Analysis of Asset Allocation

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Financial Leverage : DANGERS
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Leveraging a portfolio is dangerous. The purpose of this section is not to encourage you to borrow money but well to explain the leverage mechanisms.

DANGERS OF LEVERAGING

As we have seen in the introduction, once leveraged, your portfolio is used by the credit institution as a guarantee for the loan you have received. As the credit institutions don't want to suffer any losses, they will try to sell your portfolio before the market value goes under the amount lent to you.

Of course, even in a not leveraged portfolio, you can loose totally the money you have invested but, provided that you don't need the money to do something else, you can always apply the following principle: "Till the loss is not realized, the investment can still recover and I can earn money".

Once the portfolio leveraged, this ability disappears and you can be forced at any moment to sell partially or totally your portfolio.

The risks of a leveraged portfolio can be classified in two major categories: market risk and credit institution risk.

MARKET RISK

That is the risk that the value of your portfolio goes down and, consequently, that the cover value of your portfolio is not big enough to cover you loan. To cover yourself against this risk, you should:

  • Try to reduce your portfolio's risk by diversifying your investments.
  • Never borrow close to the cover value of your portfolio. This will give you some flexibility if the market goes down.
  • Don't go on holiday with a fully leveraged portfolio you will not take care during some weeks.

CREDIT INSTITUTION RISK

The danger can come from your credit institution as well. Before borrowing and pledging your portfolio, read carefully the clauses you have in the contract. Pay attention to the following points:

  • The ability of changing the advance ratios without informing you. If the credit institution changes the advance ratios, you could be in a strange situation where the market value of your portfolio doesn't fall but where the cover value is not enough anymore to cover the loan. You should ask to your credit institution that, if they change their advance ratios, they must first inform you immediately and, secondly, leave you a certain time to readjust your portfolio or to bring additional collateral. Really pay attention to this ability to change the advance ratios because some institutions link their advance ratios to the volatility of the market.
  • Sell off procedure. You should require to have not only a close down procedure but also a top up. We can define the top up as a level at which the credit institution informs you that the value of your portfolio enters into a dangerous zone and gives you some days to decide yourself of the securities to sell and/or to bring additional collateral. In the close down (selling off your portfolio) procedure, you should require first to be inform before the credit institution starts to sell your securities and secondly to have the ability to select yourself the securities to sell.

 


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