While leverage can be applied to great effect in boosting your financial returns, it also has some disadvantages, that need to be managed. It is therefore critical to make sure you understand these disadvantages, and manage the risk related to them.
With the appropriate attitude to risk, and a cautious approach to diversifying your portfolio, leverage can provide the rocket fuel necessary to multiply your investment capital and accelerate your wealth creation process.
Risks of Leverage:
Multiplication of Losses
The primary and widest feared drawback of leverage is its potential to scale up losses when the going gets tough. When things are going well and the markets are going your way, leverage is a fantastic tool to have on your side, propping up your earnings and increasing the speed of your returns. However, when markets and positions start to move against you, things can become pretty difficult pretty quickly with leverage turning against you to cause potentially extensive damage to your trading portfolio. Just as your earnings have unlimited potential when you win with leverage, your losses can also be unlimited when you lose.
For example, if you buy a house on mortgage with a 25% down payment and then either the market becomes illiquid or interest rates skyrocket or you banked on rentals to pay the mortgage repayments and then you fail to get tenant. You can end up with foreclosure where you lose your capital and the property. In some cases if you have given an unlimited personal guarantee then if the funds obtained at the forced disposal of the house does not cover the mortgage amount they may pursue collection from you personally. So your ultimate loss will be more than the capital you had put down. In other words, the effect of leveraging is to increase the volatility of returns, and increase the effects of a price change on the asset to the bottom line, while increasing the chance for profit as well.
Leveraging can begin with increasing losses and end with these losses being “locked in,” in a remarkably short time. This illustrates how leveraging can quickly get out of hand and end in bankruptcy very quickly.
Other Risks of Leverage
Suppose one company borrows money to acquire another company. This is called leveraged buy out. If a company’s returns are less than the cost of the debt financing, then corporate bankruptcy can result. In addition, the high-interest rates imposed by leveraged buyouts may be a challenge for companies whose cash-flow and sale of assets are insufficient. The result cannot only lead to a company’s bankruptcy but can also result in a poor line of credit for the buyout investors.
It is important to be conservative when getting debt or leveraging using someone else’ money. If you become speculative and highly leveraged then leverage works against you.
When borrowing make sure that you are borrowing at interest rates that you can manage and sustain.
You should also ensure that the asset you are buying with leverage has an inherent discount already at purchase so that you can cushion potential losses if the market turns.
As much as possible avoid leverage of trading positions like buying stocks on debt or trading currency. These are too volatile markets that require professionals. Real estate is a good place for leverage because of its stable nature and appreciation in value. But even then use caution.