Traders carve their imprint on capital

Life is carved from time, as a carpenter carves his designs on wood. In the same way, traders carve their imprint on capital. In Dublin and Ireland more broadly, the financial crisis and the failed banks have carved their imprint upon the land. During my recent visit, it was difficult to ignore the recent wave of construction projects, some finished, some unfinished, usually emblazoned with shiny billboards noting 2007 completion dates.

Yet these various pockets of unfinished construction are hardly what a visitor notices first. The Emerald Isle is Europe's windswept Atlantic garden. Its Western shore has been sculpted by the Atlantic's fierce waves over the ages. Its countryside has a certain lushness and greenness, which can only be achieved through lashings of rain. Despite the financial crisis and later the Eurozone debt crisis, Irish yields have managed to recover and at least to my untrained eye, it does seem to be on the recovery.

Of course, this does not negate the damage done to the economy from excessive risk taking during in the pre-Lehman period. I recently had Twitter conversation (with @LadyFOHF, @SardonicaX, @PolemicTMM and @ericbeebo) on the subject of excessive risk taking. I used the term "excessive" leverage relatively casually, before I was asked to define it (by @LadyFOHF).

The difficulty is that the notion of excessive leverage is dependent on your viewpoint. Investors can obviously be classified by their capacity for risk taking. A pension fund's notion of excessive leverage is likely to be different from that of a hedge fund. We can all think of funds or sovereigns which have suffered when markets have turned, due to excessive leverage. Of course, such problems are not purely confined to modern times. Take for example the credit crisis of 33 AD, which was ominously similar to the recent credit crunch (more on that in my book!)

In a sense, the only way to understand whether excessive leverage is to try to assess what the potential downside is on a trade. In a "bad" scenario, how much could a trade lose? If the answer is too much to withstand the pain, then it's too much. Furthermore, if we ignore any diversification in our portfolio, what could be the potential loss in our portfolio? Again, if the answer is too much, it suggests that we have too much leverage. Diversificaiton can often fall apart during times of severe risk aversion, simply because correlations explode. Hence, an allowance must be made for this, when judging maximum losses in a portfolio.

The key point to understand is that excessive leverage can force investors to exit positions simply to remain solvent, regardless of their underlying views. Hence, what might eventually end up a winning trade could be exited early. Of course, you might find the opposite scenario, where a massive trade comes in your favour, but if the alternative scenario is being totally wiped out due to excessive leverage, surely that means the leverage was excessive?

As Keynes once remarked "Markets can remain irrational longer than you can remain solvent." So when you carve your imprint on capital, make sure it's a lasting one, at least in the positive sense.

My book Trading Thalesians also has some colour on understanding the risk of trading strategies and a discussion around targets investors can use (mixed in with a bit of ancient history).