The Black Magic of Leverage

There are two ways to promise outsized profits. Lies and leverage. Beware of both of them.

I like the American Greed series on CNBC. That’s a show that talks about con artists and frauds. One common theme is con artists that promise extra high returns, guaranteed!! Even very smart people can be duped if you tell them they’ll make a lot of money. Many of these con artists are just flat-out lying. They make up reports that say everything is rosy, and once in a while they send along checks to prove it. But the checks are just coming from somebody else’s investment, and not actually investment profits. So lying is one way to promise high profits. And nobody thinks that’s a good idea.

But there’s another way to get outsize returns, and it’s legal and real. You can do it by using leverage. Leverage really does juice up returns. At least as long as prices are going up. But it has a very important caveat that its backers don’t always talk about. Leverage also produces outsize losses when prices go down.

So what is leverage, and why should we care? Leverage is a very old physics concept. If a boulder is hard to lift, you can stick a long stick, a lever, underneath it, and you can lift the boulder with much less effort. So leverage is anything you do that allows you to achieve the same result with less work or less input.

In finance, leverage usually means borrowing money. If you want to buy a $100 stock, you could pay for it with $100 of cash or you could use $50 cash and borrow the other $50. Why in the heck would you do that?

Let’s say the stock goes up by $10. If you paid cash, your return is 10%, you paid $100 and got $10 back. If you borrow money, your return is higher. You paid $50 and got $10 back, a return of 20%. You have to pay back the loan, of course. Let’s say the loan cost you 5%, or $2.50. You still have an outsize return, an investment of $52.50 gets you $10, or 19%. Pretty sweet!

But what if the stock goes down? Then the returns are much, much worse. Let’s say the stock goes down $10. If you paid cash, you lost 10% of your investment. If you paid $50 and still have a loan to pay back, you lost almost twice as much, 19%.

If the stock goes down really badly, 50%, your loss would be 50% in a cash transaction, but your leveraged loss would be 105%!! The math gets worse and worse, depending how bad the loss is.

If you invest cash, the worst you can do is lose your whole investment. With leverage, you can lose more than you invested in the first place!

One reason this matters is that some investments are using leverage to juice returns. There is a whole new class of investment called “Leveraged ETFs” that would love to take your money. Unlike the con artists in American Greed, the promises leveraged ETFs make are genuine, they have the potential to produce impressive returns. But if you read the small print they should be disclosing the risk of outsized losses as well.

If you own mutual funds or ETFs, it’s a good idea to take a look at the actual list of their holdings and the descriptions of how they operate. If you see debt, you might want to ask more questions. Most importantly, look beyond the history of your funds’ profits. When leveraged funds are stacked up against other funds based on recent history, they will look very impressive, since the market has mostly been going up for many years. Read the small print and know what your funds are investing in. Most importantly, be aware of whether they are juicing their returns using leverage.

Another place we’re seeing a lot of leverage is in private credit and private equity. Private credit and private equity are not sold on the stock market and they used to be mostly available to big investors. But rules are being relaxed and they are now being marketed to ordinary investors and even becoming available in 401(k)s. There are many, many reasons to treat private credit and private equity with great care, but one important reason is that they often use leverage to get the big returns they like to promise. Buyer beware!

Leverage comes into play in your personal life too. Let’s say you own a home that you paid for with a mortgage. You used leverage. If house prices are going up, and you made a very small down payment, the return you got on your initial investment can look pretty spectacular. But the math works the other way, rapidly, when house prices go down. If the value of a highly leveraged house goes below the total outstanding mortgage, the homeowner is under water and in a world of hurt.

Does that mean you can’t ever borrow to buy a house? Not at all, but you do need to calculate what would happen if house prices go down instead of up. If you have a cushion for the downside you can be fine. A tiny downpayment at a time when house prices are so high they can only go down can get you in trouble. A bigger down payment gives you a cushion even if prices drop.

Some people go beyond using leverage on their own home and buy short and long term rental properties using lots of debt. There are seminars that teach you how to do it. They call it “passive income”, which sounds pretty great. For a tiny down payment, or maybe even no down payment, you can make a killing in income property!!

Just as with your personal home, the value of those properties can go down as well as up. In fact, the prices of rental property may be more volatile than owner-occupied homes. If you buy rental properties that have lost their value using leverage, you still have to pay those loans back. Sometimes the only way out is to sell the property and take a loss, and in a bad market that might not even be possible.

Pay attention to leverage. Leverage is powerful. It can help you or it can destroy you.