Leverage and the Short Term

Just a little more time is all we're asking for
'Cause just a little more time could open closing doors
--Corey Hart

In a previous post, we considered decision-making time horizons with a focus on what makes decisions more short term oriented. We observed that while people may have an inclination for 'now versus later,' interest rates in unhampered markets serve to balance long-term and short-term thinking on a risk/reward basis.

In hampered markets, however, this balance is disturbed. Intervention in credit markets sends false signals that motivate risky behavior during periods of high time preference--a volatile combination that often produces 'crack up booms.' Leverage, defined here as borrowing to increase potential returns (and in the context of high time preference, to increase current standard of living), rises above levels likely in free market situations. We ended by proposing that this leverage is a contributing factors to shorter term focus. Stated more formally:

Proposition: The greater the leverage, the shorter the decision-making time horizon.

Scenarios using a stock market context serve to illustrate. First, consider an individual who has $100,000 in stock but has no debt. This person is unlevered. Let's say stock markets run into a rough patch and lose 50% of their value. The individual's account is now worth $50,000. If the person can tolerate this large drawdown and believes in the future of his/her investments, then the individual may do nothing. Lack of action would suggest that the individual's time horizon extends beyond the present volatility. Indeed, this individual may be 'in it for the long term.'

Now consider a second individual who has $100,000 in stock. In this case, however, $60,000 in stock was purchased with the investor's own money while the other $40,000 was purchased using a loan from the individual's broker. This is known as being 'on margin.' In this example let's specify a 'margin requirement' of 50%, meaning that the stock:loan ratio cannot fall below 2:1 (which would occur in this case if stock value fell below $80,000). Should such a decline occur, then the investor would get a 'margin call' from the broker; the investor would then be required to act--either by adding more capital to the account or selling stock to pay down the margin loan until the stock:loan ratio once again achieved 2:1.

Why would an individual want to be margined? Why, to increase potential returns! If stock prices double from here, then the return on the investor's $60K of capital is ($200,000 - $100,000)/$60,000 = 167%. Had the investor borrowed no money and merely invested his/her $60K in unmargined fashion, then the return on a stock price double would have been ($120,000 - $60,000)/$60,000 = 100%. Not awful by any means, but lower both in ROI and in absolute dollar terms ($40K less to be exact). This is the magic of leverage.

Unfortunately, leverage works both ways. What if stock prices decrease instead? A 10% decline in a $100,000 portfolio represents a $10,000 loss. Just as ROI is magnified when prices rise, it is also magnified when prices fall. A 10% decline on $100K generates a -17% ROI for the leveraged portfolio compared to, well, a -10% ROI for the unleveraged situation. The steeper the decline the more likely a reactive decision becomes. Should the losses push the leveraged portfolio below $80,000, then the investor will be forced to act by the broker.

Now lets's increase the leverage. A margin requirement of 10% would permit the individual to buy $100,000 worth of stock with only $10,000 of equity capital. This may seem like an extreme amount of leverage, but most banks operate with a maximum of 10% equity and usually much lower. Wall Street firms often achieve leverage ratios of 30 to 1 or more. Hopefully you can see that any doesn't take much of a price decline before the leveraged individual is in reactive decision-making mode.

Although we've been focusing on the individual's reponse to losses, it is also likely that the individual will be more likely to react to short term gains as well. Because of general tendencies toward loss aversion (Kahneman & Tversky, 1979), individuals are more likely to 'take their trade' and sell winners relatively soon--a condition more likely when gains are magnified by leverage.

The main point of this exercise is to demonstrate that leverage increases the likelihood of action in response to near term stimuli. When folks borrow resources to increase present day standard of living (mortgage, credit card, bank loan, etc), they are under obligation to pay the loan back some day. If for some reason the environment changes and individuals fear they can't pay back the loan, or that the leverage is decreasing rather than increasing their standard of living, then they are likely to react to that stimulus.

As such, leverage is more likely to motivate short term decisions.

Given levels and trends in debt at all levels (individual, firm, sovereign), society is operating in an increasingly leveraged state. It should be no surprise, then, we are noticing general tendency for short term decision making.

What's the source of all this leverage? Excellent question, young grasshopper, and one people should ponder in a truth-seeking manner.