Determining the return-maximizing portfolio leverage and its limitations

Abstract

Leverage in the risk allocation of an investment portfolio can be an effective strategy in achieving overall portfolio goals. While the literature on portfolio leverage is robust, quantifying the amount and discussion of its limitations are often minimized. This article focuses on the limitations by explicitly including the volatility drag from leveraging the expected portfolio returns. Maximizing the expected portfolio returns with respect to leverage results in a return-maximizing condition that balances the gains from leverage with the losses in the volatility drag. The return-maximizing condition is graphically illustrated over a range of investment returns to produce a return-maximizing leverage curve.