewhere have been reminded that a good idea and a survivable structure are not the same thing.
The analogy I often use when discussing leverage with investors is this: Leverage is like fire. Used well, it can cook a good meal. Used unwisely, it can burn down the kitchen.
Leverage changes the mathematics of survival
Consider an investor with S$100,000. Without leverage, a 20 per cent fall costs him S$20,000 – painful, but he retains choices: sell, hold or buy more.
At two times leverage, the same fall wipes out 40 per cent of his capital; at four times, 80 per cent. A relatively ordinary market correction has become an 80 per cent destruction of capital.
This simplified example excludes financing costs, fees and, critically, changes in margin requirements.
That last factor matters because leverage introduces path dependency. As prices decline and collateral shrinks, lenders may demand cash, and positions can be liquidated.
The sequence becomes brutally simple: Leverage leads to larger losses, which causes shrinking collateral, and triggers to a margin call and forced selling.
Leverage’s greatest danger is not merely that it magnifies losses; it reduces your ability to wait. It can make you insolvent before you have the opportunity to be right.
Risk tolerance is not risk capacity
A common misconception is that suitability for leverage depends on risk tolerance. It does not.
Investors must distinguish their willingness from their ability to take risk and ask whether they can survive the maximum loss without jeopardising their mortgage or retirement plans.
If not, leverage is inappropriate.
Don’t measure leverage by the multiple alone
Investors focus too much on whether something is leveraged two or three times.
That is incomplete. What matters is leverage, volatility and position size together – in other words, how much of total wealth could be lost under a severe but plausible scenario.
A small leveraged position can carry less risk than a larger one, so investors should set maximum losses before markets fall, not after.
Korea’s leveraged ETF lesson
Leveraged exchange-traded funds are another deceptively simple form of leverage. They trade like an ordinary ETF, but their mathematics differ sharply, because they target a multiple of the daily return of the underlying asset.
Repeated daily resets create volatility decay, a compounding effect that can leave losses well beyond a simple multiple of the index’s move, even when the market is roughly flat.
Single-stock products add company-specific risk on top of that – as Korean regulators recognised when they tightened the rules – and regulatory approval is not the same as an assurance of safety.
Before buying one, investors should understand what it is designed to achieve. A vehicle targeting twice the daily return of a stock is not designed to deliver twice that return over months or years.
A margin call is not a risk management strategy
Do not wait for your broker to tell you there’s a problem. A margin call should be the last line of defence, not your risk-management system.
Watch for a leveraged position growing disproportionately large after gains, rising volatility or a declining ability to post collateral. Requirements can tighten when you are least able to meet them.
Don’t assume the “weak hands” are gone
After sharp declines, investors often assume the “weak hands” have been washed out and it’s time to buy. That can be dangerously premature. During genuine deleveraging, selling is no longer about conviction but solvency.
Funds facing margin calls must sell their most liquid assets first, because those are easiest to convert to cash, which is why even blue-chip equities can fall alongside speculative bets.
Investors looking for the bottom should watch the financial system’s plumbing, not just valuations. Cheap is not a catalyst when sellers have no choice.
Conviction and leverage are not the same thing
The most important lesson is to separate conviction from leverage. A powerful long-term theme, such as artificial intelligence or clean energy, will inevitably see prices disconnect from the underlying fundamentals.
Without leverage, a 30 per cent decline is an unpleasant paper loss. But with excessive leverage, it can trigger a margin call, forcing a sale exactly when the investor most wants to hold on.
A short-term survival test
For investors, three principles follow:
- Match the vehicle to the horizon;
- Accept stomach volatility over liquidation volatility, since an unleveraged position keeps you in control of when you sell; and
- Remember that good enough can be extraordinary – turning a 50 per cent return into 100 per cent or 200 per cent through leverage risks losing everything.
American businessman and investor Charlie Munger warned that smart people go broke through liquor, ladies and leverage. Leverage is not inherently bad. Fire, after all, is useful.
But never build a fire so large that one unexpected gust of wind can burn down the kitchen.
The writer is chief strategist, Asia, Indosuez Wealth Management
