Leverage a double-edged sword that can lead to ruin, warns Howard Marks in latest memo

When things in the market are positive, with the usage of debt yielding high returns, the attitude of investors towards debt turns benign, wrote Marks.

Renowned investor Howard Marks's latest memo - The Impact of Debt - has made a detailed mention of an article by Morgan Housel - the bestselling author of The Psychology of Money - elaborately discussing the importance of debt in investment decisions.

“As debt increases, you narrow the range of outcomes you can endure in life," said Morgan Housel.

The key reason to take on debt, also known an leverage, is simply to increase "capital efficiency", Howard Marks wrote, adding that debt is cheaper relative to the expected return on any equity instrument. It is also cheap relative to equity capital, thus making it an efficient tool over equity.

In casinos, Marks remarked he's often heard the pit boss say, “The more you bet, the more you win when you win.” Similarly, the more debt is deployed, higher will be the quantity and value of the assets you can own. The more you own, the great your profits will be, when things go well.

However, no one talks about the downside, said Marks. If your assets decline in value, loss of equity will be higher if debt taken up is high.

When taking on debt, the gains and losses are usually symmetrical and equally amplified. However, there is a downside risk to leverage that doesn't have a corresponding upside - the risk of ruin - Howard Marks said.

When the risk of downward fluctuation gets under-estimated over a long period of time, the use of leverage becoming excessive, Marks said in the memo. This can lead to the greatest leverage-related losses. While investors take in normal levels of volatility into consideration, Marks wrote, 'it’s the isolated “tail events” that saddle levered investors with the greatest losses.'

Also Read | How Howard Marks' advice on risk can help investors in the small, mid-cap spaces

When market are positive, the usage of debt yields high returns and the attitude of investors towards leverage turns benign, Marks said in the memo. The potential downside is overlooked and lenders are willing to offer more leverage, with investors keen on deploying more.

However, when the picture changes and the process is reversed, debt becomes a "bad word". Lenders are less willing to open their pockets and demand repayment of outstanding dues, which leads to investors seeing negative consequences, Marks added.

Therefore, "determining the proper amount of leverage has to be a function of optimizing, not maximizing." Investors should always use less than the maximum amount of debt, since leverage can maximise losses or lead to ruin.

Howard Marks said, "successful investments - perhaps enhanced by the moderate use of leverage - should usually provide a good-enough return, something few think about in good times."

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