Racket 1: Introduction to Financial Leverage
Financial leverage is essentially using other people's money to make an investment of greater value than you could otherwise afford with your own money.
A very common form of leverage that most people are familiar with is a mortgage when buying a house or apartment. We are "leveraging" the money from the bank to buy a more expensive home than we would otherwise be able to afford with our own money.
The more you borrow to make an investment relative to the amount of your own funds or capital you invest, the more leveraged you are said to be.
Leverage is also used by investors to increase the potential return on an investment. However Leverage also increases the risk and potential downside of an investment too.
In my next Racket I'll take a look at the positive potential of leverage when investing. And after that I'll flip it over to see how negative outcomes are multiplied under leverage.
Racket 2: How financial leverage can multiply returns on investment
Let's say I have $1000 of my own money to invest. There's an investment opportunity that I think will return 20% interest in year 1. I know the bank will loan me money equal to the amount I'm putting at stake at 5% interest.
Scenario 1: I don't borrow any money from the bank.
Let's say I don't borrow any money from the bank, I can invest my $1000 and after 1 year if all goes well, I will have $1,200. My original $1000 plus the 20% I earned on the investment.
So my overall yield is pretty straight forward, it's 20%.
Scenario 2: With Leverage
Now let's say I do borrow $1000 from the bank, meaning I have a total of $2000 to invest.
After 1 year, if all goes well, I will have $2400. My original $1000, the $1000 from the bank, and the 20% return on the $2000 investment.
Now I have to pay back the bank, who I owe $1000 plus their 5% interest, so $1050.
After I pay them back I'm left with $1,350.
That's a $350 return on only $1000 of my own money, a very nice 35% return on investment.
This is the power of leverage when things all go well. Next time I'll take a look at how this plays out when things don't go so well.
Racket 3: How leverage increases risk and multiplies negative outcomes
Previously we discussed what leverage is, and then we looked at the positive potential of leverage when investing. Let's now see what happens when things don't go to plan.
Just as before, we have $1000 to invest. But we have a good relationship with the bank and they're willing to lend us 9 times our own capital, so $9000, at the same 5% interest rate. So we have we have $10000 to invest.
We invest the full $10000 into the same investment we discussed before, but at the end of the year, instead of returning 20% it has actually lost 10%. We come out with just $9000 in cash.
But we have to pay our debt to the bank, $9000 plus 5% interest , so a total of $9450. We only have $9000 after our failed investment.
We've therefore lost all of our original capital, plus we don't have enough to pay off our debt to the bank, we're bankrupt.
The important thing to note here is we didn't go bankrupt because of the bad investment. It only lost 10%. If we hadn't borrowed money, we would have invested just $1000, lost 10% and walked away still with $900 in our pocket.
We would have been down, but not out.
It was the highly leveraged position that caused our bankruptcy. That is the risk of financial leverage, and shows how a small loss gets multiplied. .