At the surface, the idea of leveraged investing is a simple one.
Take out some debt, use it to buy a productive asset, and wait for the moolah to roll in.
But take a closer look, and you will soon realize that most folks think about leveraged investing in very different ways.
As a result, some swear by it – while others swear to stay away from it.
So what exactly is leveraged investing – and should you be using it to accelerate your path to financial independence?
In today’s post, let’s explore a simple mental framework that will help you wrap your head around the concept.
Leveraged Investing – The Basics
Let’s say you’ve got $100k you want to put to work.
To avoid overcomplicating things, you plonk it down into the stock market.
Alternatively, you could also buy some real estate. Being a conservative type, you buy the property outright, with no mortgage.
Whatever it is you choose to do, you then leave it there for 20 years.
For simplicity, let’s assume that the asset you buy appreciates by 8% a year – a reasonable assumption for both stocks [link to magic money machine] and real estate.
On a fine sunny morning two decades later, you wake up, check in on your asset and see that it’s now worth $466k.
Or is it?
Great Expectations Aspirations
Say you happen to run some basic math and realize that while compounding is indeed awesome, $466k in 20 years just ain’t gonna cut it.
Well, the obvious thing you could do here is to lever up.
I mean, isn’t everyone doing it these days? And it’s not like you are buying crypto on margin (more on this later).
Thus, you decide to use your $100k as collateral to secure a $100k loan.
This can take many forms, including a margin account with your brokerage, or a plain old mortgage if you are buying real estate.
All of a sudden, you’ve got $200k to invest.
Now, you don’t have to be a genius to figure out that at the same return rate of 8%, your investment is going to be worth $932k in 20 years.
At the same time, there’s the pesky question of the $100k loan you’ve taken out way back when and is now due to be repaid.
Assuming a 3% interest rate and a bullet (i.e., end of term) repayment, your liability will have grown to $181k.
You liquidate the asset, pay off the loan – and are left with $752k of equity.
That’s a very nice 61% increase vis-à-vis the $466k in the first scenario above.
But what’s really sweet about this whole situation is that that extra money comes at zero extra cost (or frankly, effort) on your part.
Talk about value creation!
Money For Nothing
Now that you’ve tasted the sweet nectar of making money out of thin air, you obviously don’t want to stop.
50% leverage is something conservative boomers would do, not the brave Robinhood generation!
What if you were to take out a $400k loan against your $100k investment?
Unsurprisingly, the numbers just keep getting better:
Your asset appreciates to $2.3m. There’s a hefty loan of about $700k, but who cares?
After paying off the loan, you’re still left with $1.6m of equity for your troubles.
It’s an absolute no-brainer, you decide. No wonder they say leverage is the key to building wealth:
I mean, why doesn’t everyone do it? And what could possibly go wrong?
As it turns out, plenty.
The annoying thing about life is that it doesn’t always follow a predictable, upward trajectory – and neither do the financial markets.
And so the real path to wealth is lined with bumps, diversions, and an odd meltdown in asset prices that makes you want to run to your bedroom, hide under the duvet, and pray for the proverbial storm to blow over.
This is exactly what happens in year 10 of your investment. Mr. Market sneezes and all of a sudden, your asset declines in price by 50%.
To say this isn’t enjoyable would be an understatement.
But if you haven’t got any leverage, you kind of feel okay about it.
After all, you know that losing money in the stock market over the long run is near impossible:
As always in the past, the proverbial winds will blow over and the market will roar back with a vengeance.
The problem is that your levered alter ego is unlikely to survive long enough to see the good times return.
This is what happens to your investment portfolio in the event you were 50% levered:
Your asset drops in price to $200k.
Sadly, your liability doesn’t.
Rest assured, that annoying bank of yours will give you a ring with a reminder that you still owe them $134k.
Come hell or high water, they will still want their money back.
Now, if they get all nasty about it and force you to liquidate, you’ll still have about $66k left over.
In other words, the green line on the chart above is still above zero.
Phew. You are wounded, but not defeated.
But what if your leverage was 80% instead of 50%?
Crashing And Burning
We all know where this is going by now:
By virtue of shooting for the stars, you’ve walked straight into a trap.
Your asset is now worth only $500k, but your liability is a whopping $538k.
You are now “underwater” on your investment, with negative equity of $38k.
Time to say goodbye to your asset – and hello to the friendly repo men.
If you could convince them to have some patience, you’d totally make the money back – and then some.
Alas, that’s not how leverage works. Your loan will be called in, assets liquidated (at rock bottom prices) and you’ll end up on the hook for any outstanding amount.
Back To Earth
Therein lies the fundamental challenge with leveraged investing.
It works astoundingly well when the markets are on a tear.
You can double your money in a few months, lever up some more – and keep on going, rinsing and repeating your way to wealth.
But at some point, the music is bound to stop.
And even a short intermission is enough to blow up your portfolio – and take you down along the way.
Leveraged Investing: Rules Of The Road
Now that we’ve illustrated the basic concept, let’s double click on a few important points.
The obvious one is that you should never borrow money at a higher rate than the expected return from your investment.
It’s an absolute no-brainer, and yet I’ve come across folks who did just that – with dire consequences.
Then there’s the fact that the higher volatility of the asset class you are investing in, the higher the chance you’ll get blown out of the water.
Hence, while levered crypto investing may give you an awesome adrenaline rush, it’s also a sure-fire way to lose your shirt.
But the most important aspect is the asset class you are investing in – and the kind of loan you use to finance your investment.
If you are investing in equities, you will most likely use what’s known as a margin loan.
The sucky unfortunate thing about these margin loans is that they are callable.
That is, if the value of your portfolio gets too close to the value of the loan, your lender will demand that you top up your account.
If you don’t, they will liquidate some of your securities.
You don’t have to be an investing genius to realize that selling at the bottom of the market is the worst possible outcome.
Wait a second, you say. But what if I hold some cash in reserve in the event this happens?
Doesn’t that solve the situation?
Sure. But if you have some cash sitting on the sidelines, are you really using leverage in the first place?
Not really. You just paying someone else to use their money – all while your cash is sitting in a zero-yielding savings account.
What about real estate, you ask?
No one can call my mortgage in regardless of what happens in the housing market!
Spot on. Hence, taking out a mortgage to buy a house (or an investment property) is pretty much a staple in western society.
As long as you’ve got enough of a cash reserve to make your mortgage payments, even an interest-only (i.e., a 100%) mortgage can’t blow you up.
The only reason banks (and governments) don’t like the idea of high loan-to-value mortgages is because it leaves you with zero skin in the game.
If things get patchy, you simply walk away, leaving your lender on the hook.
At this point, the more creative readers might have a clever idea forming in their heads.
If you have a paid-off house, what about taking out a new mortgage against it – and using that money to invest in the stock market?
Best of both worlds, isn’t it?
Well, it kind of is – except that while the idea is indeed clever, it’s certainly far from novel.
What we are essentially talking about here is the advantage of not paying off your mortgage early – and putting your savings into the stock market instead.
There may be other advantages (peace of mind, anyone?), but that’s a topic for another day.
To wrap it up, leveraged investing is a lot like pouring gasoline on fire (pun intended).
Done properly, it can lead to some spectacular outcomes.
It can also lead to some pretty disastrous consequences.
The good news is that now you’ve got a handy mental framework to assess the risk (and upside) that comes with it.
Thank you for reading – and happy (leveraged) investing!
About Banker On Fire
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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
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