Leverage is an investing term that describes the strategy of borrowing money to make an investment.
Typically, this is done through a stock brokerage using what’s known as a margin account, though leverage can be used in a number of investment settings and in a variety of ways.
In the stock investing example, the investor uses the margin account to borrow money in order to buy a stock.
If the investment works out and the stock is sold at a gain, the investor returns the borrowed money plus interest and keep the gains from the sold position.
Of course, if the investment doesn’t work out in a prescribed period of time, the investor will need to return the money to the broker just the same, plus interest.
In the past, huge stock market crashes have resulted from the overuse of leverage by masses of investors.
For instance, a large number of people want to buy a small number of the same stocks and many of them use borrowed money to do so.
Naturally, the concentrated buying action drives up the prices of those stocks, drawing in even more investors. Those investors borrow, too, and so on until the stock peaks — then crashes back to earth.
Like with any Ponzi scheme, the early investors have a chance to exit and make a gain, and even return the borrowed money without a problem.
Many of the later investors, however, end up paying too high a price and cannot exit in time. They nevertheless owe the money they borrowed.
Pressured, some of them begin to sell other, unrelated investments to raise cash to repay margin loans.
This selling action draws in more sellers, leading to a broader decline in the stock market and perhaps even a crash.
There are reasonable uses of leverage. For instance, when you use your good credit history to buy a home you are leveraging past payment behavior to take on a very large debt.
Your debt in the house maybe greater than your equity for some time, an example of a leveraged investment.
However, once you make enough payments the market value of the home should exceed the size of the remaining mortgage.
Likewise, a business owner might use his or her track record to secure a loan to expand. The ultimate goal is to increase the size of the business and pay back the loan, then realize additional profits.
While the business is growing the loan could be said to be leveraged, since the debt payment could be a large portion than the short-term free cash flow of the business.
A student loan, too, can be viewed as a form of leverage. While getting a degree statistically means earning a higher salary over your lifetime there’s no guarantee this will happen.
Leverage can be a useful tool for some investors in some specific investment scenarios. For most long-term retirement savers, however, leverage is little more than unnecessary risk.
A better way to increase returns is to diversify, rebalance and steadily contribute to your retirement plan. Over years, simple compounding should greatly increase your balances with no additional risk.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.