Extreme Investing

snowboard, alpine, flip, extreme sports

I am still young and can take big risks when investing. Or at least I like to think so. But hey, I’m also still of the opinion that I haven’t hit middle age.

The point is that from an investing standpoint, most people who are younger than forty should be focusing their portfolio on growth and that means taking measured risks.

Risk is something that I have always loved. I’ve always been interested in snowboarding, skateboarding, biking, and all types of extreme sports.

I like taking big risks and have done so in the past

Big Risks

When I was younger (and yes I know that saying “when I was younger” makes me sound old: but I am still young!) I took a lot risks. And I still like to take a lot of risks. But I have always been really careful too! That’s something that a lot of people who don’t do extreme sports don’t understand. You can take risks but still be safe.

Someone might look at the picture below for instance and think, “wow that is too risky for me – I would never do that!” But to me that looks fun! I love being outdoors, swimming, and jumping from cliffs into water.

waterfall, jump, falls creek falls, tennessee, cane creek falls
Measured Risk = Large Reward

This picture is in fact a picture of me when I was a little younger. Ok I was a lot younger.

Here is what happened when I jumped off of an eighty-five foot waterfall at Cane Creek Falls in the Falls Creek Falls state park in Tennessee.  I know that is a mouth full but I didn’t name it; I just jumped off of it. If you go to the link there is a great picture and near the bottom of the page and a really interesting video as well.

I want to talk about taking risks and I think jumping off the waterfall is a good example of taking measured risks just like you do when investing.

Cane Creek Falls Jump

In the summers I used to go to a week-long camp in Tennessee. It was one of the highlights of my youth! We also played a lot of basketball and did some interesting excursions.

One of the activities was to visit a local state park and go swimming. So we went out to this state park with a bunch of people that we had just met started exploring.

When we got there it was absolutely amazing! The trail to get down to the swimming area was a challenge in itself. If you look at the short video you will see that the descent to the base of the falls involves navigating a steep rocky slope while holding a metal cable. I don’t think you would see anything like this in the highly litigious mid-atlantic region where I live. They would probably put a huge fence up with barbed wire to keep people out so that no one would get a scrape or hangnail. Babies!

But back to the story. As we were swimming below the falls, one of my friends said, “hey – do you guys want to jump off the waterfall?”

I immediately said, “No way, that is a horrible idea and someone could get killed.”

So they started swimming around under the falls and going 8-10 feet deep under water to make sure there were no rocks or logs and to see if it was safe to jump.

They finally decided to go up to the top of the falls “just to look” and I figured it wouldn’t hurt to go up with them. Who knows, someone might actually jump and it would be interesting to see what would happen.

But I told them there was absolutely no way I would jump. It was too risky.

When we got to the top I was even more sure that jumping would be unwise. I felt like I was standing on top of a skyscraper and looking down at a street below. The people swimming below us looked like little specks and we couldn’t hear more than a faint noise when they yelled up to us.

So my friend said, “I’m going to jump.” And I couldn’t believe it. I tried to reason with him. It would only take one awkward slip and he could get off-balance and hit the water at a funny angle. That would be it: neck broken.

But he is a HUGE risk taker. So he jumped!

It was crazy. He gently pushed off from the edge as us, and several other onlookers, gasped. It was great though! He dropped into the water, came up a few seconds later, and gave us the thumbs up.

So now I knew that it could be done. The test had been performed. There was solid proof right in front of me that on this day, in these conditions, at this water level, the jump could be completed safely.

But there was still a huge risk. I could still slip. I could still hit the water at a bad angle. Maybe I would land in a slightly different location where a rock or log was hiding.

But it was now a measured risk. It was now a risk that had been tested. So what did I do? I did what any young man looking to have fun would do: I jumped!

It was incredible. I felt like I was in the air for minutes and I was trying to figure out when to take the final big breath before impact.

Upon impact, I went 10-15 feet underwater. It was great. The reward was well worth it. But I didn’t run up to the top and do it again. Once was enough.

Extreme Investing

Investing is personal and should reflect your personality. You should do the wise thing and understand the fundamentals. But you should also do things that reflect who you are. (I hate Bonds by the way.)

And that is why I take a lot of risk as an investor. I am extreme and I love excitement. Taking risks and reacting to new situations is what makes me feel alive. I like a challenge and I like to see some volatility and change from day-to-day.

So I have a huge position in my portfolio in a highly leveraged ETF. I think it is a wise move but I know that it is a risky one. It is a measured risk.

Could anything go wrong? Definitely. But I am taking the risk now because I am younger and have some years of investing to make up for any losses.

This is Extreme Investing. I invest in a 3x the DJIA ETF. What this means is that the ETF returns three times the DJIA. So if the DJIA drops by 10% then my ETF will drop by 30% – or more! This is a couple steps farther than a 100% allocation to stocks.  This is like a 300% allocation to stocks and it could blow up in my face.

Its the investing equivalent of jumping off of an eighty-five foot waterfall.

But I don’t actually plan to sell the ETF. If the market takes a dive and my ETF absolutely tanks, I plan to keep investing in it. Eventually it should come back.

Hedging

But the other thing I am doing is hedging. The idea behind hedging is that you have one position that makes money if the stock market goes up. But you have another position that makes money if the stock market goes down too much. Its is a little bit like insurance.

I keep open orders on index futures so that if the Dow Jones Industrial Average (DJIA) drops to a certain level, then my orders are filled and I own futures contracts which make money as the stock market declines. It’s a little complicated but it is worth the peace of mind.

Hedging isn’t something I see a lot of people writing about or that I hear a lot of people are doing. But it is a very important way to reduce risk. It’s basically like portfolio insurance. You pay a premium to insure against a certain level of loss. To continue the analogy, you set the insurance contract at a level which will let you take some loss and that is like your deductible.

So if the DJIA is at 18,200, I may set my open orders to automatically hedge my position if the DJIA goes below 17,495.  The 705 point decline that I do not have insurance for is like my deductible. I am willing to cover the loss on the 705 point drop myself, but I am covered with insurance for anything more than that.

Using futures contracts to do this is very effective because you don’t have to pay anything up front. Using index options can accomplish a similar thing but then you have to pay a premium up front and the value of the insurance declines over time and eventually the options contract expires and you have to buy another one.

And just like insurance the option contract premium is gone forever if you don’t use it. Most option contracts expire with zero value just like most insurance contracts don’t result in claims.

What do you think? I love extreme investing but it requires a lot of effort, research, practice, and risk mitigation. It’s just like when you are snowboarding and about to go into a big jump. You better know where the landing is, practice your technique, and have good health insurance if something goes wrong!

What do you think – are you up for taking big risks?

Author: Patient Wealth Builder

I live in the Mid Atlantic region with my wife and children. I am a finance manager for a Fortune 100 Company with over 10 years experience and have an MBA and CPA - but my true passion is investing!

15 thoughts on “Extreme Investing”

  1. Hi Patient Wealth,

    I like your blog. Keep up the good posts.

    As for the leveraged ETF’s I would recommend that you don’t hold this for a period of time as you are naturally facing negative returns as options contracts needs to be reset on a regular basis with these type of funds. They are meant to be traded in the short term swings and not held as a long term investment. When the market moves up and down time after time you can see that the fund value drops over time. I learned this the hard way a few years ago holding a leverage ETF that was triple short the financials (SKF).

    Good luck to you.

    -Mike

    1. It depends on how the leveraged ETF is getting their leverage. I have found that over the medium term there has been no problem as they are using swaps and futures contracts to the get the leverage. These contracts are unlike options in that they don’t lose value over time. I might write a post exploring that but the short story is that options have part of their value from time while futures do not. There are some interesting ways that these leveraged ETFs function over time due to the compounding of daily returns. For instance, if the DJIA were to rise 10% slowly over two years. It is very likely that due to daily compounding, the ETF I own would increase by more than just 30% (3x the DJIA). Conversely, the losses would also be worse.

      1. If you can test this over different periods of time and have evidence that this is consistent then the strategy should be more robust. Thanks for responding.

        1. I did some reading about the 3x leverage ETFs before I bought them and there are some pretty interesting illustrations out there about how this works.

          But basically since the ETF is designed to return 3x the DJIA on a DAILY basis you have a compounding effect which can magnify gains or losses. Here is an example of how the math might work. An index goes from 100 to 120 over two days. This 20% gain happened as a gain of 10 points on the first day and 10 points on the 2nd day. So the first day it was a 10% gain and the second day it was a 9% gain (10/110). First note that because of compounding interest you will notice that the two daily gains of 10% and 9% don’t add up to 20%.

          With the underlying index moving in this way the ETF would give a return 30% on day 1 or 30 points (ending at 130) and 27% on day 2 or 35 points (ending at 165 which is the sum of day one ending of 130 + day two gain of 35 = 165). So the 3x ETF ends at 165. This is clearly a total of a 65% aggregate gain. But you might intuitively guess that the 3x ETF would turn that 20% gain into a 60% gain. This DAILY return aspect therefore has a magnifying effect and should be understood before investing. It works similarly in a declining market!

          I did a pretty comprehensive back-test of this from 1920 to the present day to see how a leveraged ETF would work and it was pretty extreme! Perhaps I will post that in the future.

          This is why I hedge my investments so that I have a margin of safety if the market crashes. Its an interesting topic – to me at least! I would be interested in any more questions or thoughts you have.

          1. Very interesting strategy, PW. I’d love to hear more about why you are so comfortable with this and the results from the back-test. I don’t know if I’m ready for this level of risk, but if there was a serious pull-back in the market, I would consider buying this at the bottom and trying to ride it back up.
            The Green Swan recently posted…Feed the Beast!My Profile

          2. That’s not a bad idea to pick up some shares of the leveraged ETF on a downturn. Just be comfortable holding it patiently for the long-term. That’s a great question about why I am so comfortable with this level of risk and a great idea for a post on the back-test. I’ll put that topic in my queue. The back-test actually scared me to death but proved that the investment won’t go to zero.

            The short answer as to why I am comfortable with the risk is that I hedge my position using futures contracts. This is a really straightforward strategy used by all the banks and hedge funds on Wall Street. You basically buy futures that make money as the stock market goes down. But you only buy them when the market declines. The idea is that you participate in the gains as the market rises but limit your losses if it crashes. It is easier said than done – but if you set up some rules for your hedges it is very effective! Maybe I should do a post on that too and give some examples. I love blogging because the topics are endless! 🙂 thanks for the questions and ideas.

  2. I’m curious about the DJIA 3x fund – I’m assuming they’re using some pretty serious leverage to generate that kind of return. Do you know how much and at what interest rate?

    Given that information, it shouldn’t be hard to make educated guesses about what your returns could look like.

    There’s going to be a threshold where positive returns outweigh the leverage costs, and it’s not insignificant at 3x leverage.
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    1. I think you may be inferring that they are borrowing money. But with the use of futures and swaps, you don’t need to pay interest to get leverage. You can get 5x or 10x leverage using futures contracts and that is essentially what they do. There may be some custom features used but it is essentially a futures-like contract and not a situation where they are borrowing money to get the leverage and thus incurring interest expense.

  3. So, when it comes to hedging, you are actually shorting futures contracts (I.e. Selling not Buying). If you were buying you would just be adding to your leveraged position.

    What ratio of your position in terms long deltas are you hedging? is it a 1:1 ratio or something less. For example, if you were long 500 shares of the SPY, this would be the equivalent of 1 emini futures contract /ES in order to achieve a 1:1 hedge.

    Also, what is you plan for holding the hedge…meaning what is your plan if the hedge is executed but then the market reverses and starts going back up?

    I too would be interested in your back testing analysis as most of the leveraged ETFs have proven not to be good long term instruments. Whether it’s options or futures there is always some sort of drag to content with.

    Since they don’t use options from the leverage, you don’t have premium decay to contend with. But you do have the futures roll to contend with, you should research contengo and backwardation, which effects futures.
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    1. Right. I said “buy” to simplify for many readers who are unfamiliar. It is about 0.75:1 hedge ratio. I don’t get too precise with it. I always set up a stop order to execute the hedge and then I have a “one triggers another” order which automatically puts in another order to sell stop about 200 – 300 points away. So for instance, if I execute selling short a futures contract hedge at 17,800 that order would automatically trigger a buy stop at roughly 18,050. This way the “premium” I am paying is defined. So I can determine ahead of time that I’m willing to lose 250 points for the hedge in the worst case scenario. i.e. the market makes a big move down and a big move up. And it can do that.

      Ok – the people have spoken I’ll work on the back test. I have it partially ready but need to layer on a dollar cost averaging assumption.

      You should check into the index futures (Dow e-mini) because they are trading in backwardation which means a long position will increase in value ceteris paribus. So instead of a drag you are getting the wind at your back. Pretty cool.

      https://en.wikipedia.org/wiki/Normal_backwardation#/media/File:Contangobackwardation.png

      Thanks for stopping by and for the heavy hitting comments. Its cool to see some interest in this.

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