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Finer Points

How to Use Leverage for Investment Returns

02/15/2019

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Leverage is not a term that is unique to the investment world. You may hear that someone is using their home as leverage or that they are over-leveraged. Leverage can be a complex term when you start digging deep but, essentially, leverage is debt.
Debt can be a scary word for many people, and there is no doubt that everyone should be prudent with taking on debt. However, many people talk about good debt and bad debt. It’s very important to make this distinction when talking about leverage, especially when discussing leverage for investment purposes.
Good debt helps people achieve goals. For example, many people simply would be unable to realize home ownership if it weren’t for mortgages since saving the entire cost of a home would require many years of hard work. Bad debt is what sets people back and perpetuates a life of perpetual debt. Examples of bad debt could include unmanageable credit card balances or payday loans with high interest rates.
In this article, we will look closely at using leverage for investment and why this debt, if used responsibly, can help investors achieve their investing goals more quickly. We will also look at some of the downsides of leveraged investing to ensure readers are able to make an informed decision that they could be comfortable with.

What Is Leveraged Investing?

Leverage for investment purposes is meant to speed up the rate at which a fund or individual investor can earn returns on investment. For individual investors, the typical way many people invest is by buying stocks or shares of a fund over time in small increments. This is called dollar cost averaging and it is a great way to invest because it is simple to do and allows investors to average the cost of their investments over a long period rather than buying in with a large amount all at once.

However, the downside of dollar cost averaging is that it is a long-term plan with slow growth potential. A 20% return is significant for any investment, but it is much less significant when comparing a $100 investment with a $100,000 investment.

Large mutual funds and hedge funds also use leveraged investing to acquire greater shares of companies they wish to invest in. With more assets under their control, gains will be even more significant and, in turn, investors in these funds will be much more satisfied with these results.

Types of Debt Used for a Leveraged Investment

There are a few types of debt that can be used as leverage for investment purposes. Each has its unique role while investing and specific considerations.

Traditional Loan

This type of leveraged investment is one that will be easiest for the average retail investor to understand. If an individual investor wishes to invest a lump sum of money, then they may reach out to their financial institution for a loan. Investors who have equity in their home may use their home as security for a lower interest rate to secure funds for investing.

This can be one of the most simple ways for an individual investor to use leverage for investment returns. However, banks may be wary of lending to individuals for investment purposes and, if individuals don’t have home equity built up that they can access, the interest rates may not be worth the potential gains of the proposed investment.

Investing on Margin

Another very common method of using leverage for investment returns is to invest using margin. This is when an investor can use the value of their portfolio almost like security to invest borrowed money granted by their brokerage. A 2-to-1 margin ratio must be maintained which means that for every $2 of assets an investor owns they will be granted $1 in equity.

One of the main benefits of investing on margin is that, as portfolio size grows, more margin becomes available. Investors don’t have to have home equity or a bank loan available in order to use leverage for investment purposes. Of course, for many investors who are dollar cost averaging into the market over time, building up any significant amount of margin may take a long time.

Futures Contacts

Futures contracts are not typically something that the average investor will be directly involved in, but they may choose to invest in funds that deal with futures contracts as part of their overall investment strategy. This is a contract which gives investors the ability to purchase an investment at a future date for a determined price. For example, if an investor believes that an investment will gain value over a period of time, then they may wish to purchase a futures contract at or near the current price of the investment.

These contracts can be a great way to mitigate risk, but they are complicated investment instruments. Retail investors that do not have a strong grasp of the concept of futures contracts should typically avoid these investments without the guidance of a professional. However, when used properly, futures contracts can be one of the most cost-effective ways to use leverage for investment returns.

Options

Options are somewhat similar to futures contracts in that they allow investors the right to buy or sell shares at a specific price determined when purchasing the option. Options are known as derivatives which simply means that their price is derived from the value of the underlying asset like a stock.

Options can be used as leverage when an investor speculates that the underlying asset will either gain value or lose value. An option will have two very important details: strike price and expiry date. The strike price is the price at which the option can be exercised for a profit. The expiry date is the date when the option contract expires and, if the strike price is not met, will be worthless for the investor.

When purchasing options, investors pay a premium which is given to the seller in exchange for writing the option. A premium is usually priced far less than the current market price of the underlying asset itself. This helps to limit the downside risks for purchasers of options.

There are two types of options: calls and puts. An investor who believes that an investment will go up in price will purchase calls. A call gives the buyer the right to buy the asset from the seller at the determined price prior to expiry. A put gives the option buyer the right to sell an asset at a determined price prior to expiry. Often, options contracts are sold, and many investors do not actually end up buying the underlying assets.

Choosing Leveraged Funds

For investors that do not wish to take on the leverage directly, there are leveraged funds that can be purchased. These funds use leverage to try and outperform average market returns. For example, investors could choose a fund that attempts to double the performance of the S&P 500 using leverage.

These funds will use a variety of strategies like borrowing $30 for every $100 in holdings to purchase contracts like the ones mentioned above. This helps take the responsibility of leverage away from the individual investor and creates the potential for substantial gains. However, the downside risks of leverage are not eliminated and, if the wrong decisions are made by fund managers, losses could be amplified when compared with other funds that employ less leverage.

Why Use Leverage for Investment Returns?

As mentioned earlier, debt gets a bad name in the world. When many people talk about debt, they are often talking about credit cards, high-interest car loans, and other forms of debt that can cause people massive amounts of stress in their lives. However, using leverage for investing is not like making frivolous purchases on a credit card.

Most investors simply do not have the funds on hand to make significant investments and, as a result, must slowly invest over time. This means that they may miss out on substantial gains simply because they don’t have a lot of skin in the game.

For large mutual funds, the concept is similar, but on a much larger scale. If these funds are managed well, then leverage can offer the ability for fund managers to amplify their results and deliver better returns to their investors.

One of the best times to consider using leverage is when the market has entered the trough stage of the business cycle. Stock market prices have dropped, but the bleeding has stopped. We know that market values consistently go up over time, even despite drops and slowdowns. By using leverage for investment purposes at this point, investors can load up on shares when prices are low and experience significant returns as the market begins to recover.

The Risks of Leverage for Investment

While leverage can be considered “good debt” and may deliver exceptional results for many investors, using leverage is not without its risks. Even so-called “good debt” like mortgage debt can turn bad quickly if it’s not managed responsibly or wisely.

One of the main risks of leveraged investing is the associated interest rates. Investors must factor the cost of interest into their investment returns to get an idea of whether or not the leverage is worth it. For example, a 10% return on an investment is a very nice return by most standards. However, if the cost of the interest was 5%, then the real return is cut in half. Suddenly, taking on the additional risk of leverage doesn’t look so attractive now. However, if the interest rate were much lower, then the return would be far more attractive.

Investors must also be sure that they can manage their leverage. Whether it’s making additional loan payments or maintaining margin requirements, investors have to be aware of their leverage position when investing. For example, when investing using margin, if an investor’s portfolio value drops below the margin ratio required, this will initiate what is called a margin call.

In a margin call situation, investors must deposit cash into their investment account to bring their margin ratio back in-line. If this is not done promptly, then the brokerage will forcibly liquidate assets to cover the margin call. This can be a shock to even the most experienced investors and cause substantial financial stress for those who are put in a margin call position.

Finally, while leveraged investing can increase upside potential, it can also increase downside risk. There are ways to limit this risk, but there is almost no way to eliminate the risk. If an investment drops in value and it makes a significant portion of an investor’s portfolio, then the losses could be amplified when compared to a portfolio with a less significant holding of the same asset. After factoring in interest, the losses could be even more substantial.

Making the Right Investment Decisions

Leverage for investment returns can be a great way to rapidly grow a portfolio’s value when used responsibly and with purpose. As with any investment method, leveraged investing should be evaluated to ensure it meets the goals and risk tolerance levels of each investor.

To learn more about leveraged investing and other important investment concepts, please contact Linden Thomas and Company today.

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