Leverage Selection, Geometric Returns, and Account Risk
Summary
This article explains why a strategy with a positive arithmetic average return can still lose money when returns compound. It illustrates the point with alternating gains and losses, showing that the geometric return better reflects long-run account growth. The article links this effect to how much capital is exposed on each trade and presents leverage as a central part of risk management.
It argues that stocks can also carry substantial leverage risk through margin borrowing, and contrasts that with futures margin. It discusses how account-level leverage may differ from an investor’s exposure across all assets, and warns that high leverage can make short-term gains unsustainable when a strategy inevitably experiences losses. The examples and market discussion are conceptual; referenced charts are not available in the text, and no detailed calculation method for an optimal leverage level is provided. Its claims should therefore be read as general risk guidance, not as a tested sizing formula or a quantitative comparison of asset classes.
Key ideas
- Arithmetic average returns can conceal losses caused by compounding, so geometric growth matters for long-term outcomes.
- The amount of capital exposed to a strategy affects the account’s realized risk and growth.
- Margin borrowing can create leverage in stock trading as well as in futures.
- Account-level leverage should be considered alongside an investor’s wider portfolio exposure.
- High leverage can magnify losses and make short-term gains difficult to sustain.
Tags
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.