The Power of Investment Leverage
I was having a beer on Thanksgiving Day with a broker friend of mine who told me a story about a client. She’s a recently widowed woman whose husband had left her a safe deposit box full of stock certificates. “When I’m gone, you’ll be set for life,” the husband had told her.
When my buddy opened the box on the widow’s behalf, he was taken aback. All of the stock certificates were nearly worthless penny stocks. The widow was, in fact, broke. (This holiday story doesn’t exactly have a Frank Capra ending.)
I was wondering if maybe the same thing could happen to some of you out there. You think you’re set for life, but then in your supposed “golden years,” you get a nasty surprise.
Bad investment decisions can ruin your retirement, but only if you let them happen. With the right tools and knowledge, devastating financial outcomes can be avoided.
Perhaps you’re feeling insecure about whether you’ll outlive your income. Maybe you get the nagging feeling that you’re running out of time to accumulate wealth. As I explain below, there are actions that you can take now to build a more secure future.
With U.S. stock markets open for only half the day on so-called Black Friday, I want to discuss the investment power of leverage, which is just a fancy word for “debt.”
Through the strategic deployment of leverage, you can give your portfolio a shot of steroids, for exponential gains in relatively short time frames.
To be sure, there are clear benefits to owning something outright. For example, stock ownership conveys to the stockholder an actual share of the company, certain voting rights (depending on the stock) and, if available, dividends.
On the other hand, without using leverage, you’re limiting your potential gain from an investment. We’re conditioned to think of debt as necessarily bad, but that’s a simplistic view.
Jim Fink, chief investment strategist of Velocity Trader, explains it this way:
“When you buy a stock, the only way to make a profit is if the stock rises in price. It must rise in price or you are out of luck. Even if the stock does rise a little, the rate of return may be minuscule because of the large upfront cost entailed in buying stock.”
When it comes to the power of leverage, the ancient Greek mathematician Archimedes expressed it aptly: “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”
Leverage can indeed move worlds of money, if used properly. Let’s look at a few common and simple ways that you can use leverage to turbocharge your returns.
The golden example…
Leverage can be used at the individual level (we’ll talk more about that later), but a good way to harness the power of debt without going into debt yourself is to buy the stock of a company that uses leverage at the corporate level. Corporate leverage is a powerful driver because it directly multiplies the corporate earnings of the company, which in turn drives stock prices.
When a company uses debt, more of its top line revenue growth flows through to its bottom line earnings number. And when you break down stock investing to its essence, a stock’s value is solely dependent on the present value of the future earnings that will be generated by the company.
In previous articles, I’ve examined the difference between owning gold and owning gold mining stocks. This difference perfectly illustrates the gain-boosting power of corporate debt.
As I explained, if you own gold mining stocks and the price of gold goes up, the notion of “operating leverage” comes into effect.
A bump in gold prices will likely exert an exponential boost to a gold producer’s top line revenue. That’s because the producer doesn’t have to put additional labor or capital into digging out increasingly valuable gold.
Using loans and lines of credit…
The simplest and easiest form of investment leverage is through a loan or a line of credit.
To better understand how leverage amplifies returns, consider a common form of leverage: the home mortgage.
Here’s a hypothetical return calculation: You decide to buy a $100,000 house with a $10,000 down payment and a $90,000 mortgage. The $10,000 is your equity investment in the home, and the rest of the purchase price is covered by the bank’s $90,000.
If the home’s value increases to $110,000, you’re able to pay back the $90,000 bank loan and keep the remaining $20,000. You made a +100% return on your $10,000 investment.
Had you purchased the house with 100% cash, you would have made $10,000 on your $100,000 investment, a return of only 10%. [The rate of return calculation is ($110,000 – $100,000) / ($100,000) = 10%]
Getting back to stocks, let’s say you have a hot tip on a stock you’re convinced will move dramatically upwards in a short amount of time. You could borrow the money to buy the stock, sell the stock before the loan is due, and pocket the profits (assuming the stock has gone up).
As a rule, stockbrokers enforce a “no credit card” policy for buying stocks, to protect average investors from getting in over their heads. But that only applies to direct card purchases. There is nothing to prevent you from using a line of credit or cash advance from your credit card to buy stocks. That being said, you have to make sure that the return on your investment exceeds the interest and transaction fees incurred by borrowing the money.
The advantage of using “plastic” as investment leverage: credit card debt is unsecured and poses no danger to your assets. The disadvantages…well, they’re obvious. You could be very wrong about your hunch and get stuck with a lousy investment, as well as a big fat credit card bill.
Buying on margin…
Most brokers will let you set up a margin account, which allows you to borrow money from the broker at a pre-set interest rate. Investors can generally borrow up to 50% of the cost to purchase stocks.
Let’s assume you have $10,000 to invest and you use it to buy 500 shares of a $20 stock. If the stock’s price goes up to $25 in 12 months, you end up with a $2,500 gain and a +25% return. That’s your un-levered return.
Now, let’s apply some leverage and see what happens.
Assume you still have $10,000 to invest, but your broker allows you to borrow up to 50% of any stock purchase at an interest rate of 10%.
Now you can buy 1,000 shares at $20 per share, for a total investment of $20,000 ($10,000 borrowed and $10,000 cash). The stock goes up to $25 per share and you cash out your shares for $25,000. You pay back $10,000 to your broker, plus $1,000 in interest. The $4,000 profit on your $10,000 investment is a whopping +40% return.
One of the worst things that can happen to an investor is receiving the dreaded margin call from his or her broker. A margin call is a brokerage firm’s demand that a client deposit cash into their account to bring the account balance up to the minimum maintenance margin requirement.
Investors must put up a minimum initial margin of 50%, a rule enforced by the Federal Reserve. Furthermore, a “maintenance margin” of at least 25% must always be maintained. The maintenance margin protects the broker if the value of your investment declines.
If your “equity” in value of your securities drops below the maintenance margin of 25%, your broker will send you a notice (a “margin call”) that requires you to either liquidate your position or inject more cash into your account.
If you don’t have the wherewithal to cover a margin call, the experience can be quite unpleasant. If you can’t cough up the money, the brokerage has the right to sell your securities to boost your account equity. Depending on the terms of the margin agreement, this can even be done without your permission. Always examine the fine print of your broker agreements.
The wizard of leverage…
The above article is merely an introduction to different ways to use investment leverage. One guy who’s a wiz at using leverage is my aforementioned colleague, Jim Fink.
As chief investment strategist of the premium trading service Velocity Trader, Jim Fink has devised investing methodologies that make money in up or down markets, in good times or bad.
Jim has put together a new presentation that shows smart investors how to earn massive gains in a short amount of time. Click here for free access.
John Persinos is the editorial director of Investing Daily. To subscribe to John’s video channel, follow this link.