Illustration of Synthetic Leverage Credit: Greekshares
Leverage is one of the most important concepts in investing. It refers to the use of debt to finance transactions that may not be executed only with one’s own capital. Understanding the implications of leverage is crucial if one wishes to become an intelligent investor. If used well, leverage can increase returns on investment. This is because one can achieve greater absolute returns with more substantial initial capital. But there’s a twist.
Formula for Financial Leverage
Credit: WallStreet Mojo
Suppose that Investor A has $500, which he deploys to buy Company A’s stocks. If, after one year, the shares go up 50%, then his stakes would be worth $750, which translates to a (750-500)/500 = 50% return on equity.
Meanwhile, Investor B has $500 and borrows another $500 to buy Company A’s stocks. When the share price rises 50%, Investor B’s stakes would be worth $1,500, $550 of which he will use to pay down the loan. In the end, he gets to keep $1,500 - $550 = $950, which translates to a (950 - 500)/500 = 90% return on equity.
However, if things do not go according to plan, using leverage exponentially increases one’s downside. Based on the same example, if Company A’s shares had instead fallen 50%, Investor A (who does not use leverage) would have $250 in the end, whereas after the debt payments Investor B (who uses leverage) would end up with -$50! Note that they both start with the same initial capital ($500).
What type of leverage makes sense? In many cases, leverage can be a powerful tool for investors. The most attractive type of leverage is non-recourse, long-term, low-cost debt taken out at fixed rates. This kind of leverage is immune to changes to the macro interest rate environment. Even in the event of default, one cannot be held personally liable.
In real estate, for instance, this type of leverage could be a great tool to amplify returns with low risk. If, say, one takes out a $100,000 mortgage loan at a 5% fixed rate for 20 years to buy a commercial property that can generate $75,000 a year in income, then one should be able to comfortably cover both principal and interest, as well as amplify returns. Moreover, in this scenario, the downside is much more predictable and does not change in the short run, unlike with an equity investment.
Image Depicting the Impact of Leverage on Profits
How much leverage? Thus, the question is not whether to use leverage but rather how much. The bottomline is that any sensible investor would avoid taking on more leverage than he can handle. To keep things realistic, investors should remember that, historically, recessions have happened every 6-7 years on average. During recessions, rentals can drop by 60–70% (temporarily) as demand declines, even for highly desirable apartments. The property's income stream might not be as strong, but if the leverage is not too large, it might still be manageable. Meanwhile, one could get whipped out if the leverage far exceeds equity.
When is leverage dangerous? Leverage may not work so well in the stock market, where the investor is taking on both systematic and company risk. In the case of stocks, several forms of leverage – some quite precarious – are available to the investor, such as margin trading and options trading, among others. With margin trading, one needs to pay out of pocket to “cover the margins” if a stock moves in an adverse direction in the short run. When that happens, the broker requests additional funds when the balance in the client's account drops below a set threshold.
For instance, suppose the investor purchases a $1,000 security, where he contributes $500 upfront and borrows the remaining $500. If the security price drops to $800 after a month, the loan amount will remain at $500, but the equity would decrease by $200. As a result, the investor must provide an extra $200 to ensure that he can trade again. In some cases, he might even have to sell the security below his purchase price to make cash. This type of action is commonly termed a “margin call,” a source of horror for many investors.
Image Depicting Margin Trading
Leverage could be hidden: More generally, leverage can have dark implications for the economy. After all, the Great Financial Crisis of 2008 was partly caused by risky, unrecognized leverage. When financial institutions carelessly granted leverage to investors who lacked the means to pay back, widespread loan defaults set off ripples that endangered the global financial system. This illustrates how leverage can introduce complexity that may not be completely understood, even by so-called experts. In fact, many financial professionals were oblivious to the impending crisis until it actually occurred.
Watch out for asymmetry: Excessive leverage introduces downside asymmetry to your portfolio. As Murphy’s Law states: “Anything that can go wrong will go wrong, and at the worst possible time.” In other words, even events with very small probabilities will occur over a long period of time. Consider driving a supercar on an urban highway at 150 miles per hour. Perhaps the odds of having an accident, with some precautions, are very low – at 0.1%. For the first few times that one goes out for a ride, perhaps it is the case that nothing bad happens. However, if one goes out for such rides a hundred thousand times, an accident is bound to happen.
Image Depicting a Car Accident
The same applies to the stock market, where one always carries some exposure to tail risk like that of covid, although these outcomes may not materialize in the short run. However, if one is investing for the long term, even adverse outcomes with a 0.1% probability of occurring will likely happen at some point. If so, losses from positions that are highly leveraged can become catastrophic for the investor, who may see his holdings completely wiped out. To summarize, the intelligent investor must not only be familiar with the potential benefits of leverage, but also the type of leverage, the amount of leverage, and the asymmetry of leverage. Our recommendation would be to avoid using leverage altogether in public markets, as any large number multiplied by zero is zero, and, as we have discussed, in the long run, given enough leverage you run the risk of multiplying your portfolio by zero.
By Siddharth Singhai; Chief Investment Officer Gunn Wanavejkul; Analyst Darpan Saluja; Analyst
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