What is it?
Investment leverage is the usage of debt in addition to (or instead of) one’s own capital, when executing an investment.
Generally speaking, leverage makes sense when its cost is lower than the expected return from the investment: if I can borrow money at 1% and I can invest it at 4%, I can pocket the difference.
The key to understanding leverage – and whether to use it or not – is to realize that the bank that lends you money for an investment does NOT take the risk of that investment: i.e. you will need to return the funds (with interest) regardless of whether the investment expected return has materialized or not.
Return multiplier
Leverage works as a return multiplier. If I invest $100 (90% of which I borrowed at 1%) and generate a return of 4%, I essentially increased my return from $0.4 (the return generated on my own funds, 4% of $10) to $3.1 ($0.4 plus 3% of $90), i.e. a x7.75 multiplier.
But what if instead of the expected return of 4% the investment causes a 5% loss? A $0.5 loss (without leverage) would increase to $6 (x12 multiplier), as a large part of the investment proceeds of $95 ($100 after losing 5%) needs to be returned to the bank, regardless.
In other words, leverage goes both ways.
When to borrow money
The decision to borrow investment money is a function of two main factors:
- the risk associated with the investment return: the higher it is, the greater the chances that leverage will amplify losses rather than returns;
- the difference between cost of debt and investment return: this has to be positive (i.e. I shouldn’t borrow money if I cannot generate a return greater than its cost), and the larger it grows, the greater the incentive to borrow becomes.
The one asset class that has historically been considered the most obvious candidate for leverage is real estate (and it’s called a mortgage in this case), and that is because it has historically been relatively stable, therefore not having valuation swings or drops that would cause leverage to amplify a loss. In addition, when it comes to real estate, most people do not actually have enough funds and only leverage makes purchasing possible.
Margin
When an investor borrows funds to make an investment, that investment is pledged to the lender so that, if the investor fails to return the capital, the lender can liquidate the investment and net its credit against the sale proceeds. When the value of the investment decreases beyond a certain threshold (maintenance margin), the investor is usually given the option to either sell the investment, or pledge additional cash or securities (margin call). This means that – in order for the lender’s position to be protected – the volatility of an instrument – which is another measure of risk – can cause an investor to increase his or her exposure beyond the own capital initially invested, or materialize the loss.
Investment leverage in the current environment.
In the recent macroeconomic environment of low borrowing rates and high inflation, leverage has been a formidable force: one could borrow at 0-1% interest rates while getting double digits returns on most asset classes. However, tables always turn at some point: central banks are already announcing interest rate hikes, and returns cannot be this high forever. One needs to thread with caution in this potentially changing environment, and manage risk carefully.
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