Sunday, April 3, 2011

The Unintelligent Investor's Definition of the Week: Leverage

Leverage

Oxford dictionary definition: the use of credit or borrowed capital to increase the earning potential of shares.

Some people have described using leverage as putting cash on steriods

The Unintelligent Investor’s explanation:

Using leverage basically means you want to get more bang for your buck. Or in other words, you increase your investment exposure by using different products or borrowing money.

An easy way to look at it is to think about property investment because almost everybody investing in property will gear or use leverage.

Say a house costs 1 million dollars, you go to a bank and ask for a loan. If you are geared 80% that means you pay 20% up front and the remaining 80% as a mortgage. So you would have paid 200 000 dollars and gained access to an asset that is worth 1 million dollars. Hence, more bang for your buck.

How is this helpful? If you had 1 million dollars to begin with, chances are you wouldn’t buy the house by cutting a million dollar cheque because that would mean you’d have to pay 1 million dollars for something that is worth 1 million dollars. If you were geared at 80%, your 1 million dollars can buy you 10, 1 million dollar houses. As a result, 1 million dollars buys you 10 million dollars’ worth of assets, more bang for buck.

Now if the value of the properties increase by 10%, the portfolio that is not geared will only give you a return of 100 000 dollars where as the portfolio that is geared will give you 1 million dollars.

Think about it, without leverage, a 1 million dollar investment, gives you a return of 100 000 dollars which is a return of 10%
With leverage, a 1 million dollar investment, gives you a return of 1 million dollars, which is 100%
In both scenarios, the value of the assets goes up by that same 10%

So leveraging is a tool used to amplify your returns. However, if the value of the asset decreases, your losses will be amplified as well.

In the share markets, there are many ways to gear your portfolio.
The easiest way is to take a loan or a Margin loan.

There are other products that increase your exposure to the share markets as well, I will not go into them today because if I do, the post will be way too long. Some examples are:
CFDs
Instalment Warrants
Capital Protected Loans
Options

So when I say I’m going to use leverage, I mean I am going to increase my exposure to the markets than my investment would normally deliver, whether it be using loans or derivatives.

Remember that I am by no means, encouraging you to gear your portfolio or make use of leverage. Leveraging your portfolio carries a very different risk profile if compared to investing or trading using cash. Remember that your profits can be amplified but so can your losses.

This post is to explain what leverage means so that we will not be so lost when somebody talks about it or if we read it somewhere.

Thanks for reading. I hope this post was helpful, do drop me a comment or an email if it was or if it was not. Definitely let me know if it was crap so that I can improve it.

Thank you!

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