Leverage Is A Powerful Tool

Leverage (borrowed money) is a simple strategy so you can use a small amount of your capital (combined with the borrowed cash) to make a larger investment.

It’s a convenient financing tool, but it won’t turn a bad investment into a good one. Leverage simply magnifies the outcome—good or bad. The benefit of using OPM (other people’s money) to skinny down the amount of cash you need to get into an investment might improve your cash flow in the short term, but that’s not the whole picture.

Infrequently, and usually without much warning, credit evaporates, margin calls happen, and leverage can become financially fatal. With excessive leverage it’s like a financial game of Russian roulette: mostly you win, but occasionally you take a bullet to the head. That’s an asymmetric proposition that doesn’t make any sense to me. A lot of investors are risk-averse and don’t use leverage, at least not in the traditional sense of directly borrowing money to invest in the market. But almost all investors do use another form of leverage: a less obvious one.

When Is A Million Dollars Not A Million Dollars?

Tax-deferred growth in a Traditional IRA or 401k, as well as unrealized gains in taxable accounts, allow you to keep using more of your cash today but eventually, taxes will need to be paid. It is, in effect, an interest-free “loan” from the government. Never forget that a significant portion of the balances in those tax-deferred accounts is not yours to spend. The government is your partner in those accounts and although it may be decades from now, your partner will eventually come calling for its share.

Leverage Is Anathema To Long-Term Investing

When (not if) chaos strikes the markets, creating the highest demand for rational thinking, leverage can force irrational behavior.

At the extremes, using short-term debt to acquire long-term assets will magnify gains and losses. But either way, whether asset values increase or decrease, lenders expect 100% of the debt to be paid back.

Debt Can Be So Disastrous It Can Force You Completely Out Of The Business Of Investing

On October 19, 1987, a day that came to be known as Black Monday, stock markets around the globe plunged. In the U.S., the S&P 500 Index fell 20.5% and the Dow Jones Industrial Average (DJIA) fell 22.6%: the largest single day percentage drop in the history of both indexes.

There are lots of reasons for the crash, but Black Monday was primarily caused by programmatic trading rather than fundamental economic problems, leading to a relatively quick recovery. The DJIA started rebounding just one month later and reached its pre-Black Monday level by September 1989.

For those investors, without significant leverage, it was a painful crash, but not a fatal blow.

For those investors using excessive amounts of leverage, Black Monday was catastrophic.

Over-leveraged investors were ruined not as a result of losing everything in their brokerage accounts, but because they lost 200% of everything. That’s the thing about OPM, the other people want to be paid back even though your investment tanked.

Leverage does not discriminate. From small retail investors to large institutional behemoths, no one is immune to its potential for ruin.

The Bigger They Are, The Harder They Fall

Leading up to the financial crisis of 2008/09, bank leverage ratios rose from about 12-to-1 in 2004 to 33-to-1 in 2008. When the housing bubble burst and markets collapsed, century-old banking institutions, some of the largest in the U.S. (Lehman Brothers and Bear Stearns) were wiped out. Several others, including JPMorgan Chase, Goldman Sachs, Morgan Stanley, and Bank of America had to be bailed out by the taxpayers.

By comparison, 2023 saw leverage contribute to only five bank failures, but the total assets of those five banks ($549b) were more than the combined assets of all 165 banks that failed in 2008 and 2009 ($544b).

Charlie Munger once said that there are only three ways a smart person can go broke: liquor, ladies, and leverage. His business partner, Warren Buffett chimed in by noting that the first two only made the list because they begin with the letter “L.”

The key to investing is that you cannot allow yourself to be forced to sell, letting someone else pull the rug out from under your feet.

Plan Accordingly

When it comes to leverage, assume the worst market conditions for your investment occur, and ask yourself if you could financially and emotionally tolerate it. If the answer is no, then you’ve got too much debt.

The best hedge against an unknowable future is prudent planning in the use of leverage. As we’ve seen throughout history, the lack of liquidity when debt comes due can turn a bad situation into a full-on rout.

Just like a chainsaw or a bottle of bourbon, leverage is a powerful tool. If used carefully and judiciously, it can make your life easier and amplify positive returns. If used indiscriminately, leverage can undermine your decision-making or worse, wipe out your investment portfolio.

Let’s be careful out there.

As always, invest often and wisely. Thank you for reading.

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The content is for informational purposes only. It is not intended to be nor should it be construed as legal, tax, investment, financial, or other advice. It is merely my own random thoughts.

This article is from an unpaid external contributor. It does not represent Benzinga's reporting and has not been edited for content or accuracy.