CONTRIBUTION Leveraged investment: rationale and animal spirit
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By Jeon Yong-bae
The prices of eight listed shares have fallen by over 80 percent in just a week due to a large-scale selling spree via Societe Generale, and news of stock price manipulation and arbitrage trading are flooding the media.
It is not yet clear what the truth is, but some people have made big profits and others have suffered big losses. In any case, this incident has taught a painful but important lesson about the risks of stock investment, especially leveraged investment (borrowing money for stock investment).
Jeon Yong-bae
The full story of this incident will be revealed through investigation by the authorities, but leveraged investment is the key to this scandal. Securities companies may lend customers money for stock investment through credit loans. That is, a customer is able to borrow 2.5 times their investment principal from a securities company in order to buy stocks, and the stocks are secured as collateral. If the stock price rises, the investor can make more profit, but if the stock price falls, the investor can suffer a big loss and even lose the investment principal.
Contract for difference (CFD), an arbitrage trading instrument, is an over-the-counter derivative product that adds to this trading structure, in which the securities company trades on behalf of the investor and settles profits and losses. Since the investor does not appear on the front, wealthy asset owners can avoid investigation into trading history or save taxes, while securities companies can earn profits through trading activation. It seems like a win-win situation, but it is also a high-risk leveraged investment.
In a rising stock market, the temptation of a leveraged investment is very high because you can make a larger profit with a credit loan than with just your investment principal. However, it becomes a completely different story when stock prices fall. If you invest 2.5 times leverage with a margin and the stock price falls by 40 percent, you lose your entire investment principal and it becomes zero. If you had not used leverage, you would still have 60 percent of your investment principal left.
The world of investment is a battlefield between "rational thinking" and "animalistic impulses." Rational thinking can detect the risks of leveraging, but animalistic impulses tend to drive investors to pursue rewards for success rather than risk. The stock market is full of retail investors, dubbed “ants” in Korea, who dream of a big break. They jump into the flames of risk like moths, pursuing expectations, hope and excitement rather than reasonable profits. Victory in the ant war goes only to the 1 percent minority armed with rationality and restraint.
Investors tend to fall into "confirmation bias.” People interpret information in ways that are advantageous to them, accepting information that is consistent with their beliefs and ignoring information that is inconsistent with them. People also fall into “overconfidence traps,” where they overestimate information, ignore new information, or do not listen to others' opinions, even if they are wrong.
"An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return,” said Benjamin Graham, who started working on Wall Street in 1910. He emphasized a stock valuation theory based on the stable financial structure and long-term profitability of companies, to buy undervalued stocks based on the company's intrinsic value and to invest in them for the long term. He presented the image of a cold-headed investor who develops the ability to resist human nature following the crowd.
During the go-go years when the stock market is rising, it seems like you are surrounded by people who have made money. This is the FOMO (Fear of Missing Out) phenomenon. Fear of falling behind or being excluded suppresses rational thinking and leads to impulsive investment decisions.
Today, various investment broadcasts and online media are targeting our desires and aiming for the pockets of vulnerable retail investors wandering around the financial market looking for profits. Although the Korean words for “investment” (tu-ja) and “speculation” (tu-gi) are pronounced similarly, their results can be vastly different.
The writer is a senior consultant and auditor of Franklin Templeton Investments Korea, where he previously worked as CEO, and is professor of University of Maryland Global Campus' MBA program.