March 24, 2014

This is a follow-up to my previous article on leveraging, where additional explanations were required to make my point clear. The formula presented lets one "control" an acceptable leveraging factor without changing much to the long-term output (as a matter of fact, less than 1%). And even there, it will be to one's advantage.

What was presented was close to the minimum capital requirement of an idealized scenario to show that simply buying on the way up using accumulating profits could do wonders long term. It is the same principle at work as reinvesting dividends. The Berkshire scenario is a real-life example of what could have been done over the last 50 years. It is not unique. It only provided a case with no dividends and no splits to account for. Other candidates could have been used just to name a few, but with added calculation adjustments:

Some Potential Candidates

Potential Candidates

(click to enlarge)

The trading strategy is based on equations that predetermine all future trading decision points. You simply change the parameters to suit your needs, preferences, or objectives. The equations should be used as guidelines and adapted to anyone's own desired trading style.

It's also just a starting point. There are more elaborate functions that can be added to the mix to make the trading strategy do what you want it to do. You will see these notions covered often in all my papers and research notes. I find it one's responsibility to solve to one's own satisfaction any of the little problems one may encounter, especially when they are so easy to solve.

If one finds the initial leverage factor too high, a simple solution is to reduce it to a more acceptable level or eliminate its use altogether. The formula is not set in stone. It was designed to adapt. I've always considered the use of leverage as trivial a problem as commissions in this type of long-term trading strategy.

For example, in the presented scenario, increasing the initial stake to $100k will have on the second trade a starting portfolio leverage set at 10%, which I think might be quite acceptable to anyone. If that was still too high, increasing the initial portfolio size to $200k will reduce the initial leverage factor down to 5% of the portfolio. Note that if one adds to the initial working capital, it will also add to the bottom line down the road.

In the above cases as the price increases, the leverage as a percent of portfolio value will decrease relatively quickly to less than 1% of portfolio value but would still not reach zero. Therefore, initially, there could be a cost associated with the leveraging factor. However, simply by keeping cash reserves, the initial leveraging can be eliminated, as shown in the following chart, which covers the first 100 levels:

Leveraging Factor

Leveraging Factor

(click to enlarge)

One can approach full market exposure (leveraging factor of 1.00) from both sides or have it tend to 1.00 as much as possible. It is all a question of trading style and preferences. I've always considered leveraging trivial since the added portfolio performance more than compensated for whatever the leverage financing was or could be. It is the reason I usually don't consider it; it is of little concern.

Say, for a starting $100k Buffett scenario, with a 10% interest rate, I might have to gradually pay up to some $30 to $50 million in interest payments over the long-term horizon. But, on the other hand, it also makes 4 times the Buy & Hold on the initially added shares (8,000), giving 4*240M = 960M to cover the added expense. I do think that it more than compensates for the added "cost" of doing business. An estimate of the commissions for the presented scenario would average somewhere around $25k, again a trivial sum not worth considering compared to the long-term payout (see the chart in my previous article).

Note one is only leveraging the new position taken since, at any step along the way, one could have liquidated the entire portfolio and bought back exactly the same number of shares at the same price, giving access to all the capital (accumulated profits included). US accounts use marked-to-market so that you don't have to sell at each level in order to use the accumulating paper profits. Also, nothing stops someone from time to time to liquidate some shares for un-leveraging purposes.

The leveraging factor depends on the new position size taken over the existing inventory. Using a trade basis of 100 shares in the 10,000 shares scenario will make it 1% leverage which from there will decrease as you increase the inventory; but will also decrease as the price rises to the next level where it will be 0% again before you purchase your next share block at the new level reached. Using cash reserves put aside to compensate for this leveraging is only a matter of choice.

This trading technique is not a pipe dream. It's more likely just a compromise of sorts. For someone not wishing to use initial leveraging, simply put more money on the table, you'll get it back anyway (with interests). How much is one ready to pay to outperform Mr. Buffett's long-term 100:1?

I can easily understand that someone is not ready or unwilling to use equations to direct his/her long-term trading decisions. However, I would still suggest that one investigate these equations on their own and find out how one can benefit from them. IMHO, the long-term prize is more than worth it. One could simply put 10% of his portfolio on such a long-term endeavor, follow the equations at their own preferred settings, and find out, with time, that it might have been their best move ever.

What is presented is a slightly different point of view on designing a trading strategy. It lets you explore alternatives based on mathematical equations as trading decision points. A stock price does not rise, the above scenario produces no profits and no additional purchases as should be expected.

When you design a trading plan that is made to last 50 years, you will have to wait a long time before showing some results. Having taken a long-term view of the stocks you want to trade in, then you can preset how you would like to deal with them over the years. That's why we design trading strategies. I still won't know what the market will do or how a particular stock will fair over the years, but I will have set my rules of engagement. To me, it's like saying show me profits, and I'll buy a little more of your shares as a measure of encouragement and as a positive feedback mechanism; the more profits you show me, the more shares I'll buy.

No one is being forced to use in any way what's presented. It is up to each one to evaluate if the backdrop of this kind of trading technique is for them or not or if it is worth exploring at all.

Created... March 24, 2014,    © Guy R. Fleury. All rights reserved.