Much of the conversation around our current economic mess has been around leveraging. This might sound like the buzz word of the week, but leveraging is a system of investing that is used by banks, financial firms, and independent investors. In the most basic sense it works by borrowing money to invest with. Businesses are ‘leveraging’ their debt against future investments and potential returns. When done right it can pay off – big time, but as the current economic situation shows, rarely is it done right.
Leverage is false equity. Here is a way to break it down as simply as possible. Let’s say that you have $5000 in the bank. Your personal equity is $5000. Now let’s say that you also have $10,000 in credit cards. So, the way leveraging works is to look at that debt as equity. So now your personal equity is $15,000. Seems a little weird, right?
Of course, this system doesn’t take into account interest rates, annual fees, transactions costs, etc.; which is only part of its flaw.
The most obvious issue with leveraging is if the investment fails. If you use leveraging to make an investment and that investment doesn’t pay off then your losses are going to be much higher than they would have been without that borrowed money. You see, leveraging increases gains, but it also increases losses. If a company was to try and leverage their shareholder’s money and that investment failed, the interest and credit risk would destroy the shareholders value. Risky business indeed.
Typically, leverages are connected to financial derivatives, which are things like swaps, index futures, and options. Yes, these things are already available to investors, but with leveraging they are much more complicated than the traditional system of simple buying and selling because you are adding borrowing into the mix.
Investors that use leveraging typically expect a double return and the job of the fund is to balance the debt and equity all of the time. But the market moves too quickly to keep things balanced that cleanly and the leverage ratios can easily be thrown off when assets or debts are no longer even. When that happens the fund will have to buy or sell shares, which will drive up the expenses and transaction costs because of the fluctuations of funds, but it will also drive up capital gains taxes. More expenses.
The other side of that is when the fund is losing value. Then it will have to sell shares to reduce debt and that locks in the losses which makes it harder to have a gain in the fund when the market starts to move in the other direction. Just like debt, it makes it harder to get out of it the further you get into it. To the savvy investor this cycle of loss and gain with leveraging is known as the Constant Leverage Trap.
When you start to research the specific leverage funds out there, it won’t take long for you to see that the overall performance is poor. In a bull market they do alright, but in an economic downturn they struggle and that is what a leveraging investment is always going to do. The costs don’t outweigh the risks.
Investors are star struck by the thought of a two for one return with leveraging, but the double is based off of daily returns; which is not the same thing as an annual doubling. With the overhead costs this isn’t earning you as much as you think it is. Because the funds can only survive by selling when costs go down and buying when costs go up, this creates instability and that is difficult to recover from.
The entire real estate industry was based off of the idea of leveraging and for many years this worked and made people a lot of money, but when the housing market crashed, well you know the rest of that story. When you purchase a home with borrowed money and the value of your home increases, you make money off of the deal. Hooray. But many people borrowed money to buy a home and then their home’s value decreased, which put them upside down in debt for a home that was now worth less than they paid for it; or more correctly, they cannot sell the house for as much money as they owe on the mortgage. This is exactly what leveraging is and why it isn’t a good idea.
Leveraging require a high risk tolerance. If you aren’t overly worried about losing all of that money, well then, good for you, go for it. But these investments are highly risky and you shouldn’t enter into them thinking that you are going to make quick money. This volatile market requires a long term investment of up to seven years and during that time you will see a lot of hits against your investments.