Many particular investors have heard about leverage and know that it can generate awesome winnings and multiply the risks, but they do not understand how it really works. In this article we want to explain the basics about it.
What is leverage?
We are sure you are familiar with Archimedes’s quote, “Give me a place to stand, and I shall move the world.” Archimedes was intending to use leverage of course, in other words, multiply his strength thanks to a tool.
In investing, leverage is exactly the same. You can multiply your financial strength by using a tool, which in this case is debt.
If you tell most investors that they have 10,000 GBP to invest, they would go to the market to pick some assets. What they do not realise is that they can ask for a loan with that money. If you have 10,000 GBP, chances are the bank is willing to give you another 10,000 because they know you have the money to pay them back.
If you actually ask for the loan instead of investing with the 10,000, you can do it with 20,000.
The magic of leverage or counting your chickens before they hatch
Now, if we do some math comparing using just your money to using it in addition to the loan, you will see how the profitability is multiplied in the second option.
Let’s say you invest 10,000 and you have a profit of 10 percent. 10 percent of 10,000 is 1000, so you would end up with 11,000 GBP.
However, if you manage to get that same profit using the additional money from the loan, you would be getting 10 percent of 20,000, which is 2,000, so you would end up with 22,000 GBP. At that moment, you can pay back the loan of 10,000, and you would have 12,000 GBP left.
As you can see, with your 10,000, by having the loan, you have increased your profits from 10 percent to 20 percent.
It is true that the loan should have some cost, but now the interest rates are very low; so even if you pay 2 percent for the loan (2 percent of 10,000 is 200), you would get 800 GBP more than if you had not asked for the loan. That’s a profit of 1800 instead of 1000.
This is absolutely real, but where is the increase of risk?
Well, you will have to pay back the loan no matter what happens with the investment. If things go wrong, let’s say instead 10 percent of profits, you will get 10 percent of losses. In the first example you would lose 1000, and 2000 in the second.
That does not seem so awful, so why do people lose it all?
Leverage should not be a very dangerous tool if used properly. The most common problem with it is that people get greedy and invest too much.
In many cases, the correct approach is to use leverage to decrease risk by diversification, not to increase it by overexposure to one asset.
If we continue with our example, people will see that they could invest 20,000 instead of 10,000 in their chosen asset; and they do it, when instead they could invest 10,000 in one asset and 10,000 in another asset and get a better diversified investment portfolio .
It is very important and difficult to remember that having cash to invest does not really mean that one should invest it all.
*This is not investing advice and is only for informational purposes.