Just in case someone doesn't know about r/wsb and thinks it's just a degenerate gambling community.. they're sort of right but there's more to it. It is a community centered around self deprecating humor, basically people enjoy trying to become successful at trading, but they know the reality is that they're not very likely to succeed, so they share their trials and tribulations on r/wsb to make jokes about their own stupidity.

Some people are richer, either because they have good jobs, inherited or had prior success, so they lose more and the community enjoys their posts more.

The idea that you would do something stupid that costs you more money than you could afford (and possibly gets you into more trouble) just so that a group of people can laugh at you and make jokes at your expense is ridiculous, but I get that some people really crave that sort of attention. It goes a bit far to say that they get "social approval" from the community though.

While we are on the topic of leverage and index funds, can someone explain leveraged index funds to me?

If I believe index funds are going to have a positive return, why not try to lever it up as high as possible? For example TQQQ (triple leverage) looks pretty enticing compared to QQQ.

Leveraged index funds generally work as expected on an intraday basis - but they're not intended for longer term holds. You can of course try it, but things will not turn out as you'd hope. Here's an article describing what happens:

https://www.investopedia.com/articles/financial-advisors/082...

Outside of tracking error and expense fees, there is a more fundamental issue. When the market goes down X%, you need it to go back up Y = 1/(1-x)-1 to break even. So the market goes down 10.0% one day and then up 11.1% the next, an investor in the normal 1x is back to where they started. A 2x investor is still down and a 3x investor is down even more. So the average daily noise of the market kills you.

> So the market goes down 10.0% one day and then up 11.1% the next, an investor in the normal 1x is back to where they started. A 2x investor is still down and a 3x investor is down even more.

Can you explain why that is? I would have expected that your gain or loss from the leverage funds relates only to the difference in price between when you purchased and when you sold (multiplied by the leverage).

Because of the triple leverage, a 33.33% drop would entirely wipe out the fund. Back to $0. A 33% drop in a single day has never happened (1987 Black Monday was 22%) but it definitely does happen if you consider a longer time frame.

Hence why it's reset daily, as the other two responses explain.

And in case it's not been made clear enough: it's the very opposite of a sound investment. It's very much a risk management / trading instrument. It's something you would trade as a hedge or leg of a complex trade; not something you want to hold by itself.

The leveraged funds like TQQQ reset their leverage on a daily basis.

the leverage amounts typically "reset" daily (not always; read the prospectus) so if you lose 10% (say $100 => $80) at 2x your day 2 base is $80; a 10% gain that day would average out to 0 on net but you would gain 20% of $80 => $96

It really depends, see my blog post on the matter (part 1):

https://smabie.github.io/posts/2019/10/04/vol.html

In short, assuming a normal distribution, your max leverage ratio should be the future expected returns divided by the expected variance.

I’m not at a computer right now so I can’t run the math on real S&P returns, but assuming 10% returns and 10% vol and a normal distribution, the highest leverage ratio you would ever be able to justify is 10/10^2 or 10x leverage.

In my blog post I looked at the beginning of 2018 up to present. The ideal leverage ratio according to my equation (I’m sure it’s not novel, but haven’t been able to find anyone else talking about it), is 2.99x.

Of course, the more skew or kurtosis the distribution has the less accurate this equation becomes.

Right now I’m working on a hypothetical S&P ETF that adjusts leverage bases on forecasted volatility and returns. Almost impossible to get right, but my preliminary model has outperformed (not risk adjusted) any fixed leverage I’ve thrown at it.

You made a blog post that 10x leverage would be good given the past 12 months (where the market has mainly been up-up-up)? Doesn't that 100% ignore the effects of drag when the market goes down-down-down?

First of all, the market has not been exactly “up-up-up.” There has been massive volatility and drawdowns in the last year.

Second, my analysis was from the beginning of 2018 to present. Using that data, the ideal leverage ratio is 2.99x.

Third, the ret/var model put forth in the post assumes a log-normal distribution. The less log-normal the returns are, the less accurate it becomes. Excess kurtosis or skew will definitely affect the accuracy of the model. So the model would probably be fine if the market was up-up-up or down-down-down, I haven’t encountered any periods in which the non-normality of the distribution is so severe that it completely breaks the model.

This isn’t true. Market returns are almost always going to be higher than the borrowing cost. In fact, I can’t think of a single hedge fund that doesn’t use leverage either through: shorting, borrowing, options, or futures.

Leverage is almost always the secret sauce to institutional strategies. And if we’re talking about quant funds, without leverage they wouldn’t exist.

"Market returns are almost always going to be higher than the borrowing cost"

This sounds like perpetual motion to me. It's like Moore's law - no matter how long it's gone on for, it can't go on forever.

If everybody believes that, and people who actually control trillions of dollars do it on a massive enough scale, just borrow money and invest in stock, then it has to break things down at some point, doesn't it?

Due to volatility tax [1], there’s an upper limit on how much leverage you can assume. This amount is a function of forecasted returns and variance: r/var(r). The larger this ratio is, the more leverage you can take on. In general, just investing in the broad equity market with anything above 3-5x leverage over the long-term is probably unadvisable. So groups like hedge funds first reduce their volatility by going long and short, and then leveraging up afterwards. Even with market neutral funds (0 market exposure), the leverage applied rarely goes past 6x nowadays.

Banks are a little different and while the rules are complicated, big banks need to have around 3% of their total book at hand. Or in otherwords, they have around 33x leverage. Because of the leverage, banks need a very diversified uncorrelated portfolio in order to reduce volatility. No bank would stuff all of their money into equities, the risk of ruin is too high.

Also, there’s another perspective to look at your question: the efficient market hypothesis. In short, EMH states that in general, all investments have the same or trend toward the same risk/reward profile. That is, the ratio or slope of the returns vs volatility should be the same. With debt/credit, there are two primary options: you get paid back with interest or you don’t (let’s ignore bankruptcy). With equities you are assuming a lot more risk, the stock could go up or down or whatever. Since you are assuming more risk with equities than credit, it would violate EMH if you weren’t compensated for the extra risk.

This however, doesn’t explain why equities perform so much better than everything else. This is called the equity premium puzzle [2].

So maybe you’re right? No one really knows. Maybe the jig will eventually be up? Or maybe not, no one really knows.

[1] https://en.m.wikipedia.org/wiki/Volatility_tax

[2] https://en.m.wikipedia.org/wiki/Equity_premium_puzzle

I spent some time thinking about leverage and margin, and my thinking was

- I don't want to invest on margin unless the interest rate is significantly lower than stocks generally return

- as a rule of thumb, 7% is a conservative estimate for stocks in the long run, while a typical broker charges close to 10%. So it seemed like a non starter.

- however, it is possible to find rates as low as 3-4%, so then the question becomes how much leverage to use?

- my logic was, what kind of drawdown is plausible if you invest at a market peak? It appears based on known history that -70% could happen. Therefore it would be best to limit leverage so that more than a 70% decline would be needed to cause a margin call.

- which seems to lead to borrowing no more than 25-27% of one's equity.

for a large number of reasons it's hella hard to make money in finance. you can make whatever the vanguard index fund makes "for free" in your pajamas, so in order to justify your existence as an org within a financial institution you're going to need to put together some returns that are, obviously, way higher than that. so out come things like leverage and derivatives (=> hyper-leverage).

and yeah, there are failures, and they lose their shirts, and the beat goes on. but you're probably not going to make very much money (=> last very long) if your rate of return is the same order of magnitude as the collateral you're taking out. it's just not worth it from the POV of the bank.

But isn't much of their money being made from fees?

Clearly not, gains of the stock market are much higher than interest

But that is the exact opposite message that Robinhood wants to send (even if it is the correct message).

I think Robinhood wants to send the message that they offer a simple, elegant stock trading app. I feel (no proof) that they target people with net worths of less than $50k to come and trade a few stocks. AAPL, TSLA, NFLX, MSFT, GOOG, etc.

I don't think they actually want you to trade on margin. It's just, some people are addicted to volatility / the chance of "sweet gainz" and they see "regular Joe" posting pictures of turning $1k into $100k by making "the correct lucky" options trade, so they are down to try to do it too.

I don't think that's Robinhood's message. It's just a side effect of having an easy to use app with no fees.

> I don't think they actually want you to trade on margin.

Have you used RH? I use it for exactly your example, every other paycheck I put some in VOO and a bit on some individual stocks. They push Robinhood Gold so hard. There used to be a glowing gold banner at the top of your portfolio advertising to join gold and get $10,000 today or whatever.

Why don't you just buy VOO on vanguard considering there is no commission fee on vanguard when buy vanguard ETFs?

Because I'd still like to buy other stocks. There's also no fee on RH so what is the downside of using RH?

RH can simply not offer margin if they don't want their customers to use margin. "not handing out money" is the traditional way that anyone avoids the risk of losing money due to handouts.

I disagree. I signed up to check it out and they’ll consistently push notifications about upcoming earnings calls. They’re clearly trying to promote a very short horizon mindset