Leverage: What It Is And How It Works

Leverage is an investment strategy of using borrowed money to generate outsized investment returns. Before getting into greater detail on how leverage works in an investment context, it is useful to have a broad understanding of the general topic. Let's start with a familiar example.

Most people have gone to an automobile dealership and admired the new vehicles available to purchase. A significant number of car shoppers have left the lot with a brand new car, even though they could not afford to pay for that car in cash. To obtain the car, these buyers borrowed the money. They then gave the borrowed money to the car dealer in exchange for the vehicle.

If the cost of a vehicle is $20,000 and a buyer hands over $2,000 in cash and $18,000 in borrowed money in exchange for the vehicle, the buyer's cash outlay was only 10% of the vehicle's purchase price. Using borrowed money to pay 90% of the cost enabled the buyer to obtain a significantly more expensive vehicle than what could have been purchased using only available personal cash. Instead of driving around in a battered $2,000 jalopy, the buyer is cruising around town in a shiny new car, having used leverage to acquire a better vehicle than he/she could have purchased using only available cash on hand.

From an investment perspective, this buyer was levered 10 to one (10:1). That is to say, the ratio of personal cash to borrowed cash is $1 in personal cash for every $10 spent. Now, let's take the example a step further.

If the buyer in our automobile example was able to drive away from the dealership and immediately sell that car for $22,000, the buyer would pocket $2,000 in profit from a $2,000 investment, ignoring the interest expense. Mathematically speaking, that would be a 100% return on the buyer's investment. By contrast, consider the case if the buyer has paid cash for the car, without taking out a loan, and then immediately sold the car for $22,000. With a $20,000 initial investment resulting in $2,000 profit, the buyer would have generated a 10% return on the investment. While a 10% return is certainly nice, it pales in comparison to the 100% return that could have been generated using leverage.

Other Everyday Use of Leverage Moving beyond the new car example, the use of leverage can be applied to real estate, stocks, bonds, commodities, currencies and other investments. Consider a real estate investor who has $50,000 in cash. That investor could use that money to buy one home valued at $50,000. If that home could be quickly sold for $55,000, the investor would have gained $5,000. If that same investor used the original $50,000 in cash to put a $5,000 down payment on 10 different homes valued at $50,000 each, financed the rest of the money, and then sold all 10 homes for $55,000 each, the investor's profit would have been $50,000 - an astounding 100% return on investment.
The use of leverage in real estate investing is similar to the way it can be used in the stock market. Margin loans, futures contracts and options are a few of the more common methods investors use to add leverage to their portfolios. Just as in the real estate example, a limited amount of money can be employed to control a larger amount of stock than would be possible through a direct purchase made with available cash. Bond-market investors can also use leverage. Consider a scenario in which the interest rate on a one-year loan is 1% while the interest rate on a 10-year loan is 5%. By borrowing money at the short-term rate and investing it at the long-term rate, an investor can profit from the difference in rates. Indirect Use of Leverage
Investors who are not comfortable employing leverage directly have a variety of ways to access leverage indirectly. They can invest in companies that use leverage in the normal course of their business. An automaker, for example, could borrow money to build a new factory. The new factory would enable the automaker to increase the number of cars it produces, thereby increasing profits.

Through balance sheet analysis, investors can study the debt and equity on the books of various firms and can choose to invest in companies that put leverage to work on behalf of their businesses. Statistics such as Return on Equity, Debt to Equity and Return on Capital Employed help investors determine how companies are deploying capital and how much of that capital has been borrowed. To properly evaluate these statistics, it is important to keep in mind that leverage comes in several varieties, including operating, financial and combined leverage. Understanding these concepts is critical to analyzing their use. If reading spreadsheets and conducting fundamental analysis is not your cup of tea, you can purchase mutual funds or exchange-traded funds that use leverage. By using these vehicles, you can delegate the research and investment decisions to experts.

Downside of Leverage
Leverage is a multi-faceted and complex tool. The theory sounds great, and in reality the use of leverage can be quite profitable, but the reverse is also true.

Revisiting a few of our earlier examples illustrates the point. Consider that automobile purchaser using leverage to acquire a $20,000 vehicle with a down payment of just $2,000. The minute that new car leaves the lot, its value drops because it is now a "used" car instead of a "new" one. So, that $20,000 car may be worth $19,000 just a few hours later. A month later, the buyer will need to make a payment in exchange for the $18,000 loan used to purchase the vehicle. More often than not, that loan charges interest. By the time the loan is paid off, once the interest payments are factored in, the buyer may have spent $25,000 or more for a vehicle that is now valued at $10,000. If the buyer had not used leverage to buy the car, the amount of money lost on the purchase would have been lower.

In the housing purchase example, the investor used five down payments of $5,000 each to purchase 10 homes valued at $50,000 each. If real estate prices fall and those homes are now worth only $45,000 each, the investor would take a $50,000 loss (100% of the initial amount invested) if the homes were sold. If the value of the homes fell to $40,000 each, the buyer's potential loss of $100,000 is 200% of the original investment amount. In each scenario, the buyer would also need to continue making mortgage payments (including interest) and insurance payments in addition to periodic home maintenance. In this scenario, the losses can add up quickly and the amounts lost become substantial.

A similar concept applies to the fixed-income investor who took out a short-term loan at 1% interest to invest in a loan that paid 5%. If short-term interest rates rise to 6%, and the investor is only earning 5% on the long-term investment, the investor loses money.

The Bottom Line
When it comes to leverage, unless you are a professional trader and your losses will be covered by your employer, leveraged investing should probably not be your primary investment strategy. If you are not a professional and you choose to use leverage, don't invest more than you can afford to lose. Also, be sure to conduct careful research and make prudent decisions. This approach is more likely to result in a positive outcome than blindly investing in a hot trend based on your observation that other people are making money in real estate, currencies, stocks or some other investment vehicle that has become so popular that investors are borrowing money to buy it.