Definition: Leverage Amplifies Everything
When you think of leverage what generally comes to mind? A fulcrum? A pulley? In the world of money, leverage means DEBT! That’s right, whenever you hear the word leverage in the context of money it is always a reference to debt. Debt, the evil that brought down the financial markets in 2008. Debt, the nemesis of Dave Ramsey and Suze Orman.
While debt can be a very dangerous thing the fact is that without debt, without leverage, our financial systems would simply not function. In this article of The 12 Principles of Money we address Principle #4 – The Principle of Leverage and I will remove the hype and the hyperbole and describe what debt/leverage is and what it is not. Let us take an objective look at the leverage. To start the process you must first understand that leverage is the same as debt, and that…..
DEBT Is Not Another Four Letter Word!
Seriously… one of the fundamental principles of Dave Ramsey is to pay off all of your debts, including your mortgage before you start to save for your retirement. Frankly, for many home owners this is a very good philosophy because for many of them paying off the mortgage first is the ONLY way to begin saving money. That being said, the reality is that debt is not inherently a bad thing. In fact, debt is a very, very good thing because debt/leverage amplifies the gains on our investments. However, it also multiplies our losses and that is why as The 4th Principle of Money we simply state that, “Leverage Amplifies Everything.”
Example of an Investment with No Leverage
Initial Cash Investment = $100,000
Rate of Return = 10%
Return on Investment = $10,000
This example is simple. If you had $100,000 and were to invest that money at a rate of 10% (yearly interest) at the end of the year you would have earned $10,000.
Example of an Investment with Leverage
Initial Cash Investment = $10,000
Borrow = $90,000
Cost of loan 6%
Total Investment = $10,000 + $90,000 = $100,000
Rate of Return = 10%
Return on Investment = $10,000
In this example we are going to invest $100,000 just like we did in our previous example. However, we are only going to invest $10,000 of our own money. The other $90,000 will come from other people (O.P.M. – Other People’s Money) which we will borrow from them at a cost of 6% interest.
Altogether, we have $100,000 to invest at 10% per year. Once again, at the end of the year we will have earned $10,000 from our investment. If we stopped right here, however, we would be telling only half the story because we need to deduct the cost of borrowing the $90,000 from our $10,000 of earnings. At 6% interest the cost of borrowing $90,000 would be $5,400. As a result:
$10,000 – $5,400 = $4,600 in Net Profits
On the surface this looks like a bad deal. After all, wouldn’t you rather have $10,000 instead of only $4,600? Of course you would, however, you must look at the entire picture. How much of your money did you actually invest to earn $4,600? You did not invest $100,000 of your money. You invested only $10,000 of your money and borrowed the other $90,000. Since we have already deducted the cost of borrowing the money from our profits the net return on investment formula now looks like this:
$4,600/$10,000 = 46% Rate of Return
Do you see what happened? Your profit exploded! This is the power of Principle #4 – The Principle of Leverage. This very simple example clearly demonstrates how leverage will amplify your earnings. Generally, to earn a higher rate of return we would have to accept a higher level of risk for our investment; the greater the risk, the greater the return.
For example, everyone would agree that a bank Certificate of Deposit is far less risky than a Junk Bond. Therefore, (as of January 22nd 2012) a Bank CD would pay around 1% interest and a Junk Bond would pay 7% as the riskier investment pays a higher rate of return.
With leverage, however, we can effectively increase the rate of return on our investment and, because we did not change the actual investment, we did not make a fundamental change to our risk. Yet, we increased the net rate of return by a whopping 460%. Truly, debt/leverage amplifies everything.
If you were to follow that logic one might conclude that if a little leverage is good, then a lot of leverage would be……..GREAT! After all, if we can increase our rate of return without increasing the risk of our investment, why not? Really, why not? The logic is solid with one very important consideration, leverage works both ways. Meaning that not only will leverage amplify your gains, it will also amplify your losses and since NO INVESTMENT is absolutely risk-free, you have to consider that your investment could lose money too.
Example Losing 1% with Leverage
Initial Cash Investment = $10,000
Borrow = $90,000
Cost of loan 6%
Total Investment = $100,000
Loss of Return 1% = $1,000
Net Investment = $99,000
Rate of Return = 10%
Return on Investment = $9,900
Cost of borrowing = $5,400
Net Returns $9,900 – $5,400 – $1,000 (Loss to principle) = $3,500 in net profits
Now our returns look like this:
$3,500/$10,000 = 35% Rate of Return
A measly 1% loss to our investment causes our rate of return to decrease by more than 20%. Yes, leverage amplifies everything, both your gains and your losses. Let’s take a look at another example.
Example Losing 6% with Leverage
Initial Cash Investment = $10,000
Borrow = $90,000
Cost of loan 6%
Total Investment = $100,000
Loss of Return 6% = $6,000
Net Investment = $94,000
Rate of Return = 10%
Return on Investment = $9,400
Cost of borrowing = $5,400
Net Returns $9,400 – $5,400 – $6,000 (Loss to principle) = ($2,000) net LOSS
Total Investment = $10,000 + $2,000 = $8,000
Now our returns look like this:
($2,000)/$10,000 = 20% Loss
Wow! Now a measly loss of 6% to our investment reduced our rate of return from a positive 46% to a negative 20% rate of return. Yes, leverage amplifies everything, both our gains and our losses.
Let’s take this a step further. Let’s apply Principle #1 - The Regeneration Principle to this example. In other words, now that you have experienced a 20% loss of your money, how much will you have to earn on the remainder of your money just to break even? How much? Well…
Example of Principle #1 – The Regeneration Principle
Initial Cash Investment = $10,000
Net Investment After Loss = $8,000
Difference Needed to Break-Even $10,000 – $8,000 = $2,000
$2,000/$8,000 = 25%
That is correct, after experiencing a 6% loss of principle you would need to earn 25% on your money just to earn back the money you lost. That is a big problem, but it gets worse. If you invested in the same investment as you did previously you would only earn 10%, which is not enough to break even. This means that you would likely need to invest in a riskier investment, one that would pay a higher rate of return. However, with a higher rate of return comes a higher risk of loss, which if you were to experience would put you even further behind.
But wait…there’s more!
One might ask, “Why bother investing in riskier assets to increase our rate of return?” After all, we have learned that leverage amplifies everything, right? Why not just borrow more money to increase our leverage and then purchase the same lower risk investments? Why not borrow enough money so that the same investment with the same rate of return would earn enough money to bail you out. Brilliant! !
Let’s play this idea out. Remember, you initially borrowed $90,000 @ 6% interest. Now you would may consider two different options. 1) You could borrow $90,000 again. Then, the $5,400 of interest still has to be paid. 2) You could borrow $92,000 so that you would once again have $100,000 to invest. Either way, you will need to earn an even greater Rate of Return just to break-even. Let’s look at the details using option #1.
Example of Principle #1 – The Regeneration Principle
Initial Cash Investment = $10,000
Net Investment After Loss = $8,000
Difference Needed to Break-Even $10,000 – $8,000 = $2,000
Cost of Borrowing = $5,400
Total Return Needed to Break Even = $2,000 + $5,400 = $7,400
$7,400/$8,000 = 92.5% Just to Break-Even!
Brilliant? Brilliant unless, or until, you experience another loss. Then what? Are you going to borrow even more money? If it does not work and if you were to experience enough losses eventually you will run out of principle altogether. Then what? Are you going to borrower 100% of the money you need to invest? I don’t think so!
The most important question you need to ask is should you consider using leverage to help you to achieve your financial goals? My basic answer would be absolutely yes! In fact it is almost impossible for you to achieve your financial goals without using leverage. That said,
- Use it wisely
- Use it appropriately
- Understand and the risks
- Have a realistic plan to recover from any losses you would experience if they do occur, because the will
The bottom line is this, leverage is another financial tool and like any tool used properly it can provide tremendous advantages. Used unwisely, excessively or foolishly it can be an absolute disaster.
It’s a Good Life!
Randall A. Luebke RMA, RFC
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