Use of leverage and investment performance

Key Markets report for Thursday, August 7, 2025

With the development of internet brokerages, over the past 20 years or so, investing became “democratized” as tens of millions of individuals took the step of setting up retail brokerage accounts to manage their own portfolios. The trouble is that most of them by far lose money.

In jurisdictions where internet brokers have to disclose the percentage of their clients who lose money, the figures they disclose tend to be in the 70s and 80s. That’s consistent with the 2016 research report by the UK Financial Services Authority (now renamed as Financial Conduct Authority) which showed that 82% of all retail traders lose money. There are a number of reasons for this and one of them is often unrestrained risk taking

How much risk?

One of the important aspects of trading is setting out clear investment objectives and gauging one’s risk appetite. With online trading, gaining leverage is relatively easy and active traders are accustomed to see very considerable fluctuations in the value of their investments. This can lead to overly optimistic expectations: if my account can gain 2% or more in a single day, I should easily be able to double my portfolio’s value in a year. That, in a nutshell, is the temptation with online accounts.

It is clear that to generate investment returns, we must take risks. But how much risk we should take is not obvious. Our inner gambler always wants to press on the gas pedal to profit more, especially when we are trying to recover some previous losses. But like with driving, the harder we press the gas pedal, the more likely we are to get hurt.

Investment trading is a psychological challenge and excessive risk taking has a robust tendency to compound errors. Research from FXCM brokerage offered some interesting empirical evidence to support this. Namely, FXCM noticed that the higher the leverage their clients used, the lower the proportion of their profitable trades:

So, traders who kept their leverage below 5:1, scored about 40% of profitable trades; those that exceeded 25:1 only had 17% of profitable trades. What’s the explanation?

It’s about loss tolerance

If you bet correctly, the higher your leverage, the greater the profit potential. But if you are wrong, you have much less of a loss-absorbing cushioning, forcing you to abandon trades with a loss sooner. In the short term, market price fluctuations are close to random and this implies that your trade is equally likely to be profitable as it is to slip into the red in the short term.

If your risk management is sound you should be able to easily tolerate these temporary drawdowns. But if you are too aggressive, you might find yourself having to cut good trades at the worst moment. If this happens repeatedly, your profitable trades might not suffice to restore you to profitability.

I believe that even 5:1 in the above table is still too much leverage. Leading CTA hedge funds who should rightfully be regarded as a standard in robust risk management seldom exceed 3:1 or, if they do, the bulk of their leverage would be in market instruments with very low volatility.

Always drive in the slow lane!

Over the years, I have strongly recommended against seeking returns too far above 20% per annum. For some reason, many active traders think this number is too conservative and they believe they can do much better than that, but such optimism requires a reality check. Over the long run, best among the best active investment managers tend to generate net returns of around 15%-16%, or about 20% gross regardless of their know-how, sophistication or experience.

Believe me, if they could safely generate higher returns, they would, but they clearly tend to set their speed limits at about 20% gross. That level is what a realistic investor should set as their objective and this should be easily attainable with leverage well below 5:1. As we saw from FXCM’s research, driving your portfolio in the slow lane also reduces the risk of bad trades and it thereby enhances your odds of actually attaining your investment objectives.

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Today’s trading signals

With yesterday’s closing prices we have the following changes for the Key Markets portfolio: