Dwarves are sometimes only human.
After our fellow dwarf Hulrum’s adventures in cost averaging, cost averaging with variable size to boost returns and mitigate downside, and fees in the dwock exchange cave, he somehow got a bit bored by the slow growth of these useful but rather conservative strategies.
So, one day, Hulrum decides to meet his friend Bheldan Grumblebelt. He asks him if Bheldan possibly could lend him a few ickles (dwarves’ money). Hulrum’s gnometastic plan is to use both his and Bheldan’s ickles to invest in the dwindex (i.e., the dwarves’ stock index). Bheldan agrees, if Hulrum pays him a few ickles in interest — so in the end, hopefully, both are happy: Hulrum will make more ickles in the dwock market and get higher returns from investing both his and Bheldan’s ickles — and Bheldan, in turn, receives some interest for helping Hulrum, which he (of course!) plans to instantly reinvest in the delicious pixie stout beer from his friend, the brewer dwarf.
Before pursuing this great idea, or so he thinks, Hulrum decided to open the tunnel to our world of humans again and ask the author about his opinion. The author, still desperately hoping for one of his many wishes to be granted by the dear dwarf, agreed happily.
Disclaimer: the following content is for informational purposes only and does not constitute financial advice. Do not take any decisions based solely on my writing.
Dear Hulrum,
what you plan to do is called “leverage” in our human world — just like a mechanical lever serves to multiply force, a financial lever serves to multiply returns. I created two scenarios for you to assess your plan: An upward scenario and a downward scenario. Both are created from real-world return distributions to serve as a reliable basis.
The scenarios are (roughly) mirrored, and “close” stands for “Close Price”, so price at the end of each day. Let us assume that you take Bheldan’s and your ickles and invest all of them into the dwindex at one go, starting right next month. After that, you intend to hold your dwinvestment for one year before you (hopefully) pay out yourself, and, in turn, your friend Grumblebelt.
Let’s have a look at three possibilities in the chart below: In the first case, you will only invest your own ickles (say, 10000 ickles). No ickles are taken from Bheldan, which means there’s no lever (the multiplier is 1). In the second case, you lend further 10000 ickles from Bheldan, so you have 20000 ickles to invest — double the amount you had in the first case — and, thus, the multiplier is 2. In the third case, Bheldan is very ready to take risks and believes in your abilities a lot. He gives you 40000 ickles, thus you have 50000 ickles now and a leverage of 5.
Think about the first scenario. What happens if the dwindex goes completely to zero? You will have lost all your money, no less (let’s say, there are no fees), but also no more. If you have a leverage of 2, after the dwindex goes to half of its value, your 10000 ickles will be lost. But what about Bheldan now? I guess, he will get very nervous about his ickles now — and he’s not going to wait. So, he wants his ickles back, and you will have to sell your (or rather, his!) remaining dwindex shares. (In our world, we rather borrow money from banks and brokers than from dwarves— and in such a case, they will reach out to us for a “margin call”). Now you lost all your money, in spite of the dwindex just losing 50 %!
Even worse, in the „highly levered” third scenario, a drop in the dwindex of just -20 % is enough to kick you out of your dwinvestment. Furthermore, Bheldan will additionally want his few ickles in interest with no regard of your losses. And there may be fees! So, Hulrum, be aware of the risks!
Now we apply your leverage to our two scenarios (downward and upward). You will notice that especially under high leverage, these risks really materialize (upper row, leverage = 5).
But not everything is bad about your idea. Suppose the dwindex moves up (lower row), you’ll have a large increase in your personal return — even after you will pay a few ickles to your friend Bheldan for lending his money. (For simplicity, interest is not depicted in any of the charts.)
To sum it all up — what happens in the scenarios?
In the upward scenario, your return will increase (roughly, no interest and fees considered) in line with your multiplier — i.e., the amount you lent from your friend. So, in the upward scenario with lots of leverage ickles, you might even double your money! But this holds also true for losses in the downward scenario. And if you hit rock bottom (pun intended), as in the downward-leverage-5-scenario above — see “Hulrum’s broke” in the figure — you will at that point in time either have to get additional funding from your personal ickles (to calm down Bheldan, or the brokers/bankers in our world) — or else the -79.1 % return will actually be -100 %, as you won’t make it throughout the whole year. So, choose your leverage carefully — and in bad and uncertain times, refrain from using it at all.
Dear human friend,
Thank you for this helpful (and yet, compared to my beloved gold mining, a bit dull) elaborations. Somehow, my risk appetite is not so large anymore… but nonetheless, maybe I can use this idea for some small speculations. What about just investing in the brewery in the springtime when our dwarves’ beer gardens open? It would be great to know what would happen if I specialized a bit…
Yours gleamingly
Hulrum
For curious dwarves who want to dig deeper:
- The studies were conducted using the “margin” and “mult” arguments in backtrader’s “setcommission” function. The slight difference in calculated begin-to-end returns, compared to the randomly generated scenarios, stems from a (indicator-related) few days delay until the one-time investment is made. Fees and interest payments to Bheldan Grumblebelt are not considered in the graphs, but only discussed. Fees and/or interest are, of course!, significant if dwarves plan to implement more elaborate dwinvestment systems. This dwarves story series is made for beginner dwarves.
- For more on cost averaging with and without variable size, see the previous Hulrum stories (here and here). There you’ll also find more information on how the financial time series used here are constructed (random walk / not a normal distribution).
Coding dwarf’s acknowledgements: Studies were carried out using backtrader (https://www.backtrader.com/) in Python within the PyCharm IDE (https://www.jetbrains.com/pycharm/), among other libraries. Thank you to the developers for providing such great user-friendly and reliable tools.
DISCLAIMER: This article presents my own learnings based on studies generated on synthesized (random, i.e., artificial) data which is statistically similar to real-world time series, and personal experience. The content is, thus, purely educational. Past performance is not reliable indicator of future results. The article should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.
