Leverage is a fundamental concept in finance that is essential for every new investor to understand. It is fundamental to one’s understanding of risk, and therefore one’s ability to invest.
What is leverage?
Leverage refers to an investment that is made with some, or all, of another individual's money. For example, if investor A buys a share of company X for $100 dollars, but gets 50 of those 100 dollars from a bank loan, then that investment is considered to be levered. Bank loans are not the only source of leverage. Anytime an individual uses funds or buying power that does not solely come from their equity (or money) in an investment, that investment is levered. Leverage does not only come in the form of bank loans. Purchasing options contracts are a form of leverage, and some ETFs are leveraged to amplify their volatility.
Why use leverage?
Leverage can increase the returns an investor realizes on a profitable investment. In the example above, imagine investor A buys a $100 dollar share of company X with only her own money. Thus, she has $100 dollars of equity in the investment. Now imagine three years from the time she purchased the share of company X, she sells it for $200. Her net return is 200-100 = 100. That is a 100% return. Now, imagine she made the same investment but with 50% leverage, like in the paragraph above. Now her return on her money is 200 - 50 = 150. That is a 300% return. In the real world, investor A would have to give a little bit of that return back in the form of interest, but this example illustrates how leverage can magnify the effects (and returns) of a profitable investment.
What are the risks of leverage?
When things go badly, they go worse if they are levered. Just like leverage magnifies the positive effects of a good investment, it magnifies the negative effects of a bad one. For example, imagine investor A pays $100 of her own money for a share of company x (no leverage), and sells it for $75 dollars a year from now. She lost 25% of her initial capital. That's not great, but not terrible. Now imagine that investment was levered. She loses $25 of the $50 dollars she put in because she still needs to pay the bank back 50 dollars. Thus, she loses 50% of her invested capital. That's much worse than if the investment was not levered.
Should you use leverage?
In short, no. No new investor should use leverage. As one gains more experience, small amounts of leverage can be beneficial, but it is essential to understand exactly how much a position is levered and weigh the benefit and risk of the extra volatility.