Investing with Leverage Is like Cooking with a Really Sharp knife
Chapter 33 of The Rational Investor
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Certain tools should be kept in the hands of professionals.
I learned this lesson the hard way when I bought my first industrial-quality chef's knife.
Do I need what amounts to a sword to chop onions and carrots?
No.
Did I almost cut my finger off several times and stain my cutting board with blood?
Yes.
A knife that sharp only needs to be wielded by a professional who;
Can use the knife to create dishes I can’t and;
Have enough skill and experience to use it safely. If you’ve ever seen an experienced chef's hands, you’ll notice all the scars; that’s how they got their experience.
When it comes to investing, using leverage is a lot like using an insanely sharp chef’s knife; it looks good on TV, but you’ll probably end up cutting a finger off.
How does investing with leverage work?
Leverage is a fancy finance term for debt.
Using leverage simply means borrowing money to invest. Think of the real estate investor who doesn’t have $600,000 in cash to buy a rental property, so they put up $100,000 and borrow $500,000 through a mortgage.
Although the mechanics are different, some stock market investors use debt for the same reason real estate investors do; so they can invest more and (hopefully) build wealth faster.
Let’s go back to the real estate example.
You buy a $600,000 property using $100,000 of your money and borrowing $500,000. A year later, the property went up in value by 16% and is worth $700,000. A 16% return in one year is pretty great, but the story get’s much better. Remember, you put up $100,000, and the property went up in value by $100,000, so your return on the money you used to invest is 100%.
The above is an example of how leverage can magnify your investment gains.
Here’s another example with nice round numbers to crystallize this concept of levered returns.
You buy a $1 million income property using $100,000 cash and $900,00 in debt.
1-year later, the property is worth $1.1 million — It went up 10%.
Your levered return=100% because ($1.1 million ─ $1 million) ÷ $100,000=1
Or in more simple terms you put down $100,000 and the value went up $100,000 and since $100,000=$100,000, you doubled the investment that you put down.
By the way, the reverse is also true; if the property went down by $100,000, your return would be negative 100%. You have a $900,000 property and $900,000 in debt, which means you have $0 in equity.
But wait, it can get much worse than that.
When you invest your own money, the worst you can do is lose 100% of your money. When you invest with leverage, it becomes possible to lose more than 100% of your money.
If you bought a $1 million rental property with $100,000 in cash and then the real estate market goes in the tank, and the property value gets cut in half to $500,000, you have a negative 500% return.
You put up $100,000 and took on $900,000 in debt for a $1 million property.
You still have $900,000 in debt, but now you have a property worth $500,000.
Your levered returns are ($500,000 ─ $1million) ÷ $100,000=-5 or -500%.
You invested $100,000 to lose $500,000.
You’d be $400,000 underwater on that property. That means if you sold it, you would lose your original $100,000, plus you’d still owe an additional $400,000.
That’s how you ruin your life or using my chef’s knife metaphor, it’s how you cut off your finger using a tool you had no business messing around with.
So far, we’ve used real estate as an example of how investors use leverage. Let’s turn our discussion to using leverage to invest in stocks.