Leverage: The Financial Amplifier

Dec 8, 2006 by

Definition:
Leverage: Using borrowed money to finance an investment.

Imagine that you had $2,000 and wanted to invest in Google, which was trading at say, $500 per share. Given your own financial resources, you could only buy four shares of the stock. If the stock went up $100 per share (to $600), you would make $400. If the stock went down $100 per share (to $400), you would lose $400.

Now, imagine instead that you decided to borrow $10,000 from the bank (at 10% per year), and invested it in Google for a year. Once again, you bought the shares at $500 per share. Given the borrowed $10,000, you could buy twenty shares of Google. If Google went up $100, at the end of the year, you would end the year with $12,000. However, you would have to pay back the $10,000 plus 10% interest, for a total of $11,000. Thus, you would make $1,000 on the investment, and not have to put any of your own money on the line.

However, imagine the opposite scenario, in which Google went down $100 per share. Then, you would lose $2,000 (leaving you with $8,000), and still have to pay back the $10,000 plus 10% interest. Thus, you would get $8,000 back from your investment, and have to pay back the bank $11,000. At the end of the year, you would be down $3,000.

So, by using leverage, you can both make and lose more money than would be possible if you were investing your own money. Leverage amplifies the game, increasing the variance of returns.

Usually, investments aren’t fully leveraged. For instance, you could have had $5,000 of your own money and borrowed another $5,000 (at 10% APY) for the investment in Google. If Google went up $100, you would end the year with $12,000 at the sale of the investment. Out of that $12,000, you would have to return $5,000 * 1.1 = $5,500 to the bank. Thus, you would end the year with $6,500. Meanwhile, if the stock went down $100, you would end the year with $8,000, and would owe the bank $5,500. Thus, you would end the year with $2,500. As you can see, being partially leveraged produces smaller losses and smaller gains than being fully leveraged.


This is probably common sense, but it is worth stating. If you only invest money that you don’t really need, and avoid leverage, you will never go into debt as a result of your investing. However, if you leverage your investments and they turn sour, you can easily owe more than you own.

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6 Comments

  1. Evan

    Ouch. If you look at it purely as a game of chance where it is 50/50 that a stock will be up or down within a year after your investment, using leverage would seen to be a bad idea in all cases. Using all borrowed money at your rate of 10% APY, 66% of your investments would have to break in your favor to statistically break even. Seems that you should prove yourself a decent investor before you start playing dangerous games with other people’s money.

  2. People usually leverage investments when they think they have a high probability of turning out a certain way. I don’t see the outcome of a leveraged deal as a 50/50 scenario. I simply used the numbers that I did for simplicity. (For instance, a 10% APY was chosen so that readers could do the multiplication in their heads.)

  3. Josh

    The other side of the coin is de-leveraging with a risk-free asset.
    Instead of having $5k in equity and $5k in debt both invested in a
    risky asset, Google in your example, you have $4k in the risky asset
    and $1k in a bank CD or long-term T-bills. This serves to lower the
    volatility of return. Check out the Modern Portfolio Theory page on
    Wikipedia, it shows how you can leverage or de-leverage a risky asset
    to tailor the level of volatility and return.

  4. Leverage is a slippery slope with such great potential that even the greatest have been caught in it. As in all forms of gambling, the key is to stop while you are ahead and go home!

  5. Sigrun

    Sounds like the key is not to leverage unless: a) odds are very good that the stock will go up, not down. b) you have a substantial amount of investment experience (to know that a is true). c) you can afford to lose the money if the stock declines.

  6. sahaja

    Leverage the idea is good for increasing profits. It will be a good idea while investing to go in for 2 or 3 different types of companies like software, construction, petrochemical etc which are not interdependent, so that you can invest higher amounts with lesser risk.
    Even if there is a fall in one script the other investment could cushion the losses

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