On Leverage, Markets, and False DiversificationFeb 10, 2022
Three things to write about today: Markets, diversification, and leverage.
I’ve had many discussions recently about the current run-up in the market as well as some debates about leverage, especially as it relates to life insurance cash value.
When ever I get into these discussions, as it progresses, it usually boils down to the same ol’ discussion about rate of return.
My position is that strategy beats rate of return.
Current Events in the Market
Reading from the book Warren Buffett On Business, recently, I found an excellent passage about investing and speculation.
I haven’t seen people give him much credit for it, but one thing Buffett does really well is use analogies. I think it plays a part in his excellence at investing. In this, he has often been recognized for his ability to simplify the complex.
Here is the passage:
“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money.
After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities—that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future—will eventually bring on pumpkins and mice.
But they nevertheless hate to miss a single minute of what is one helluva party.
Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”
(BUFFETT, WARREN. WARREN BUFFETT ON BUSINESS (PP. 155-156). WILEY.)
One thing I’ve often found interesting is how people like to quote Buffett regarding how to invest …but seldom do they actually invest like Buffett.
I’m hearing a lot about people’s skyrocketing brokerage accounts lately. Yet, from what I’ve seen, there isn’t much about their recent success is based on any strategy other than jumping into stocks that are on the rise. And even worse, they are so focused on this recent run-up, that they are having a hard time leaving the proverbial ball.
And it’s not just the stock pickers. The dollar-cost-averaging, “invest for the long term” people have a problem too.
Here is a 20yr snapshot of the S&P 500, starting in ’97 – the year before I moved from Illinois to San Francisco and discovered a burgeoning “dotcom” industry:
During the first 10 years of my career in Silicon Valley, the gold standard of average investing reset back to the same levels. Twice.
A couple of questions that I like to ask about this:
- “If the market reset back to 1997 levels again tomorrow, would that be a problem for you?”
- “Knowing that resets also happen during retirement, how many more times could a reset like this happen before it became a critical problem?”
To quote Kiyosaki’s Rich Dad Poor Dad:
“It’s not how much money you make. It’s how much money you keep.”
With that in mind, my last questions would be:
- “At what point would it make sense to lock in some of the gains you’ve experienced and position those gains in a way that would allow you to take advantage of the coming changes in policy, taxes, and the market, rather than react to it?”
Thoughts on Leverage and “Diversification”
Most people are familiar with the idea of using “other peoples’ money” to create and/or amplify returns that would not be possible using our own money, directly.
Leveraging the value of a home to collateralize a line of credit is a commonly used strategy today. Lesser known strategies include bonds and even dividend stocks to secure lines of credit in order to then go out and buy other income-producing assets.
As we know, however, leverage works both ways. Losses are also amplified if things don’t go as planned. This circles back to Cinderella at the ball.
I find, more and more, successful investors, especially here in Silicon Valley, have been successful not because of any savvy investing, but by sheer high-income brute force that comes from the good fortune of having spent the last 20 or 30 years in the land of “unicorns.”
This brute force method of investing has left open what I think is a big blind spot when it comes to “diversification.”
How a lack of true diversification, combined with leverage, increases risk and hinders opportunity.
This brings me to my second quote from Warren Buffett On Business:
“The goal of investment is to find situations where it is safe not to diversify.”
(Buffett, Warren. Warren Buffett on Business (p. 166).Wiley.)
Two things regarding this:
- Not only is diversification anathema to value creation. Name a business that becomes successful by diversifying…
- Almost no one is truly diversified
The big blind spot in diversification is that the assets most people diversify into are, one and all, in the market or affected by the market. Remember 2000? Remember 2008? Nothing was safe during these total market corrections. Stocks, bonds, and real estate were all affected.
Think about what this means when using leverage. If the underlying value of the collateral for any loans or lines of credit is slashed by 30%, 40%, even 50%, what effect will that have on those loans? Will the loans accelerate? Will maintenance margins be reached, causing a call?
What about the opportunities that will be missed? In a market correction, when there is the proverbial “blood in the streets,” will a greatly-reduced, leveraged, and “diversified portfolio” provide the liquidity needed to take advantage of potential once-in-a-lifetime opportunities during a time when “it is safe to not diversify?”
Enter the life insurance policy loan
Whole life insurance cash value provides leverage in a way that is simply not available anywhere else.
- It allows the policy owner to leverage the net present value of a future guaranteed cash flow; the death benefit.
- The policy loan provision provides contractual, guaranteed, no-questions-asked access to capital. No applications. No qualifying.
- There are no payback terms on a policy loan. Interest will capitalize but if needed, both principal and interest payments can be deferred, no questions asked.
- Perhaps most notably, the underlying collateral of a policy loan is guaranteed by the lender (the life insurance company).
These guarantees make life insurance cash value a truly diversified asset class. And, ironically perhaps, having this true diversification allows for finding and investing in “situations where it is safe to not be diversified.”