Leverage, in the context of investing, refers to the use of borrowed funds to increase the potential return on an investment. While leveraging can amplify gains, it also increases the risk of losses.
As a financial planner, understanding how leverage works, its benefits, and its risks is crucial when advising clients.
What is Leverage?
Leverage involves using borrowed capital to increase the potential return of an investment. It allows investors to control a larger amount of an asset with a smaller initial outlay. The idea is that if the investment performs well, the returns generated from the larger asset base will more than cover the cost of borrowing, resulting in a net gain.
For example, if an investor wants to buy $100,000 worth of stocks but only has $50,000, they might borrow the remaining $50,000. If the stock value increases by 10%, the total portfolio would be worth $110,000, resulting in a profit of $10,000. Without leverage, a 10% increase on $50,000 would only result in a $5,000 gain.
Types of Investments Using Leverage
Real Estate
One of the most common uses of leverage is in real estate. Investors often use mortgages to purchase properties, with the aim that rental income and property appreciation will outweigh the cost of the loan.
Buying Stocks using Margin
Investors can use margin accounts to borrow money from brokers to buy stocks. This allows them to purchase more shares than they could with their own capital alone. The costs are brought down even more if the stocks pay a dividend along with a rise in value (capital gain).
Derivatives
Options and futures are financial instruments that allow investors to speculate on the price movement of an asset without having to purchase the asset outright. These instruments often involve significant leverage.
Private Equity
Leveraged buyouts (LBOs) involve acquiring a company using a significant amount of borrowed money. The assets of the acquired company often serve as collateral for the loans.
Benefits of Using Leverage
Increased Returns
The primary benefit of leverage is the potential for higher returns. By using borrowed money, investors can amplify the returns on their investments.
Diversification
Leverage can allow investors to diversify their portfolios by investing in a wider range of assets. This can help spread risk and potentially improve overall portfolio performance.
Tax Benefits
In some cases, the interest paid on borrowed funds may be tax-deductible, depending on the jurisdiction and specific investment. This can further lower the cost of using leverage.
Access to More Opportunities
Leverage can provide investors with the opportunity to participate in investments that they might not have been able to afford otherwise, such as high-value real estate or large stock positions.
Risks of Using Leverage
Amplified Losses
Just as leverage can amplify gains, it can also amplify losses. If the value of the investment decreases, the investor still needs to repay the borrowed amount, potentially leading to significant losses.
Margin Calls
In the case of leveraged stock investments, a drop in the value of the stocks could lead to a margin call, where the investor must provide additional funds to maintain the investment. This can result in forced selling of assets at a loss.
Interest Costs
Borrowing funds incurs interest costs, which can eat into investment returns. If the returns on the investment do not exceed the cost of borrowing, the investor may end up losing money.
Market Volatility
Leverage increases the sensitivity of an investment to market volatility. A highly leveraged position can become very risky in a volatile market, leading to significant fluctuations in the value of the investment.
Key Considerations for Investors
Risk Tolerance
Investors need to assess their risk tolerance before using leverage. Those with a low tolerance for risk may find leveraged investments too stressful and potentially damaging to their financial health. Be sure you have a plan to pay back the borrowed funds if the investment goes against you.
Investment Horizon
Leverage is more suitable for long-term investments where the investor can ride out market fluctuations. Short-term investments using leverage can be extremely risky due to market volatility.
Market Conditions
It's essential to consider the current economic and market conditions. Using leverage in a bullish market can be profitable, but in a bearish market, it can lead to significant losses.
Diversification
Even when using leverage, it's important to maintain a diversified portfolio. Relying too heavily on a single leveraged investment can increase risk. If you are using borrowed funds to invest, don't invest it all in one product. Invest a smaller portion in a safe product like a cashable GIC.
Exit Strategy
Investors should have a clear exit strategy in place. Understanding when to take profits or cut losses is crucial when using leverage.
Conclusion
Leverage can be a powerful tool for investors looking to amplify their returns. However, it comes with increased risk, and it's not suitable for everyone. As a financial planner, it's important to educate clients on the potential benefits and pitfalls of using leverage. By carefully assessing risk tolerance, investment horizon, and market conditions, investors can make informed decisions about whether leverage is the right strategy for their investment goals. Remember, while leverage can magnify gains, it can also magnify losses, and it's crucial to use it responsibly.
