Collateral, Leverage, & Volatility: The What, How, & When To Invest

There’s nothing like a crisis to bring foundational investing principles to the fore. They lay all my triumphs and tribulations bear for me to see. Evasion is no longer possible. Assumptions, rationalizations, and truths are crystallized as profits and losses. This turbulence, though, is a crucible for learning. For me, the past few months illustrated how collateral, leverage, and volatility interplay to drive investment performance. I see them as the “what”, “how”, and “when” to invest, respectively.

So much of investing is focused on what to buy. Valuation, factors, price, and trend get all the attention. Naturally, the investments selected and the idiosyncrasies of the economic landscape drive performance. But as Daniel Want, the Chief Investment Officer of Prerequisite Capital Management, puts it:

“Throughout different times in history, what is considered a ‘collateral’ asset can change, in some circumstances collateral could mean cash, or certain currencies, or treasury bonds, or gold, or commodities, or real estate, or even certain types of equities at times. You just have to simply ask yourself… in light of how the system currently is structured and working within view of the predominant issues, (1) what things would rise with conditions of ‘growing confidence’, and (2) what things would likely rise in conditions of ‘growing demand for collateral’ (& collapsing confidence)? At different points in history you will answer very differently to these questions.”

Daniel Want, Prerequisite Capital Management’s July 14th 2019 Quarterly Client BRIEFING

As Want points out, there are factors other than “what” to consider when investing. How to own your exposure and when its best to do so are just as impactful. Want sees these as matters of collateral and confidence. For me, viewing investments through the lens of collateral, leverage, and volatility provides this perspective.

Collateral

I see collateral as the foundation of investing. Collateral are things directly exchangeable for currency with a direct use value. The value can be for consumption—like wheat; for accumulation—like a bond (i.e. a contractual stream of cash flows); or have intangible value, like a trademark. Even cash is collateral since its utility is to mediate exchange.

Collateral are assets in the most basic form. It’s the “what” in investing. iPhones, sneakers, advertising slots, computer code, electricity, transportation, cloud storage, and even people’s attentions are all types of collateral. They are the goods and services that we trade for every day in society. As investors, it’s collateral’s value that we ultimately seek exposure to and on which we speculate.