The Promise - And Problem - Of Investing With Borrowed Money

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Today we're going to step back from individual stocks and business themes and focus on a very important investing concept: that of using debt, or "leverage", in investing.

We will start by defining what exactly "using leverage" means.

Then we will describe why leverage is employed, and how it can dramatically magnify the gains on a successful investment.

On the flip-side, we will explain the reverse, and how leverage can also magnify LOSSES, and how this can become a major financial problem.

Finally, we will briefly explain where using leverage makes sense - and where it doesn't.

Let's start with the concept itself.

What is Leverage?

The term "employing leverage" is just a fancy way of saying "investing with debt".

Proponents refer to it as "investing with other people's money", which is in fact a pretty accurate way to describe it. Investors will secure a loan and then plow that money into whatever investment opportunity they have encountered.

A very common example of this is in real estate investing, both commercial and rental. Few investors hold enough cash on hand to make outright purchases of real estate, and even if they did, it is less risky to spread that cash out across several properties than to tie it all up into a single one. Bank mortgages are the usual source of leverage here.

Another example are expanding businesses. For example, say a regional restaurant chain wants to expand into a neighboring state. Well, instead of relying on operating cash flow to expand, which would be a slow process, the company can take on leverage to more quickly build out several new locations all at once. In business, sources of leverage include bank loans, debt that is convertible to company equity, term debt, etc.

What are the Advantages to Employing Leverage?

There are several advantages to using debt (or leverage, whatever you want to call it) in business investing ventures.

For one, as mentioned, it allows a manager to expand her business more rapidly. This can be key when there is a new opportunity with several competitors vying to capture new business. Being a first mover can be a key advantage, locking up key assets or forming customer relationships before competitors can. There is a reason that "Get Big Fast" was Jeff Bezos' business motto when he was building Amazon (AMZN). He saw the huge potential of e-commerce, and wanted to build scale, brand, and customer relationships before others did. Amazon's success is a testament to his strategy.

From a purely financial standpoint, though, leverage acts as a "magnifier" on investment gains. Consider a scenario where you are investing $10,000 of your own money into an investment that returns 5% a year:

$10,000 * 0.05 = $500 return per year

At the end of the year, you are left with $10,500. Not awful, but fairly mediocre.

Now, assume you managed to secure an interest-free one-year loan of $50,000, and you added that to your $10,000. Now the return looks like this:

($50,000 + $10,000) * 0.05 = $3,000 return per year

It's the same $10,000 out of your pocket, only now you are earning an effective 30% return on your money by using leverage! At the end of the year, after paying off the loan, you walk away with $13,000 - quite a bit more than if you did not use leverage at all!

This is a simple, but powerful, technique, that is key to the success of many businesses, particularly in finance (banks, insurance companies), real estate, and hedge funds.

Individual investors may think "hey, I can do that too!". And while it is technically possible, there are several risks one should consider, and as a result we prefer to avoid leverage in individual investing, particularly when investing in common stocks.

Risk #1 - The Costs of Borrowed Money

Risk #1 is simply that the costs of borrowing have to be factored in.

Our very simple example above assumed an interest-free loan, with no loan closing costs. Obviously, this is pretty rare. Average personal loan rates are above 10% even for the very best credit scores. The base margin rate for brokerage accounts at present is above 8%. There are credit cards with 0% introductory rates, but many of them require minimum payments and the rates are exorbitant if not payed off before the deadline.

Some sources of financing (loans in particular) also have origination fees to consider when calculating the cost of borrowing.

All of a sudden, borrowing for individual investors becomes much less more attractive. Your return on investment MUST exceed your cost of borrowing, otherwise you will lose money on your leverage. This must be considered as well, because leverage magnifies LOSSES as well! For example, say you borrow at 5% (a good rate), but your investment doesn't do as well as projected and returns just 3%, you will LOSE money on the deal - and at more than -2%. Now let's look at the prior example:

(($50,000 + $10,000) * (0.03)) - ($50,000 * 0.05) = -$700 loss

Uh-oh! Now instead of MAKING $300 on that 3% investment, you are LOSING $700. That's a 7% total loss on investment!

The costs of borrowing money, weighed against the return on investment, is extremely important when using leverage. If you mess this up, the magnifying effect on losses can make things go south VERY quickly!

Risk #2 - You Gotta Pay It Back

If you mess up the investment return vis-a-vis your borrowing costs, you can start to get into real trouble.

In the previous example, just a slightly less-than-expected return led to a substantial loss on investment.

Now, consider if the investment REALLY went south. Let's say that investment above actually did not-so-well and declined 20% by the time the loan came due:

(($50,000 + $10,000) * (-0.20)) - ($50,000 * 0.05) = -$14,500 loss

Now there's a big problem. Not only is your entire out-of-pocket investment gone (instead of just down $2,000), but now you have to raise ANOTHER $4,500 just to pay off the lender!

That attempt to accentuate what you thought would be a stellar investment has now led to a scramble for new capital.

While this is extremely simplified, what was just outlined here is the basic reason for many financial collapses, and why you can see once high-flying hedge funds and real estate investment companies crash into insolvency very rapidly.

Invest Conservatively

Leverage like loans or margin is very risky for individual investors. If an investment goes poorly, leverage dramatically magnifies those losses, which can not only lead to loss of capital, but also loss of capital far in excess of your initial investment. That can lead to major financial problems if you are unable to pay back the debt.

In some industries, like real estate, using leverage makes sense. The up-front costs of investment here are high, returns are (relatively) stable and predictable, and costs of borrowing are reasonably low given the tangible collateral and favorable tax treatment.

However, in an investment market as volatile as the stock market, which is unpredictable in the short term and can routinely swing 15-20% annually, the risks just are not worth it.

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