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Berkshire Hathaway Inc. Message Board

  • goofybot_7 goofybot_7 Dec 23, 2003 4:15 PM Flag

    On different kinds of leverage

    Generally most types of leverage will not make you rich, on the contrary, long term effect is actually negative. Occasional great losses compensate for amplified winnings in the long run. Besides, your losses are amplified more than your winnings.

    Now each kind of leverage individually:

    1) issuance of common stock in the business you run and own. The only winning kind of financial leverage. Your winnings are amplified, while your loses are not.

    2) Debt. Both winnings and losses are amplified at the margin. Greater moves in either direction amplify losses faster than winnings. At some point you may lose more than you have invested.

    3) Short selling. Not really a leverage. But you stand to win much less than you can lose. Also can lose more than invested.

    3) Stock options. Stock price movements are amplified in both directions in terms of percentage change. Both winnings and losses are amplified, but losses will never exceed what you have invested. On the other hand, low liquidity leads to very high transaction costs.

    4) Futures. Act very much like debt, only without interest and the amount of debt far exceeding invested amount. Winnings and losses are greatly amplified compared to trading the straight underlying asset. Can lose FAR more than invested.

    Conclusions: if you want to get rich, avoid debt and derivatives and put your best efforts into running a business or predicting which assets will move up the fastest with minimal chances of dropping.

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    • Hmmm ... this is just a math curiosity I guess. But the whole idea of a long-term average is much shakier than it sounds. The problem goes right down to the nuts and bolts: there's no particular reason why an otherwise innocent-seeming series of prices need reveal its long-term average, or even *have* a stable average over any length of time, however long.

      For example, "the stock market" supposedly has provided 10% average gains for multi-decade-timescale investors, over a century or more. But I've also seen other "commonsense" figures for pretty much the same century: 3%, 8%, and 12% come up too, as best fits (not just endpoint ratios) over similarly huge lengths of time (50+ years). And that's the *historical* data!

    • Yeah ... that is sort of what scares me about that idea. You can cook up a bet at 6:5 odds or something, and yeah, you usually win. But that doesn't tell you much until you've done it a couple dozen times.

      So suddenly everybody I talk to is selling options. I feel like a dinosaur: analyzing stocks full time and I don't even have an opinion on what my friends are playing.

      But an opinion is slowly growing ... The last time I felt like such a dinosaur, everybody had doubled their money in dot-coms and telecom.

      :-(

    • xiefotah noted:
      >short term capital gain taxes, commission cost
      >and you prozac co-pay costs. Much better off
      >buying and holding a basket of nice value funds.
      >But the action beckons me in the night like a >sickness that must be fed. The journey is the >destination.

      Yeah I have that problem bad sometimes. Especially when all my stocks are especially "value-oriented" for a few months. I just need to TRADE ... just one hit!

      I have a little account that I use when I want to unleash the full power of my financial acumen on an unsuspecting market, free of sissy-boy risk controls. So far I've almost broken even!

    • >It can be very stressful even with small amounts
      >of money because of all the monitoring and rooting. :-)

      Absolutely! If I don't show up and cheer for my options, rain or shine, then where's their motivation to perform?

    • <<I wasn't trying to imply an exact percentage like 20 successes and one failure. I was more or less saying that it is possible to have 20 successes in a row, conclude you are a genius, and still not really have the best of it. :-)>>

      True. I agree with your original point you were making. I've seen it too. I've seen speculators buy simply because something is beaten up regardless of fundamental merit. Buying stocks because they're going up via the greater fool theory is following the crowd. However, adopting a blind contrarian approach by simply buying because other people are selling is just as mindless and dangerous. There has to be some type of filter there to catch the ugly debris.

      -TF

    • I understand your point.

      I wasn't trying to imply an exact percentage like 20 successes and one failure. I was more or less saying that it is possible to have 20 successes in a row, conclude you are a genius, and still not really have the best of it. :-)

    • I've been selling puts for over 20 years,in my taxable accts and my IRA. Remember,in taxable accts its all short term gains when the puts expire so uncle sam has 1/3 of your action on a free roll. The VIX, and put premiums are @ 7 year lows. Does anyone think the downside risk in this market is at 7 year lows? Do you really want to book downside risk,at this time,from these levels,after this monster rally? Be VERY careful my friend and make sure you understand the risk.

    • <<So assuming the 21st time you made a whopping mistake that took 70% away from your pincipal, you're still left with $26,020.>>

      "If your 21st time is Enron you're left with $0."

      Or to put it in the words of Homer Simpson:

      "DOH!!"

      -TF

    • <<So assuming the 21st time you made a whopping mistake that took 70% away from your pincipal, you're still left with $26,020.>>

      If your 21st time is Enron you're left with $0.

    • <<Sometimes the reason a stock is down is because of the potential of a low probability negative event. If that event does not occur, you win. If you didn't even understand the issue to begin with you were lucky. Given that these negative possibilities are often low probability events, you might win 20 times in a row and think you are genius when in fact you are clueless. It just takes a long time for the probabilities to catch up to you.>>

      I understand what you are saying and I agree with the majority of your post. For fun, let's take a look at the math though.

      If you win 20 times in a row and make 25% as an average gain on such conditions in a tax free environment like a Roth IRA, then if you started with $1,000 you would end up with $86,736. So assuming the 21st time you made a whopping mistake that took 70% away from your pincipal, you're still left with $26,020.

      If it took you 10 years to complete that 21 stock cycle then your average annual return would be 38.5%.

      If it took 15 years to complete, your average annual return would be 24.2%.

      If it took 20 years to complete, your average annual return would be 17.7%.

      If you were lucky 10 times in a row and gained 25% each time that $1,000 would grow to $9,313. If you made that -70% in that 11th time your FV falls to $2,793.9 (it doesn't matter when that -70% stinker comes in really). Still, over a 10 year period that's an average annual return of 10.8%, right were the long-term stock market average lies.

      -TF

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