There is a recurring pattern throughout the history of modern financial markets.
A new secular bull market begins. Economic conditions improve. Corporate earnings accelerate. Liquidity expands. Investors who previously suffered through a bear market gradually regain confidence. Prices rise. The rising prices themselves attract more capital. Momentum strengthens. Narratives become increasingly compelling. Investors begin extrapolating recent returns far into the future.
Then something changes.
The same momentum that previously rewarded investors begins working in the opposite direction.
What initially appears to be an ordinary correction can become a violent repricing when excessive leverage, derivatives, concentrated positioning and speculative behaviour have accumulated during the preceding rally.
This is one of the oldest lessons in financial markets:
Leverage is most dangerous when investors become most confident.
The problem is not simply that an asset can decline. Markets have always declined. The deeper problem is that leverage can transform a temporary decline in market prices into a permanent destruction of investment capital.
The recent collapse in the South Korean equity market provides a contemporary illustration of this phenomenon.
KOSPI, 22 June – 30 July 2026
The precise percentage varies across data providers depending upon the measurement convention and timing, but the magnitude of the drawdown is unquestionably extraordinary.
For an unleveraged long-term investor, a severe drawdown is painful. For a leveraged investor, it can become existential. And that distinction matters enormously.
The Seductive Mathematics of Momentum
One of the most powerful forces in financial markets is momentum. When an asset has appreciated substantially over an extended period, investors naturally begin interpreting the historical performance as evidence of future performance.
A stock rises 20%. Then 30%. Then 50%. Then perhaps 100%. The psychological interpretation gradually changes.
“Why is this going up?”
“How much higher can this go?”
“Why wouldn’t I own this?”
That final stage is particularly dangerous. The investor is no longer evaluating the underlying economics independently. Price appreciation has become part of the investment thesis.
This creates a feedback mechanism:
The reflexive cycle upward
The system becomes increasingly reflexive. George Soros famously developed the concept of reflexivity to describe how participants’ perceptions can influence market fundamentals, which subsequently influence perceptions again. The mechanism is particularly powerful when financial leverage is involved.
Leverage effectively increases the sensitivity of the system. A 10% increase in an unleveraged asset creates a 10% return on invested capital. A 10% increase on a position financed with substantial debt can create a much larger return on the investor’s actual equity.
That asymmetric reward encourages additional risk-taking. But the same mathematics operates in reverse.
A 10% decline can become a 20%, 30% or 50% loss of equity capital depending upon the amount of leverage employed. And once margin calls begin, the investor may lose the ability to choose whether to sell. The broker, lender, or derivatives clearing mechanism effectively makes that decision.
The Most Dangerous Time to Use Leverage Is When Everything Appears Safe
This is one of the paradoxes of investing. Leverage appears least dangerous when markets are rising. Volatility is low. Collateral values are increasing. Margin requirements appear manageable. Unrealised gains provide psychological comfort. Investors begin believing that the risk has disappeared.
In reality, the opposite may be occurring. The very success of the strategy can encourage investors to increase their leverage.
Suppose an investor has S$100,000 of equity and borrows another S$100,000. The investor now controls S$200,000 of assets.
This is intoxicating. The investor may then conclude that increasing leverage further is rational. But consider the reverse: a 20% decline produces a S$40,000 loss. Equity falls from S$100,000 to S$60,000. The underlying asset declined 20%. The investor’s capital declined 40%.
If the decline continues, the situation becomes progressively more dangerous. The investor can be forced to sell into weakness.
That creates another feedback loop: declining prices → margin calls → forced selling → additional price declines → additional margin calls → further forced selling.
At that point, fundamentals become almost irrelevant in the short term. The market is no longer simply discovering fair value. It is liquidating positions.
This Is Why Market Crashes Are Often Nonlinear
A common misconception is that a market that has risen for years should eventually decline by approximately the same amount through an orderly process. Financial markets do not necessarily behave that way. They are complex adaptive systems containing millions of participants with different objectives, time horizons, constraints, and balance sheets.
When volatility suddenly increases, the behaviour of these participants can become highly correlated. This creates nonlinear outcomes. A small initial shock can therefore generate a much larger market response.
The engineering analogy is useful. A stable system can absorb disturbances. A system operating close to its structural limits has much less tolerance. Financial leverage effectively reduces the system’s margin of safety.
That is why I consider financial leverage to be analogous to reducing the safety factor in an engineering structure. A bridge designed with substantial excess structural capacity can tolerate unexpected loads. A bridge operating permanently near its maximum rated capacity has far less resilience. The same principle applies to investment portfolios.
South Korea: A Contemporary Reminder
The recent South Korean market decline is therefore important beyond the headline percentage.
A decline of this magnitude is sufficient to expose the difference between owning an asset and financing an asset. An investor who owns a diversified portfolio without leverage can endure a major drawdown. It may be psychologically unpleasant. It may temporarily reduce wealth substantially.
But the investor retains optionality. No lender is demanding additional collateral. There is no forced liquidation. There is no expiry date on the investment thesis. The investor can continue owning the underlying businesses.
The leveraged investor does not necessarily possess that luxury.
“What will the asset return?”
“What happens to my capital if I am wrong — or merely early?”
That question introduces the concept of survivability.
China Provides Another Important Historical Lesson
The Chinese equity-market episodes of the past decade provide another useful illustration of the interaction between speculation, leverage, policy intervention and investor psychology.
During the enormous mainland Chinese equity rally leading into the 2015 crash, speculative participation increased dramatically, and margin financing became an important source of purchasing power. Investors became increasingly confident as prices rose. Then the direction changed.
Once prices began falling, leverage amplified the downside. Forced selling accelerated the decline. Government intervention subsequently became extensive, including measures designed to stabilise the market.
The lesson should not be reduced to the simplistic claim that the Chinese government alone caused the collapse. Markets are considerably more complicated. The important lesson for investors is the interaction between speculative enthusiasm and leverage.