What You Need To Know About Leverage

The concept of leverage is important in the world of finance. It can lead to outsized returns, as well as enormous losses. But for the most part financial leverage is misunderstood and misused. This piece will explain what financial leverage is, where it’s useful, where it’s dangerous, and what this means for you.

Leverage is the use of borrowed capital to fund an investment. Think of it in the context of a house costing £500,000. You may have a £100,000 deposit and borrow £400,000 (the debt).

For most of us, it’s only by adding debt that you can afford to buy the house – in other words you use leverage to fund your purchase. In this example, your leverage ratio is 5:1, because you have a £500,000 asset for a £100,000 equity investment. The remaining £400,000 is debt.

A Double-Edged Sword

If the house increases in price by £50,000, its value increases by 10%. But what happens to the value of your stake?

With the house price at £550,000 and your debt still at £400,000, your equity is now worth £150,000, up from £100,000.

As the house price has risen 10%, your equity position has risen 50%, reflecting the leverage ratio of 5:1.

This seems to be an easy win – leverage magnifies your upside. But leverage is a double-edged sword – just as it improves your gains, it also increases your losses.

Take the same example of buying a house with £100,000 deposit, and £400,000 of debt. If the property price falls from £500,000 to £400,000, you still have your £400,000 of debt, but your equity is fully wiped out - because the property value is equal to the debt you owe.

And if the house price fell further, you would be in ‘negative equity’. This means you would owe more money in debt than you had in the value of the asset.

This is the negative aspect of leverage, magnifying the downside.

Why Leveraged Trading is a Terrible Idea

Applying the same concept from houses to financial markets, you can see why leverage becomes a problem. In upward markets, leverage seems to be your friend, but in downward markets it can quite literally drive you bankrupt.

You may think that a certain company is undervalued, and you may be right. If you are unlevered, the most you can lose is the size of your initial investment. But if you have levered up your initial investment with debt, you can lose multiples of your investment – money you probably don’t have.

You might be right in the long-run that the company/stock is undervalued, but if the price falls in the meantime you will go bust. This type of behaviour is not conducive to long-run investment success; over time, it inevitably leads to failure. Just look at the 2008 Financial Crisis as an example.

So Why Does Leverage Even Exist?

You may be pondering this very question. The answer is that, in some contexts, leverage can be very useful.

When applied with care, it can be useful for buying a house. If you make your first purchase in your thirties, it’s unlikely you can afford the full value of the property up-front. But it’s quite likely you will be able to afford it by the end of your working life. So rather than buying it 30 years later, you can buy it now, with a mortgage (leverage), and pay mortgage interest for the privilege.

Leverage is also useful for businesses as they expand. If they don’t have all required money to build a new factory, they can borrow some now and pay back the interest through the revenue they generate from the new factory.

If the factory is unsuccessful, they will have financial problems. But if successful, it’s a clear win. The business can build its new factory today with some borrowed money, rather than waiting ten years to save for the up-front cost. This type of entrepreneurial leverage is a key part of capitalism’s success.

How Should I Use Leverage?

Cautiously.

Financial assets – including stocks, bonds and real estate – can go up and down. If you have a leverage ratio of 10:1, it will only take a 10% downside to wipe out your entire position. This is not prudent.

A better way is to limit your use of leverage to property, and to pay down the debt until it reaches more sensible levels, say 60% loan-to-value. And for positions in the stock market, it’s far better never to use leverage at all.

Financial leverage is useful in certain arenas, but dangerous in others. Think and act accordingly – you have been warned.