Chapter 27: Money on Steroids

Jack Singer: “Do you know what a straight flush is? It's like... unbeatable.”

Betsy: " ’Like unbeatable’ is not unbeatable.”

– Honeymoon in Vegas (1992)

The surest way to financial success is the most boring: save regularly and invest consistently day in and day out and go about your life. That is the recommendation of this book and so this chapter is entirely optional.

People are people. They are impatient. They want to speed up the process. They start (or restart) saving and try to play catch-up late in life. Or they like the thrill. They want to take a flyer at the chance of buying into the next Amazon or Apple stock. Too often they are misled into believing they can buy an investment that earns high return with low risk.

For these people, Wall Street will happily pull up a chair at the table, comp them a steak dinner, and offer up a variety of gambles. Those gambles often employ leverage. Leverage can create fantastic returns. Until it doesn’t. [64]

Leverage

Leverage is a fancy word for debt. It’s a way to supercharge investment gains, but also losses. Look at this example.

Say I want to invest $1,000 in the stock market. I decide to use $1,000 from my brokerage account to buy the Vanguard Total Stock Market ETF (VTI). If the market goes up 20%, I end up with $1,200. If it goes down 20%, I’m left with $800. Win 20% or lose 20%.

What if I take my $1,000 and I borrow an additional $1,000 at a 5% interest rate? Now I can buy $2,000 of VTI. Then, when the market goes up 20%, I have $2,400. Once I repay the loan with interest ($1,050), I am left with $1,350. The market went up 20% but I increased my investment by 35%. That’s the power of leverage.

Now for the flipside. If the market goes down by 20%, my investment drops to $1,600. When I repay the loan with interest, I’m left with just $550 instead of $800. Instead of 20%, I lost 45% of my money. That’s the risk of leverage.

Notice that the extra loss due to leverage ($250) is more than the extra gain ($150) because either way I had to pay interest on the money I borrowed. The house (the lender) made $50 regardless of what the market did.

Margin

Okay, so where do I borrow the extra $1,000? It could be anywhere, but Wall Street makes it easy. If I set up my brokerage account as a margin account, I can automatically borrow when I buy VTI. In other words, the brokerage company will let me buy $2,000 of VTI even if I only have $1,000 in the account. They will lend me the extra $1,000 “on margin” and charge me interest on it.

How can they do this? By using my shares as security for the loan. What this means is that if the price of VTI goes down and drops below a certain level I will get a margin call. A margin call requires me to put extra money in my account right away, or the brokerage firm will start selling VTI shares to get their loan back. If I don’t have extra cash, a margin call can lock in a loss, or worse, wipe me out.

Options

Another popular way to use leverage is with options. Options are so-called derivative financial instruments that let you create leverage without explicitly borrowing money. The increased risk and reward are built in.

Options are complicated. There are two basic types: call options and put options. I’ll just briefly describe them here. Warning: This is not enough information to do options trading.

Let’s use VTI as an example, as before. [68] Here goes.

If you think the stock market will go up you can buy a call option on VTI. This option lets you buy 100 shares of VTI for a set price (called the strike price) at any point before some date (the expiration date.) The price you pay for this option, also called the option premium, will be just a fraction of what 100 VTI shares would cost you. Notice you don’t have to buy the shares. Hence “option.”

Once you own the option, if the price of VTI rises above the strike price, you win. You can then buy the VTI shares for the strike price and sell them at the higher market price for an immediate profit. [69] The profit can be quite large compared with the premium you paid. This is the leverage. On the other hand, if the price of VTI doesn’t go up, the option expires worthless and you lose your entire investment (the premium).

So, small initial bet, big potential payoff, or lose your wager. Vegas on Wall Street!

The other basic type of option is a put option. It works the same way but lets you sell VTI at the strike price. It is a bet that the price of VTI will go down, allowing you to buy it cheaply in the market and then immediately sell it at the strike price for a gain.

Employee Stock Options

Short Selling

Short selling is a way to bet on the price of something going down. You profit from the price decline. In investing lingo, you are “short” or you “shorted” an asset. (Conversely, when you invest with the hope that the price will go up, you are “long” or “went long” the asset.)

To understand the mechanics of short selling, let’s go back to the VTI ETF. Say I’m convinced the stock market is going down. With a short sale I go to my brokerage firm and borrow some shares of VTI. I promise to return the same number of shares plus some interest in cash. Say I borrow eight shares when the price of each share is $125 (or $1,000 worth). I then take the borrowed shares and sell them for $1,000. The $1,000 goes into my margin account at the brokerage firm as collateral.

Some time later, if the price of a share of VTI later goes down 20% to $100, I buy eight shares for $800 in the market. I hand the shares back to the brokerage firm that lent them to me. I collected $1,000 when I sold the borrowed shares and had to pay only $800 when I returned them, along with some interest, leaving me with a profit of a little less than $200.

Now consider the case where the price of a share of VTI goes up instead. Maybe it goes up 20% to $150. To return the shares I borrowed and sold I would have to pay $1,200 for eight shares. I have a loss of $200. Maybe I wait a little to see if the price comes back down. But instead it goes up further to $175. My loss increases to $400. If the price continues to go up there’s no limit to how much I could lose. As my loss goes up, I will get margin calls from the brokerage requiring me to put more cash in the account.

Buyer Beware

Leverage, margin, derivatives, and short selling are sharp knives. Brokerage firms are supposed to make you jump through extra hoops before they will let you loose in the kitchen with them. You need special account approvals to use these techniques. Which is as it should be.

But…Wall Street has found a way to peddle them to inexperienced and even unsuspecting investors. Mutual funds and ETFs can use them as part of their investing strategies. Those funds, in turn, can be sold to almost anyone. The consequences can be dire. The first quarter 2020 bear market wiped out a number of funds and their investors. [70]

If you are tempted to stray from basic index funds to Investments that use leverage or short-selling remember that these techniques either 1) increase potential return and increase the risk of loss or 2) decrease risk of loss but also reduce the potential return. Sometimes marketing pitches make it sound like an investment will provide higher returns without increasing risk. Don't believe this.