What I Meant by a āSelf-Contained Engineā
A lot of the replies to my previous post turned into a broader discussion about leverage, which is completely fair. I just wanted to clarify the specific type of structure I was referring to.
For context, I am not opposed to leverage. My own use of it was partly inspired by Ian Ayres and Barry Nalebuffās paper, āDiversification Across Time.ā
Their lifecycle approach begins with up to 200% stock exposure, meaning $1 borrowed for every $1 of investor capital, and then gradually deleverages as the investor accumulates more financial wealth.
I did something similar with XEQT at IBKR. I chose a level of exposure I was comfortable with and used employment income to bring it back toward that target when necessary.
The percentage also does not tell the whole story. Two investors can both have 200% exposure while taking on very different levels of practical risk.
In my case, the amount actually leveraged was relatively small in raw dollars. My TFSA, RRSP and FHSA were already maxed at the time, and I had employment income available to support the position.
That is very different from being leveraged to the gills, where a normal market downturn could lead to margin calls, forced selling, or the need to sell unrelated investments to service the debt.
One of the main reasons to use leverage is to increase your exposure to assets you expect to produce higher returns over time.
Being able to maintain that exposure through a drawdown matters because it allows you to participate more fully in the recovery and the strongest green days that follow.
If the structure forces you to reduce your exposure after prices have already fallen, it can undermine the original reason for using leverage.
What I was referring to in the previous post was the idea of building a supposedly self-contained system while accepting that other investments may need to be sold, margin calls may occur, or outside money may be required to keep everything running.
At that point, the system is not really self-contained. The rest of the portfolio and your outside income are part of the engine, whether they are described that way or not.
I also think having several circular engines operating at once adds unnecessary complexity. One investment provides distributions to service a loan, another asset provides collateral, and other investments are expected to cover any shortfalls.
It can all appear sustainable while markets are favourable, but a broad downturn can put pressure on every part of the structure at the same time.
Everyone can choose how they want to approach leverage. I am just writing out my own notes on which structures seem robust and which ones depend too heavily on favourable conditions.
