Reinvesting capital gains is a central problem facing any leveraged investor. Capital gains increase equity, which provides an opportunity to make new investments and generate new returns. Reinvested gains are the engine of a growing portfolio.

But portfolios become riskier with leverage. With too much leverage, a market downturn can wipe out all of the equity and leave the investor with more debt than assets. This situation can lead to a cash crunch when interest payments are due, and could even force an investor to contribute additional capital or face a margin call.

This problem also has elements of a decision trap. What if the investor had portfolio losses instead of gains? Should assets be liquidated in a downturn just to reduce debt?

In this article, we'll take you through the leveraged reinvestment problem and then look at several possible strategies.

Compounding Returns and Leverage
While leverage is often used as a speculative tool to generate quick short-term gains, the greatest profit opportunities come from compounding large amounts of investment gains over long periods of time.

For example, suppose that an investor borrows $100,000 at 5% and invests $200,000 in a stock fund expected to return 10% a year. The interest accumulates over time and the investor makes no additional investments or interest payments.

-- Assets Debt Equity Return on Equity Leverage Ratio
Starting Point $200,000 $100,000 $100,000 -- 2.00
After 1 year $220,000 $105,000 $115,000 15.0% 1.91
After 2 years $242,000 $110,250 $131,750 14.8% 1.84
After 5 years $322,100 $127,630 $194,470 14.2% 1.66
After 10 years $518,750 $162,890 $355,860 13.5% 1.46
After 20 years $1,345,500 $265,330 $1,080,170 12.6% 1.25

After 20 years, the investor has assets worth $1,345,500 and a debt level of $265,330. This leaves an ending equity of $1,080,170. This high return is the result of the original $200,000 investment compounding much faster than the associated debt.

As the portfolio builds equity, the leverage ratio falls. The leverage ratio is calculated by dividing assets by equity, and is a critical variable in leveraged portfolios. Higher leverage means higher expected returns but higher volatility.
Highly leveraged portfolios are very volatile, and at low levels of equity, portfolios can gain or lose 5-10% of their value every single day. This high volatility sometimes pushes portfolios underwater - asset levels fall below debt, leaving the investor with no equity.

Still, even underwater portfolios can still build value. Whenever assets are expected to compound faster than debt, probabilities will favor the investor continuing to build equity.

Leverage Pushed to the Limits
In the above example, the investor made no additional investment, but simply allowed the original investment to compound over a long period of time. What if the investor continued making additional investments by borrowing more money?

Statistically, a leveraged investor who simply reinvests his or her gains at the highest level of leverage has a very high probability of taking huge losses over time. Here's why: Let's say that an investor is able to purchase shares at a maximum leverage level of 4x and at an interest cost of 5%. Using $100,000 of equity, the investor purchases $400,000 of stock. The portfolio has a good year, and the investor doubles his or her equity.

Now, using the $200,000 of equity, the investor purchases $800,000 of stock, but this time, the market falls. The annual interest payment, $30,000 is due, and the investor doesn't have the funds on hand and has no further ability to borrow. As a result, the portfolio is liquidated at a loss and the investor's equity is wiped out.

Let's take a look at three strategies that could help avoid this scenario:

Strategy 1: Maintaining Constant Leverage
Clearly in the previous example, the investor didn't manage his or her ability to repay interest or the potential losses. What if the investor simply tried to maintain a low, but constant, level of leverage over time?

This simple strategy is actually used by many leveraged funds and exchange-traded funds (ETFs), but has hidden dangers. These funds are marketed based on their predictability – i.e. in a 2x leveraged fund or ETF, a 1% rise in the daily value of the S&P creates a 2% rise in the value of the fund. Unfortunately, that ratio doesn't hold over time, and given periods of several years, these funds often lag the underlying index upon which they are based.

The problem is that when the market declines significantly, the fund has less equity compared to assets and the leverage ratio goes up. The fund then has to sell some of its assets and pay down its debt. Given the cyclical nature of markets, the strategy leads to funds buying lots of shares during market highs and then selling them during market lows.

-- Assets Debt Equity Leverage Ratio
Starting Point $200,000 $100,000 $100,000 2.00
10% Market Decline $180,000 $100,000 $80,000 2.25
Daily Correction Required $160,000 $80,000 $80,000 2.00

In this example, after a 10% correction, the fund sells $20,000 worth of assets and pays down debt in order to maintain the target leverage ratio. It will have a smaller asset base in the next rally and will have more difficulty recovering. Also, because these transactions must be done daily, this leads to high transaction costs and taxes.

An argument could be made that constant leverage funds break the golden rule of investing - the longer you're in the market, the more money you'll make, on average. Any fund that partially exits the market every time there is a decline will have a lot of difficulty holding onto gains, let alone compounding them.

Strategy 2: Target Debt Levels
A more consistent approach is to maintain a manageable level of debt based on the ability to repay interest. Gains are reinvested and interest is paid out of pocket. Investors focus on their long-term ability to repay debt and leave the asset compounding to the market.

For example, an investor with $25,000 on hand determines that $100,000 is a manageable level of debt given her income and her ability to repay the interest. The investor purchases $125,000 of stocks and ETFs that are expected to appreciate at 10%. She starts with very little equity and a very high level of leverage.

-- Assets Debt Equity Interest Paid Leverage Ratio
Starting Point $125,000 $100,000 $25,000 -- 5.00
After 1 year $137,500 $100,000 $37,500 $5,000 3.67
After 2 years $151,250 $100,000 $51,250 $10,000 2.95
After 5 years $201,314 $100,000 $101,314 $25,000 1.99
After 10 years $324,218 $100,000 $224,218 $50,000 1.45
After 20 years $840,937 $100,000 $740,937 $100,000 1.13

Given the expected appreciation, this portfolio's equity increases from $25,000 to $740,937 in 20 years. However, the investor also has to pay $100,000 of accumulated interest over the life of the investment. These interest payments prevent the debt from compounding and accumulating.

Strategy 3: Target Asset Levels
Another strategy is to identify an initial high fixed level of market investment and to consistently maintain that level regardless of market conditions. Over time, the investor could adjust this level of investment based on annual percentage increases. This may be used in conjunction with a rebalancing strategy.

In this example, an investor decides to invest $200,000 in a portfolio of stocks and ETFs expected to return 10% a year, and to grow this amount by only 5% a year. Next year, he will have $210,000 invested, the year after that $220,500, etc. Regardless of market conditions, he will keep a constant amount invested.

Using $100,000 of debt, the investor purchases the initial assets. After a year, the assets appreciate, and he sells a portion of the portfolio and pays down the debt, reducing his future interest costs. Every year, he grows assets and reduces debt.

-- Assets Debt (or Cash) Equity Leverage Ratio
Starting $200,000 $100,000 $100,000 2.00
After 1 year $210,000 $95,000 $115,000 1.83
After 2 years $220,500 $89,250 $131,250 1.68
After 5 years $255,256 $66,853 $188,403 1.35
After 10 years $325,779 $7,757 $318,022 1.02
After 20 years $530,660 ($240,060) $770,720 0.69

Controlling the market exposure over time lowers the overall volatility of the portfolio and allows the investor to benefit from market fluctuations by purchasing more shares during down markets and sell them during upturns. The effect is similar to dollar cost averaging.

In this example, all of the debt is paid off after a little more than 10 years and the portfolio begins to accumulate cash. At the same time, the portfolio continues to purchase additional stocks and ETFs to further grow its earning power.

The Bottom Line
Average market participants continually reinvest gains and losses - in other words, if they have $100,000 in stock and the market goes up 10% the next year, then they have $110,000 invested. They let the market make their reinvestment decisions for them.

Leveraged investors have more choices but can get into more trouble. Investors who push the limits of their borrowing capacity can put themselves in situations where they have a declining asset base but accumulating interest due - just attempting to maintain a consistent leverage ratio can lead investors to overtrade and sell too many shares in downturns.

In order to avoid these cash flow crunches, investors should determine the appropriate level of assets and/or debt for themselves based on the ability to handle interest payments and market fluctuations. The investors should then maintain these asset and debt levels over time and adjust them based on their changing financial situation rather than the market's daily whims.

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