Use this article as a basis to explain what leverage is and how it impacts your clients’ investments. Feel free to copy and edit as you see fit.
What is Leverage?
Leverage is the strategy of using of borrowed money to increase investment power. An investor borrows money to make an investment, and the investment’s gains are used to pay back the loan. Leverage can magnify potential returns, but it also amplifies potential losses. There are different types of leverage, including financial leverage and operating leverage. Financial leverage refers to the use of borrowed money to buy assets or invest in securities.
The Benefits of Leverage
Leverage increases the potential returns on an investment. Here’s an example of how that would work. Let’s say you have $100 of your own money, and you can borrow $1500 from the bank at an interest rate of 6%. You invest the entire $1600 in an investment, that you are confident will grow 15% in a year. You plan to return the borrowed money plus interest at the end of a year.
If that works here is how it would look. The value of the investment will be $1840 at the end of the year. You will pay the bank back $1500 + $90 = $1590. That leaves you with a total of $250 and a net gain of $150 once you subtract the initial $100 you invested. That’s a 150% return!
The Risks of Leverage
While leveraging offers several benefits, it also comes with significant risks. Let’s look at what happens if our rosy picture above doesn’t work out. We still start out with $1,600, $100 of our own plus $1,500 from the bank.
In this case, we lose 15%. Remember that is 15% of $1,600 or $240
Now at the end of the year, we have $ 1,360 ($1,600-$240). We have to still pay the bank $1,590 ($1,500 + $90 in interest). That means we owe $230 more than the $1,360 we have. Based on our $100 initial investment, we lost 330%. Ouch.
The greater the percentage change in the investment, the greater the potential gain or loss. So leverage magnifies market volatility. In a volatile market, this can lead to significant losses. Additionally, leverage can lead to margin calls. A margin call is when an investor is required to deposit additional funds to cover losses.
The most common use of leverage for an individual is a home mortgage. Most investors use a home mortgage to fund the purchase of a home, with a standard down payment of 15-20%. Leveraging a home is so common because home prices over decades are generally not volatile. The housing bubble of 2008 notwithstanding.
Factors to Consider When Using Leverage
Before using leverage, investors should consider their investment goals, risk tolerance, market conditions, and liquidity. It is important to have a clear investment strategy in place before using leverage to avoid significant losses.
Conclusion
Leverage can be a powerful tool in investments, but it also comes with significant risks. It is important for investors to understand the benefits and risks of leveraging and have a clear investment strategy in place before using leverage. Proper risk management is crucial to avoid significant losses and achieve long-term investment success.
