For you risk taking investors, the concept of leverage is enticing but shrouded in uncertainty as to how you might actually use it in your portfolio.
What is leverage?
In investing parlance, leverage describes ways you extend the capital with which you invest, often by borrowing money. For sophisticated investors, taking out loans at low interest rates and investing the money to earn a higher rate can dramatically accelerate results. Of course, it’s also wildly risky.
At first glance, the idea of borrowing $10,000 at 5 percent and making 8 percent seems like a no-brainer. It’s an idea that we’ve touched on before when discussing the benefits of investing versus paying off debt.
Famous Hedge Fund guru Bruce Kovner began his career by charging $3,000 on his credit card to invest in soybean futures. He saw a $40,000 gain before it dropped down to $23,000 when he sold out of his position. By using leverage he presided over a gain of 13 times his original investment before losing almost half. Clearly, the more leverage used, the more volatility you’ll have to weather.
Creating leverage by using margin accounts
If you have a brokerage account, you’ll have an option of opening up a cash or margin account.
A margin account gives you access to leveraged strategies like borrowing money or investing in options. Make no mistake, a high risk tolerance is needed to apply most of these strategies to your investment plans, but used responsibly, they can add considerable gains to your portfolio and even help manage risk.
Borrowing money to invest it in a margin account can be expensive (margin rates may exceed 8 percent) unless you have enough capital to lower the rate which varies according to each firm’s predetermined tiers. Assuming you can lower the cost of borrowing capital to a reasonable 6 percent or less, you can invest greater amounts in the stock market that you would otherwise be able to and take advantage of the amplified returns.
Although margin accounts are a common way to borrow money for investing, investors may turn to other sources such as a low-rate home equity line of credit or even credit cards. Hopefully it goes without saying that investing with a credit card isn’t recommended due to the risk. Even borrowing money on a 0 percent introductory rate card could leave you holding a bill in 12 months at 15 or 20 percent APR if your investments don’t pan out.
An example of investing with borrowed capital
For example: Say you have $10,000 and you are able to borrow an additional $4,000 at a 6 percent interest rate and invest the total. Let’s further say that you invest in a stock that increases from $50 a share to $55 in a year. Without leverage, you earned 10 percent in gains, or $1,000. With leverage of $4,000, we are able to generate 11.60 percent after making our interest payment of $240.
Borrowing on margin can also be used to take advantage of opportunities instead of just as an amplifying technique. If your capital is 100 percent invested in the stock market when an opportunity to buy a stock that you think will rise comes along, you won’t be able to purchase it unless you buy it on margin.
As with anything else, the key to responsible use lies in moderation. Luckily, most firms don’t allow leverage beyond 50 percent, so you can’t have $10,000 invested and leverage $20,000.
Leverage is used extensively in complex investment management companies like Hedge Funds and in far more extreme strategies than shown above. Easily mismanaged, leverage will amplify losses along with gains, leaving it solely within the hands of the most risk tolerant investor to use.
Next week, I’ll discuss the use of options both for leverage and risk management purposes in your portfolio.