Liquor, Ladies & Leverage

War and oil are back in the same headlines, and the harder question is not what happened but what to believe. Competing narratives, contradictory signals, and markets that are pricing one thing while geopolitics is doing another. The gap between the headline and the actual risk has been a running theme, and this week widened it further.

Crypto carnage has thinned the herd. Like all fads, a few got rich and many got poor, and the order of those two outcomes is not random. The people who got rich tended to arrive early and leave early. The people who arrived late, drawn in by the stories of the early movers, tend to be the ones left holding the loss.

Steve's framing for the week: situational awareness. The old line about the three things that bring down great men and great portfolios, liquor, ladies and leverage, is a reminder that the risk you need to watch for is rarely the one making the headlines. It is the one quietly building inside the structure of the system. This week that structure is leverage, in the form of private credit, margin debt, and an Australian property market that has gone from confident to quiet in a hurry.

We think every working Australian needs to understand private credit, because there is a good chance their super fund already has exposure to it. Being largely unregulated means investors are not fully aware of the risks, and there is very little protection when things go wrong.

The structure is straightforward enough. These are lending operations that sit outside the traditional banking system. They raise cash from wealthy individuals, pension funds and wherever else they can, and then extend loans to borrowers who cannot meet the credit standards of the major banks. During a boom it is extremely profitable: the lenders charge a hefty premium over bank rates, and the borrowers are just happy to receive cash they could not get elsewhere. But the higher rates come with a caveat: greater risk, and that risk is magnifying as the phenomenon grows.

Nothing much changes in finance, just the players. Private credit has a place, and if properly monitored it can be beneficial. But lenders operating outside the banking system and without oversight, in a world already awash with debt, could be the catalyst that tips sentiment from greed to fear.

This is general commentary on risks within the financial system. It is not advice to buy, sell or hold any specific product.

Most investors have heard that compounding is powerful. Fewer have sat down with the numbers and worked out what it actually means at their expected rate of return. The Rule of 72 is the simplest tool: divide 72 by your annual compound rate, and you get roughly how many years it takes to double your money.

Now think about what this means practically. If you invest in the S&P 500 at today's prices, the expected compound rate is roughly 3.4% a year. That is a double every 21 years. Add fees, add inflation, add tax, and the real purchasing-power return is headed toward zero or below. So not so great.

Contrast that with an investor who waits for the fat pitch. A 10% compound rate doubles your money every 7 years. The difference between buying at a CAPE of 42 and buying at a CAPE of 16 is not a slight adjustment. It is a generational gap in outcomes.

Here is the part the brochure never covers. Volatility eats away at compound returns, and the effect is not small. A 100% gain is wiped out by a 50% loss: you go from 100 to 200 and back to 100. That asymmetry is always working against you.

The long-run average volatility of the S&P 500 is around 17%, so call it 20% as a round number. At 20% annual volatility, the drag on your average return is roughly 2 percentage points per year. So an 8% average becomes about 6% compound.

Now push volatility higher, which is common at extreme valuations. At 30% annual volatility, you lose about 4.5 percentage points a year. At 40%, which is not unusual when the CAPE is as stretched as it is now, you lose 8 points. An 8% average return at 40% volatility compounds at roughly zero.

This is why waiting for the fat pitch and ignoring all those perma-bulls actually matters. Not because they are always wrong, but because the maths of compounding depends entirely on where you start. The finance sector still gets paid regardless of whether you benefit or not. Your job is to know when the numbers actually work in your favour.

Pull the week's threads together and the picture is consistent. Private credit is the leverage risk nobody's brochure is flagging properly. Compounding only works the way investors imagine if they pay a price that gives them a decent starting rate, and today's prices do not. And the volatility that comes with extreme valuations takes what is already a thin implied return and grinds it down further. There are good times to invest and bad times, and on the numbers we walked through, we are getting into dangerous territory.

As always, this is general information about how we read markets and financial products, not personal advice tailored to your circumstances.