The Importance of Leverage in Investing – Lee Chandler

In investing, one term that you may commonly hear mentioned is leverage. Essentially,
leverage is the act of borrowing money or taking on debt to finance an investment. Leveraged
investing takes several different forms and has various strengths and weaknesses, which will be
discussed in this article.
Strengths:
The primary strength of leveraged investing is that one can gain access to greater capital
than they otherwise would have. This enables investors to have greater upside on their returns, as
even moderate gains on the overall investment leads to extremely high returns on the capital the
investor provided. To see how powerful this effect can be, refer to the table below:

As illustrated above, using leverage increases the potential for returns significantly. However,
this increased potential is also true for losses.
Weakness:
The downside of leveraged investing exists for the same reason as its upside. With
leveraged investments, any decrease in value can also lead to far more significant losses than
what is otherwise possible. Here is the table for the same leverage assuming 5% annual declines.

As shown in the table, the risks on leveraged investments can be just as high as the rewards.
Additionally, gaining access to leverage often comes at the cost of high interest rates. Thus,
when investing using leverage, it is important to hedge your risk by finding lower interest rates
and making sure that your investment can provide a steady source of income.
Examples of leveraged investments
1. Margin trading
● Margin trading is when one borrows money through a broker to trade financial
instruments like stocks, bonds, futures, options, etc.
● Margin trading is very risky since interest rates are typically high and there is no
source of income other than dividends
2. Commercial Real Estate
● Purchasing commercial real estate is similar to buying a house with a mortgage
● The advantage is that some commercial real estate properties like multifamily
housing can be approved for loans relatively easily and for a low interest rate
● In addition to potential for appreciation, commercial real estate properties also
generate monthly cash flow in the form of rent
3. Leveraged Buyouts
● Commonly used by private equity funds, leveraged buyouts are when businesses
are acquired through the use of debt
● Leveraged buyouts offer similar advantages to commercial real estate in that they
can provide consistent cash flow in addition to value appreciation
● Interest rates can vary greatly depending on the business that is being acquired
Overall, leverage can be a very powerful tool when applied correctly in investing. However, due
to its inherent risk investors need to be especially cautious when deciding to invest with leverage.
Sources:
Amadeo, K. (2019, June 25). How to Use Leverage in Investing, Business, and the Economy.
Retrieved July 21, 2020, from
https://www.thebalance.com/leverage-investing-and-business-3306199
Cassell, W., Jr. (2020, January 29). 3 Reasons to Invest in Multi-family Real Estate. Retrieved
July 21, 2020, from
https://www.investopedia.com/articles/personal-finance/041216/3-reasons-invest-multifamily-re
al-estate.asp
Hayes, A. (2020, July 02). Leverage. Retrieved July 21, 2020, from
https://www.investopedia.com/terms/l/leverage.asp
Twin, A. (2020, June 29). Margin Definition. Retrieved July 21, 2020, from
https://www.investopedia.com/terms/m/margin.asp

 

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