Due to positive experiences, many people grow comfortable with hedge fund managers and the leverage they use, even without fully understanding the dangers leverage can pose when times get tough. Understanding horizon leverage and risk tolerance can help the investor avoid financial ruin when the perfect storm hits.

Horizon Leverage and the Positive Return Dilemma
Many smart people managing sophisticated funds have run clients into financial ruin. Why? Because money managers are not properly accounting for horizon leverage. Investors who don't have money to lose must not over-wager with these managers, hoping the perfect storm won't hit; it's better is to plan that it will, and adjust your risk parameters accordingly. (For more tips, check out 8 Ways To Survive A Market Downturn.)

Let's Play a Game
For instance, imagine you were to place a bet where the odds of you winning are great, but the consequence of losing is bankruptcy. To a person who understands positive expected return - defined loosely as the product of the probability of a positive outcome times the expected reward is greater than the product of the probability of a negative outcome times the expected loss - this seems like a good bet.

Now suppose you start with a bet of $10 and win! This game seems good, so you play again and again until you are now going double or nothing on several million dollars. While the odds of winning haven't changed, the disastrous consequences of losing have. Beware! You are going up a leverage cliff, and you are about fall off. After about twenty years into the game, the perfect storm hits and you are broke and despondent.

Financial Ruin Using Sound Strategies
A money manager who is myopically focused on positive expected return plays the game over and over again, leveraging up bets. The leverage investment strategy may be sound, but risk tolerance of constituent investors is not being factored in. It is a mathematically certainty that eventually you will lose the bet, and you'd better hope you are not betting all of your money when it happens.

This is a problem for many investors, since money managers often don't feel your risk tolerance like you do. Money managers only focus on expected return and get lost in it, not accounting for the horizon leverage. They are being well compensated for generating high returns, but do not suffer as much if the perfect storm hits, which eventually it will, since all of their money is likely not in the fund. (For more, read Use A Money Manager Or Go It Alone?)

Bankruptcy or No Bankruptcy
If money managers did feel your risk tolerance, things would be much different. This can be readily witnessed on the game show Deal or No Deal, where the player guesses on which briefcase holds a million dollars, and is then made offers to stop playing before going through all the cases. The offer is rarely a good move based on an expected return standpoint, suggesting that you should keep climbing up the cliff and never take the "deal." However, some people do. Do they crunch numbers as they progress? No. Rather they go off their gut instincts.

Breaking this down a little further, they are starting to envision themselves with the money offered, understanding that they have a very real possibility of losing it. They then think about things like the time it would take them to earn the wagered amount, the time it would take them to replace the wagered amount if lost, and savings goals relative to their ages.

One step further, I would almost guarantee you that if Warren Buffet played the game, he would never make a deal due to it being negative expected return and his risk tolerance is way beyond a million dollars. (For more, read Personalizing Risk Tolerance.)

Real World Application
Better investing seems to lie in the willingness to make good bets, where the expected return is positive, but only wagering in an amount you can certainly afford to lose. In the first example, $10 was definitely an amount most people could afford to lose; however, one million dollars is generally not. Thus, the risk tolerance needs to be coupled with expected return. This way, the investor can be prepared for the perfect storm while still making good investment decisions, just to a lesser degree.

Rule of Thumb

A good rule for many might be to wager no more than would affect your earnings power the next year. Simply put, preserve principal, taking risk only to the extent of not making money for the year, but not permanently losing your principal either. If you are near retirement and need your investments to live off of, your risk capacity would be even lighter, suggesting ultra-conservative, non-leveraged investments.

Understanding horizon leverage and risk tolerance can help the investor avoid financial ruin and the associated feelings when the perfect storm hits. Hired money managers can be useful in building wealth, by understanding what they are investing in and how much leverage they are using. Try to match your risk tolerance to your underlying investment strategy in order to mitigate the likelihood of financial ruin when you are several years down the road and your ability to play the investment game is hindered. Lastly, understand that the perfect storm will eventually happen; just be able to handle it - not by trying to miss the storm through luck, but by having the ability to weather it. (For more on risk tolerance, read Determining Risk And The Risk Pyramid and Risk Tolerance Only Tells Half The Story.)

Related Articles
  1. Fundamental Analysis

    Is India the Next Emerging Markets Superstar?

    With a shift towards manufacturing and services, India could be the next emerging market superstar. Here, we provide a detailed breakdown of its GDP.
  2. Professionals

    Are Hedge Fund ETFs Suitable for Your Portfolio?

    Are hedge fund ETFs right for you? Here's what investors need to consider.
  3. Investing Basics

    How AQR Places Bets Against Beta

    Learn how the bet against beta strategy is used by a large hedge fund to profit from a pricing anomaly in the stock market caused by high stock prices.
  4. Stock Analysis

    How Rollins Inc. Transformed from Radio to Pest Control

    Discover how Rollins, Inc. grew and expanded, making numerous acquisitions, transitioning from the radio industry to the pest control industry.
  5. Term

    Understanding the Maintenance Margin

    A maintenance margin is the minimum amount of equity that must be kept in a margin account.
  6. Term

    Estimating with Subjective Probability

    Subjective probability is someone’s estimation that an event will occur.
  7. Investing Basics

    Understanding the Modigliani-Miller Theorem

    The Modigliani-Miller (M&M) theorem is used in financial and economic studies to analyze the value of a firm, such as a business or a corporation.
  8. Economics

    Explaining Kurtosis

    Kurtosis describes the distribution of data around an average.
  9. Investing Basics

    Explaining the High-Water Mark

    A high-water mark ensures fund managers are not paid performance fees when they perform poorly.
  10. Personal Finance

    Simple Interest Loans: Do They Exist?

    Yes, they do. Here is what they are – and how to use them to your advantage.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Principal-Agent Problem

    The principal-agent problem develops when a principal creates ...
  3. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  4. Debt/Equity Ratio

    1. A debt ratio used to measure a company's financial leverage. ...
  5. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability ...
  6. Financial Singularity

    A financial singularity is the point at which investment decisions ...
  1. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  2. What does a futures contract cost?

    The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>
  3. Are there leveraged ETFs that follow the retail sector?

    There are many exchange-traded funds (ETFs) that track the retail sector or elements of the retail sector, and some of those ... Read Full Answer >>
  4. What is the 12b-1 fee meant to cover?

    A 12b-1 fee in a mutual fund is meant to cover the fees of companies and individuals through which investors of a fund buy ... Read Full Answer >>
  5. How can I use a regression to see the correlation between prices and interest rates?

    In statistics, regression analysis is a widely used technique to uncover relationships among variables and determine whether ... Read Full Answer >>
  6. What are some common cash-debt strategies that occur during a spinoff?

    Cash-debt strategies that are commonly used to in a spinoff to enable the parent company to monetize the spinoff are debt/equity ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!