One of the parts of The Framework Investing about which I am most proud and happy is the new method of measuring and managing leverage that I develop in the book.

This blog posting shows my current thinking about what I term Loss Leverage and Gain Leverage in the book and shows why a mixed allocation of stocks and options can be such a sensible, powerful asymmetric investment strategy.

Writing a book, one is forced to spell out all the things one has been rolling over in one’s mind. Because of this, the act of writing a book–if one sets out to write a good one–is in itself, a terrific education.

What I found, however, was that after I had submitted the book to my editors in NY and after the final mark-ups had gone to the printer, I realized that one issue related to Loss Leverage that I had in the book was, in fact, not congruent with the way I was thinking about it in my own investing.

When I pulled together the IOITools.com website, I made the corrections to the calculations there, but was not able to make corrections to the book by that time. Here, then, is a short and simple explanation of IOI Leverage calculations.

**Loss Leverage**

The main axiom underlying the IOI Loss Leverage calculations are that all realized losses represent true risk. No one can do any worse in investing than suffering a permanent loss of investment capital, so realized loss represents a hard boundary that an intelligent investor should seek to avoid or minimize. [1]

For the Loss Leverage calculation in the book, it includes a reference to a small amount of stock loss leverage, but upon thinking about this more, I no longer believe this amount should be included within the loss leverage calculation. The reason for that is simple?it is not a realized, permanent loss of capital.

So the Loss Leverage calculation is simplified to:

**Gain Leverage**

For the Gain Leverage side, I simply think of this as the relationship of two baskets of securities. One basket contains as many stocks as can be bought to bring the position to a ?full allocation? (i.e., if one wants 5% of one?s overall exposure to be to a given security, a full allocation is the number of stocks that brings the investor as close to that allocation as possible without going over). Whatever capital not spent on stocks is reserved as cash, though this is probably a very small amount.

The other basket contains some combination of stocks, options, and cash in a proportion that is determined by one?s risk appetite. The total capital at risk for this basket must equal the amount of a full allocation that we used to determine the number of stocks in the first, unlevered basket.

Just as the most profound risk is that of realizing a permanent loss of capital, the only return that should be counted as such is a realized gain of capital. So the potential return for both baskets is the difference between the present price of the stock and the fair value estimate we make as intelligent, insightful investors (which assumes we realize a profit at our fair value estimate for the stock).

So, if the stock moves from its present market price to our fair value estimate price, what will the value of the two baskets be?

Let?s say that the unlevered full allocation basket was originally worth $5,000 and is now worth $6,500. On the other hand, the levered basket is now worth $8,000. In this case, we compare the $1,500 of profit from the unlevered basket to the $3,000 profit from the levered one and see that the ratio of levered to unlevered is 2:1. This ratio represents the Gain Leverage of the investment.

IOI Leverage is simply the two numbers–Loss Leverage and Gain Leverage–displayed together so one can separate out both the risk and reward of the investment.

** **

**Asymmetric Investing**

Everyone who learns about options by reading a book other than The Framework Investing learns to think about options from the standpoint of hockey stick diagrams like this one.

While I think that this diagram is trivial in the context of a single investment, a very similar graph is profound in the context of a mixed allocation of stocks, options, and cash.

In the following picture, the slope of the black line over the stock price range of $0-$15 is much shallower than the slope of the stock price range from $15 and up.

This difference in slope is, in fact, shows beautifully an asymmetric exposure to a stock that is tilted more heavily towards a gain. The ratio between the slope of the line from $15 on to the slope of the line from $0-$15 can be thought of as a single, overarching leverage factor.

While this overarching leverage factor is a useful metric at which to look as well, I think splitting out Loss Leverage from Gain Leverage reminds us as investors of both sides of the risk / reward equation, and also ties us to something that really matters?potential gains and losses on an actual allocation of capital.

—

[1] Recall Buffett’s rules of investing. The first rule is “Don’t lose money.” The second rule is “Don’t forget the first rule.”