Tag Archives: wealth creation

What is Money II


 

Money in the modern economy is just a special form of IOU, or in the language of economic accounts, a financial asset. Because financial assets are claims on someone else in the economy, they are also financial liabilities one person’s financial asset is always someone else’s debt. If a I take out a mortgage, I acquire the obligation to pay my bank a sum of money over time — a liability — and the bank acquires the right to receive those payments — an asset of the same size. So the mortgage is a liability to me but an asset to the bank. Remember Robert Kiyosaki taught us that an asset puts money in your pocket while a liability takes money out of your pocket.

A debt is as good as the trustworthiness of the person who owes you. There is need for trust in financial transactions. Money in the modern economy is an IOU that everyone trusts. Because everyone trusts in money, they are happy to accept it in exchange for goods and services — it can become universally acceptable as the medium of exchange. Obviously no all IOUs are created equal.

It is useful to consider some of the different types of money that circulate in a modern economy — each type representing IOUs between different groups of people. For explanatory purposes the economy is split into three main groups: the central bank; the commercial banks; and consumers.

Many people do not realize that when we talk of money not all money is equal or equally available to all economic players. The types of money available in the economy are:

  1. Currency (banknotes and coin) — these are IOUs from the central bank, mostly to consumers in the economy. That is why the Zimbabwean Dollar notes would clearly state, “I promise to pay the bearer the sum of —, on demand.” Bank notes in reality are simply a promise by the Central bank to make a payment when needed. The USD notes will state that this note is legal tender to settle all debts both public and private.
  2. Bank deposits (these are your bank account balances)— They are IOUs from commercial banks to consumers. Many people mistakenly think that the money they deposit in their account actually stays there in a safe. They don’t realize that they actually surrender the money to the bank to use at it sees fit and in return are given a promise to pay them on demand. That is why when banks fail depositors lose money. The bank would not be in position to honour its debt obligation and extinguish its IOU. With this understanding the commonly spoken of issue that bankers used depositors money is exposed as interesting if not misleading.
  3. Central bank reserves– these are bank deposits for banks that are placed with Central bank. So they are IOUs from the Central bank to banks in the economy. We the consumers have no access to these.

From this description of the different kinds of money we could actually surmise that money as a concept is nothing more than a debt -an IOU from one player in the economy to another. Money is a financial asset to one player and a financial liability to another.

From these distinctions economists define two money concepts namely:

Broad money – is the amount of money circulating in the economy and available to consumers for transactions. This comprises of currency (bank notes and coins) and bank deposits).

Base money or ‘central bank money’, comprises IOUs from the central Bank and includes currency- bank notes and coins in circulation (an IOU to consumers) but also central bank reserves – bank deposits for banks held by the Central bank, (which are IOUs from the central bank to commercial banks.)

Put simply money can be conceptualised as a debt or IOU. Money is nothing more than a financial asset to one economic player and financial liability to another economic player.

Advertisements

Origins of Money


The Origins of Money

In our pursuit of wealth creation we often forget that one of the key elements of wealth is money. Money is a critical element of the world economy. We need therefore to understand its history, its definition and how it is created. In the next postings I will walk through this study of money. It is amazing that we spent a large part of our lives in pursuing a thing we rarely understand. We start today we tracing the origins of money. 

IN THE BEGINNING: BARTER

Barter is the exchange of resources or services for mutual advantage, and the practice dates back tens of thousands of years, perhaps even to the dawn of modern humans. Today individuals, organizations, and governments still use, and often prefer, barter as a form of exchange of goods and services. Even during the hyperinflationary period in Zimbabwe barter trade was very common. Companies could exchange services and products instead of cash which at that point was valueless.

9000 – 6000 B.C.: Livestock

Livestock, which throughout history and across the globe includes cattle, sheep, camels, and other livestock, are the first and oldest form of money. Within our African context cattle is still a source and store of value and wealth. With the advent of agriculture also came the use of grain and other vegetable or plant products as a standard form of barter in many cultures.

1200 B.C.: COWRIE SHELLS

The first use of cowries, the shells of a mollusc that was widely available in the shallow waters of the Pacific and Indian Oceans, was in China. Historically, many societies have used cowries as money, and even as recently as the middle of this century, cowries have been used in some parts of Africa. The cowrie is the most widely and longest used currency in history.

1000 B.C.: FIRST METAL MONEY AND COINS

Bronze and Copper cowrie imitations were manufactured by China at the end of the Stone Age and could be considered some of the earliest forms of metal coins. Metal tool money, such as knife and spade monies, was also first used in China. These early metal monies developed into primitive versions of round coins. Chinese coins were made out of base metals, often containing holes so they could be put together like a chain.

500 B.C.: MODERN COINAGE

Outside of China, the first coins developed out of lumps of silver. They soon took the familiar round form, and were stamped with various gods and emperors to mark their authenticity. These early coins first appeared in present-day Turkey, but the techniques were quickly copied and further refined by the Greek, Persian, Macedonian, and later the Roman empires. Unlike Chinese coins which depended on base metals, these new coins were made from precious metals such as silver, bronze, and gold, which had more inherent value.

118 B.C.: LEATHER MONEY

Leather money was used in China in the form of one-foot-square pieces of white deerskin with colorful borders. This could be considered the first documented type of banknote.

806: PAPER CURRENCY

The first known paper banknotes appeared in China. In all, China experienced over 500 years of early paper money, spanning from the ninth through the fifteenth century. Over this period, paper notes grew in production to the point that their value rapidly depreciated and inflation soared. Then beginning in 1455, the use of paper money in China disappeared for several hundred years. This was still many years before paper currency would reappear in Europe, and three centuries before it was considered common.

1816: THE GOLD STANDARD

Gold was officially made the standard of value in England in 1816. At this time, guidelines were made to allow for a non-inflationary production of standard banknotes which represented a certain amount of gold. Banknotes had been used in England and Europe for several hundred years before this time, but their worth had never been tied directly to gold. In the United States, the Gold Standard Act was officially enacted in 1900, which helped lead to the establishment of a central bank.

1930: END OF THE GOLD STANDARD

The massive Depression of the 1930s, felt worldwide, marked the beginning of the end of the gold standard. In the United States, the gold standard was revised and the price of gold was devalued. This was the first step in ending the relationship altogether. The British and international gold standards soon ended as well, and the complexities of international monetary regulation began.

THE PRESENT:

Today, currency continues to change and develop. Tomorrow I will discuss the concept of money in modern economy. Money is really nothing more than a concept and an idea.

THE FUTURE: ELECTRONIC MONEY

In our digital age, economic transactions regularly take place electronically, without the exchange of any physical currency. Digital cash in the form of bits and bytes will most likely continue to be the currency of the future.

In this diagram taken from a Bank of England article we can see the rationale and evolution of the concept of money. We will build on this in tomorrow’s posting.

Screen Shot 2015-11-30 at 7.38.32 AM

Source: http://www.pbs.org/wgbh/nova/ancient/history-money.html

Wealth Transfer


There has been much talk about a coming wealth transfer. I am fully expecting to participate in it. Those of faith realize that the Book talks of the transfer of wealth to the righteous. I have come to the conviction that this has to happen through a trade system. Any transfer of wealth or financial resources from one person to another that is unsupported by a transaction or trade is tantamount to a scam or robbery. Praying and believing for God to rob unrighteous John in order to reward righteous Paul seems inconsistent with biblical teaching and the economic system.

I am now convinced that what people of faith should target is accessing wealth creation and wealth transfer systems that become a basis of a trade. For example to be paid a salary I trade my time for money- its called receiving a salary. Accessing a salary without giving my time and effort in exchange is robbery. By the way trading time for money is a poor trade because time is finite while money can be created. You are trading something that you cannot create for something that can be created. It is a poor trade.

Those who are paid better trade value/contribution for money. They provide value which people are willing to pay well for. Those who are paid for time have a limited income e.g. $100/hr while those who are paid on value added have their income dependent on the value they provide. For example a corporate CEO who generates an annual revenue of $1 billion can easily take home an annual salary of $15 million without the shareholders complaining. The salary is a minute percentage of the value generated. He has traded value for money. What is sad these days is that there are some people who are paid obscene salaries for poor performance and zero value addition simply because they are CEOs. This is daylight robbery. They are paid for the position and not for their contribution. It is an unfair trade.

If my assertion above is correct it means in terms of wealth creation, I need to meet a challenging need for many people in such a way that they are willing to pay me significantly for the value addition or contribution. The more unique problems I solve the more wealth I can create through wealth transfer. People will gladly part with their wealth to acquire the solution that I am providing. It stands to reason that since God created me as unique and as a solution to certain problem, once I identify the problem which I was created to solve then I can legitimately expect wealth transfer. People will gladly transfer part of their wealth to access the solution that I provide.

My question is: What problem have you solved to expect a wealth transfer? Be solution conscious! The more challenging the problem you resolve the more you are paid. Life is a trade. Before you think of wealth transfer ask yourself on what basis? What am I trading in return? What do you want to be paid for? Time, Effort, Position or Contribution.

Lord help me solve insurmountable problems. Help me make a difference. As I do I fully expect to participate in the greatest wealth transfer ever seen.

Final Thoughts on Compound Interest


As we close this week’s posts I add various practical thoughts and tips for dealing with compound interest in wealth creation. Enjoy.

Understand the Rule of 72. There’s an easy rule you can use to work out how your savings or investments can grow with compound interest. Just divide the interest rate (or average annual return) into 72. The result tells you how long it will take for your money to double without further savings. It can only be used for annual compounding. For example, an investment that has a 15% annual rate of return will double in 4.8 years. An investment with a 20% rate of return will double in 3.6 years. The reverse is also true: If you know you want to double your money in four years to find out the interest required you divide 72 by 4. So you will need an 18% interest rate to achieve that.

Compounding can work in your favor when it comes to your investments, but it can also work for you when making loan repayments. For example, making half your mortgage payment twice a month, rather than making the full payment once at month end, will end up cutting down your amortization period and saving you a substantial amount in interest.

By paying extra on your loans, early-on in the term, you will reduce your interest bill by a ton. In fact, with your mortgage, making a few extra payments in the beginning can knock years off the length of the loan.

There is a debate on whether to pay off your debt and avoid compound interest penalties or invest the amount elsewhere. Many people think it’s not worth your time to pay off your mortgage early since you can get a better return by investing the money. In other words, you can earn more by investing than you would save by paying off your mortgage early. Obviously this depends on both interest rates. My recommendation: when you can consistently earn more by investing than you save by paying off your debt, then its better to invest first. However if the interest on the debt is higher than the investment returns then its wiser to start by liquidating the debt first.

Get the power of compounding working for you by investing regularly and increasing the frequency of your loan repayments. Familiarizing yourself with the basic concepts of simple and compound interest will help you make better financial decisions, saving you thousands of dollars and boosting your net worth over time.

CSF for Wealth Creation Through Compounding


Critical Success Factors for Wealth Creation

In today’s posting I discuss some critical success factors that enable you to maximize returns based on compound interest on your investments. Enjoy the reading.

  1.  Time– Compounding is every investor’s best friend because it basically suggests that the sooner you start, the sooner you can get your money working in your favour. The longer your money can remain uninterrupted, the bigger your fortune can grow. In USA for example people place their funds in Mutual Funds (or Unit Trusts) which are indexed to the Stock Exchange rather than buy individual stocks and leave them for the long haul with regular dividend reinvestment.
  2.  Frequency– The frequency of compounding is critical. As stated in a previous posting if investing you prefer more frequent compounding e.g. quarterly whereas if its debt you prefer less frequent compounding e.g. annually.  In other words, you earn interest on interest frequently.  Regular reinvesting of your yields would increase this compounding effect. Imagine developing an investment scheme whereby you lent your money against suitable security to a microfinance company and they gave you a return of 2% per month. Then you decide to reinvest most of the monthly returns monthly to increase your capital. You start earning interest on interest on a monthly basis. This accelerates your wealth creation. But remember to keep the security provided against your funds current and valued at the amount you placed with them.
  3.  Interest rate– Obviously, the higher the interest rate the faster your money grows. Doubling the interest rate more than quadruples the result.  Obviously places like Zimbabwe with higher interest rates are great investment destinations from a return perspective based on compound interest. The returns one gets from the Western world will be lower. For example a return of 6% p.a. is considered fair but this implies your money doubling in 12 years through compound interest whereas if one invest in Zimbabwe at an 18% p.a. basis the funds would double within 4 years. So if I was to disregard security of funds Zimbabwe would yield better investment returns. As a matter of fact many investors are slowly realizing this and moving funds towards Zimbabwe.
  4.  Regular investing– Finally to make compounding work for you is to save regularly.  If you can put away money every month and be consistent about it, money grows that much faster. Consistency is key to the process. It is therefore critical to set up a dollar cost averaging investment scheme as was discussed yesterday.  If you have an earning capacity that allows you for example you can place a stop order for an investment amount to be sent straight to your investment account whether with a Stock broker or wherever.

Compound interest is very powerful when you understand it.  One can manipulate any of these four criteria to accelerate one’s wealth creation pace. I trust that you are absorbing these lessons and beginning to finds ways to implement them. Knowledge without action will not change your financial state.

Snowball Effect of Compound Interest


Have you ever wondered at what makes an avalanche so powerful? It is because of a snowball effect. Lets define it.

“a ​situation in which something ​increases in ​size or ​importance at a ​faster and ​faster ​rate: The more ​successful you ​become, the more ​publicity you get and that ​publicity ​generates ​sales. It’s a ​kind of snowball ​effect.” Cambridge Dictionary.

Metaphorically, a snowball effect is a process that starts from an initial state of small significance and builds upon itself, becoming larger (graver, more serious), and also perhaps potentially dangerous or disastrous (a vicious circle, a “spiral of decline”), though it might be beneficial instead (a virtuous circle).” Wikipedia

“ (adj.) descriptive of an entity or situation where something once small and relatively insignificant grows exponentially at a swift pace, engulfing everything in its path. A more dramatic progression than the classic domino effect. The basic workings of a literal snowball effect can be illustrated by taking one’s average baseball-sized snowball and dropping it down the side of a snowy hill. As it descends it gathers more snow and whatever leaves, sticks, etc. are in its way. The snowball accumulates not only size, but speed.” Urban Dictionary

Put simply the rolling of a small ball snow down a snow-covered hillside results in that snowball growing slowly is size as it picks up anything in its way. It also gathers momentum and speed as it rolls down the hill. As it rolls the ball will pick up more snow, gaining more mass and surface area, and picking up even more snow and momentum as it rolls along. The higher the hill slope the longer it travels and gathers more momentum and grows until it becomes an avalanche that destroys anything in its way. At some point it becomes an unstoppable and exponentially growing force.

Compound interest works the same way. It builds slowly and in unnoticeable ways at first.

Just as a snowball compounds and grows, so can your wealth through compounding.

Compounding interest at its core is best served by conservative investing. Someone who chases speculative and very trendy stocks won’t see the power of compounding interest. An investor whose primary concern is compounding interest will instead look for the company that is growing slowly and surely. Like the tortoise who plods along at a painstakingly slow pace, an intelligent conservative investment will beat out any high flying “trend / technology” stock of the day. Time and time again. Warren Buffet has grown his wealth through the same process. He buys bargains with great potential and holds on to them. Then allows time to do the work of compounding. Warren Buffet is quoted as saying, “I always knew I was going to be rich, so I was never in a hurry to.”

One of the best pieces of investment advice you can get is simply this: “Invest the same amount every month and be consistent/diligent over a long period of time.” The name for this investment strategy is Dollar Cost Averaging. Compounding interest is best pursued when you are dollar cost averaging. Use this system to your advantage. It builds on the snowball effect. You keep getting interest on interest and your invested amount continues to grow. If you are investing on the Stock Exchange then you can use a similar method by reinvesting your dividends rather than cashing out. Econet Wireless in Zimbabwe grew using the same method. For the greater part of its first 5-8 years it did not declare any dividend but reinvested its earnings. The snowball effect of compound interest took care of the rest. When they started declaring dividends it was an almost unstoppable avalanche.

The two graphs below show the snowball effect of compound interest over your investment life. They demonstrate the need for patience and diligence. Initially there is no evidence that you are building wealth.

“Those who understand compound interest are destined to collect it while those who don’t are destined to pay it.” Gartner Fools

Compound Interest and Wealth Creation


I have recently finished reading Tony Robbins’s book Money: Master The Game. I highly recommend it. He makes a passionate appeal for people to understand compound interest and its impact on one’s wealth creation strategy. So this week lets take a look at this concept.

Interest is a powerful thing. When you borrow money, you pay interest. When you lend money, you earn interest.Interest is defined as the cost of borrowing money, and depending on how it is calculated, can be classified as simple or compound interest. Simple interest is calculated only on the principal amount of a loan.

Interest compounds. Starting with the principal, after interest is calculated and paid, it is added to the original amount to make a new larger principal. Compound interest is calculated on the principal amount and also on the accumulated interest of previous periods, and can thus be regarded as “interest on interest.” This larger principal now garners slightly more interest, and so on … This compounding effect can make a big difference in the amount of interest payable on a loan if interest is calculated on a compound rather than simple basis.

In the words of Ben Franklin: “The money that money earns, earns money”

On the positive side, the magic of compounding can work to your advantage when it comes to your investments, and can be a potent factor in wealth creation. While simple and compound interest are basic financial concepts, becoming thoroughly familiar with them will help you make better decisions when taking out a loan or making investments, which may save you thousands of dollars over the long term.

Compound interest is a double-edged sword. It’s great if you’re saving money but it can be cruel if you’re borrowing money. You can collect interest due to compound interest or you can suffer from paying compound interest depending on whether you invest or borrow.

You want savings to compound as often as possible. It’s better if you compound quarterly rather than annually when you’re saving money. If you’re borrowing, just the opposite applies.

Time is on your side. The longer money compounds, the faster it grows. Money growing at 6 percent per year will double in about 12 years, but it will be worth four times as much in 24 years.

Time is not on your side. Be careful about credit cards and mortgages as they use compound interest against you. It is wiser to always pay slightly more than the minimum repayment required so that you constantly reduce the capital amount. This reduces the compound interest that you repay. Suppose your interest rate is 14 percent and you add just $5 per month to your payment. In 10 years, you would have saved $1,315 in repayments. My family used this method way back in 2001-2005. We borrowed several million dollars (by the way did I say it was Zim Dollars) to buy a commercial property. It was a 15 year mortgage. We decided to pay more than the required amount and within 5 years we had paid off the mortgage and saved ourselves millions of dollars worth in interest repayments. Obviously the bank was not happy and they charged us a penalty. But this was nothing compared to the savings.

Time is either on your side or against you. Compound interest supercharges your savings because you earn interest on the interest you earn as well as the money you deposit. The longer you leave your money, the more powerful the compound interest effect. The longer you leave your money, the more powerful the compound interest effect. So the earlier you start saving, the more you will make from compound interest (but only if you don’t withdraw the interest). The same applies to other investments such as shares, where you regularly reinvest dividends, or the company reinvests its profits.

Compound interest simply means to REINVEST your investment return into your total investment amount. Total investment amount is called PRINCIPAL in personal finance. Your principal grows exponentially with the compound interest, that is how the magic works and that’s why we like to say it is powerful.

Compound interest can be your friend or your enemy. When it applies to debt it’s a wealth eroder. The longer you leave a debt which charges interest, the bigger the debt becomes. Compound interest works against you through either mortgage debt or consumer debt. At one time we took a mortgage to finance a company we owned. The company paid the mortgage faithfully for a few years and later inconsistently during a tough time. When we had to bail the company out 5 years it had paid over $150 000 but the outstanding balance was still $293 000 out of a $300 000 -10 year mortgage. I was so disappointed. Compound interest had worked against me and in favour of the bank. When I took over I undertook to pay more than the required amount and consistently so as to reduce the effect of compound interest working against me.

Compound Interest is really interesting interest that you should show interest in. It can either build you or destroy you along the wealth creation journey.

Early Retirement in Wealth Creation


I turned 49 on 2nd September 2015. And on 15th September 2015 I hung my dental gloves and officially retired from clinical dentistry after 25 years in the industry. Though this was four years later than originally planned it felt good all the same. In the last two months I have been surprised by the comments and views of people when they heard that I had retired. So today I want to make some comments on early retirement.

Many people want to retire early but dare not. Most books on wealth creation promise early retirement but do not answer the question so what next. This has often caused confusion in people’s minds. What exactly do I have in mind when I think of early retirement? Other people imagine me sitting idly and lazily at home doing nothing but just spending my hard earned wealth. Others imagine me packing my bags and going to my rural home to spent the rest of my days in quiet and peace. Others imagine me going to Canada or some such place to spent the rest of my days either on a beach or at some island watching birds. That is not my idea of retirement.

Many people who retire this way will:

  • either die early because they have no purpose for living anymore so they “retire” from life
  • or will outlive their wealth and regret the early retirement. Many forget that most people now live longer than 80 years of age because of medical advances.

I have no plan to join any of the above categories. I have too much life and too much to contribute before I check out of this world. I have a Kingdom assignment and life purpose that needs to be completed. As a matter of fact I already have a plan for my next thirty years. I fully expect to contribute and have greater influence and impact than the last 25 years. I have been preparing for this. I am busier now than ever before.

So to me an early retirement simply means an occasion to re-fire (not re-tire) and redeploy my skills and resources towards my ultimate purpose. It divides my life into Life 1 and Life 2. In life 1 the aim was to make a living and in Life 2 the main purpose is to contribute to the well being of Africa while doing well. It’s the time of my life that allows me to fully develop and establish my legacy. Most of the super successful people are still active contributing way past their 80s. They are doing what they love.

For most of us we made decisions about career and profession when we were teenagers and that completely define our whole lives. Some people keep investing in themselves until at a certain age even though they are enjoying their primary profession, they realize they can achieve more and faster if they followed their passion and calling. This then calls for a retirement from primary profession and redesigning their career pathways. In this redesigned new career for Life 2 they have flexibility to work from anywhere and allows them to travel while still earning probably more significantly than in Life 1. They bring to bear the experiences and competences of the first half into the second half. In fact the primary career was simply a stepping stone to significance.

As I was considering my life trajectory and the things God has spoken into my life, I realized that though I was doing well, I was not running at the pace that would allow me to fulfill God’s call. Over the years I kept developing myself until I now hold 2 Masters degrees (one in Business and another in Theology) and a Doctorate over and above my dental surgery degree. On reflection it dawned on me that I was still earning at my entry qualification level if I continued in dentistry rather than earning at my highest qualification level. It was like a person earning at an O- Level basis when he holds a Bachelors degree. That called for a retirement and re-firing!

After 25 years of enjoyable clinical work I realized that I was now too comfortable to be able to dare to do things differently. I was coasting along comfortably. But those who make a significant difference in life are not the comfortable type BUT those who keep pushing the boundaries of what can be achieved. So it was time I gave up my comfort and trade it for greater impact! I am dreaming big. I am stretching myself for the Kingdom and for Africa. Like Caleb, I boldly declare, “Give me this mountain for I am well able to take it just as God promised.” (paraphrased).

Robert Kiyosaki wrote a book called retire Young Retire Rich but he is working harder now that he is retired. Jason lee wrote a book called Retire Young Through Property. And yet he is working harder now than ever. Warren Buffet is busier now than ever and yet he has made billions. They are all fired up. They do not have to work. They love working!

So to all my friends who were perplexed by my early retirement- do not worry, it’s a redeployment to maximize impact! I am fired up! I am energized!

Disadvantages of Leveraged Investing


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.

Unending Loss

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.

Solution

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.

Advantages of Leveraged Investing


As we have stated before leveraged investing is the practice of borrowing money to invest. It is a risky practice that can result in significant financial losses, but there are also several advantages to leveraging your investments. In today’s posting we focus on the advantages.

Access to Capital

Leveraged investments can be used to access more capital. In real estate, for example, a borrower can borrow 75 percent of the property’s value. For instance, a borrower with $50,000 to invest might use it as a down payment on a $200,000 mortgage, increasing his access to capital by 300 percent.

Multiplied Results

Because leveraged investing increases your access to capital, it also increases your profits if your investment pays off. For example, if you have $1,000 and you make an investment that has a 15% annual return, you would earn $150 in profit. If, instead, you borrow another $19,000 on top of your $1,000, then the investment would yield $3,000. Assuming that you paid interest of 12% on the loan, your cost would be $2,280, leaving you a net profit of $720 – 4.8 times greater than if you had simply invested the $1,000. So we can see that using leverage allows you to earn larger percentage gains on the amount you have invested. It multiplies your investment gains.

Tax Deductions

We are always looking for ways to reduce the amount of tax we pay. Most of the money we make is used in ways that are not tax efficient. Borrowing money to invest in income producing investments can create a tax deduction from your income. Leveraged investments in real estate can actually provide tax benefits. The interest payments on mortgages are typically tax-deductible, subject to certain limits. This deduction reduces the effective interest rate you pay.  Another advantage of borrowing to buy real estate is that you increase your potential upside. We explained how this works in a previous post using an example of buying a house cash versus buying on mortgage.

Gaining Control

You can use leverage to gain control over an investment that you could otherwise never afford. This is what happens in a leveraged buyout, when an investor borrows money to buy a controlling interest in a business. Having a controlling interest allows the investor to make unilateral decisions about the company’s strategy that best represent his own interests.

Leverage Makes Investments More Affordable

The cost of some investment types may be too expensive for many investors, and the use of leverage allows investors to participate with a smaller amount of capital. I know an investment platform where you need a certain threshold to be able to invest. But some innovative banks have used leverage to provides letters of credit on a certain leverage ratio to allow you access to the minimum amounts required for the investments.

Leverage Makes Some Markets Work for Investors

Some types of investments move in very small increments. Investing in these types of products would not make sense without leverage. Currency trading is a good example of a market that needs leverage. If you want to trade currency be very careful. I have seen many people being wiped out. I personally do not understand this investment type and caution people from investing in things that do not understand.

Building wealth with other people’s money. Many of us have bought homes with borrowed money. Typically, we buy houses with borrowed money because we are tired of renting or we think it is a great investment.

Forced Saving plan. One of the principles of wealth creation is to save money regularly. Some are good at this while for others it is challenging. Leveraging can be a means of forced savings. The difference is you would invest a lump sum of borrowed money and your money would start working immediately. On a monthly basis, you would be paying the interest instead. Any way you do it, forced savings is essential to building wealth.

Leverage Is Not New

Think about it, you borrow money in our every day lives. We borrow to buy our homes, we borrow to buy depreciating assets like cars and we also borrow to buy assets that have no value like consumer goods. Most of the time we borrow to do things that are not financially productive. Leveraging can be incredibly productive when it is understood and used properly.

Using leverage as part of your investment strategy could help you reach your investment goals sooner. The use of leverage multiplies the gains for the same amount of money invested. The amount of leverage you can use depends on the markets in which you are investing and trading.

When used properly, leverage can be an amazing tool to build wealth. You’ve now heard some of the powerful benefits of leverage. Although it can be a double-edged sword and compound losses as well as gains, the prudent use of leverage can be a powerful tool. Tomorrow, I will discuss some of the risks associated with leveraging.