In 2010, Yale economists Ian Ayres and Barry Nalebuff, in their book “Lifecycle Investing”, suggested that people should introduce leverage into their retirement portfolios.
They made a seemingly shocking case urging people in their 20’s and early 30’s to take all their retirement savings and buy stocks on margin.
What Is leverage?
Simply put, leverage is an investment strategy to use borrowed money (usually from the banks or other financial instruments like margin accounts) to increase investment returns.
It allows an investor with a smaller pocket to trade in larger positions; or, in the case of property, invest in multiple and more expensive properties.
Most of us would have experienced leverage when we buy and sell property; we borrow money to purchase our homes and sell it at a profit later.
When used correctly, leverage can be an important strategy to help us maximize our returns but, the reverse is also true.
Let us illustrate this with two examples.
Leverage In Property investments
Most property investors use some form of leverage when they borrow from the bank to purchase a property.
In fact, it is not uncommon for experienced property investors to own several properties without using much or any of their own money. The secret is to use leverage.Consider a new property that is put up for sale at one million dollars.
If you are like most people, chances are you will not pay for the entire property in cash. You will pay a fraction of it say 10%, and borrow the remaining 90% or $900,000 to purchase the property.
Assuming that you timed the market correctly and the property appreciates at a rate of 10%. You would have paid $100,000 with a profit of 100%!
However, if you have decided to borrow only 50%, your profit would be much lower. This demonstrates the power of using leverage (or borrowed money) which can have a significant and positive impact on your investment returns.
Leverage In ForexMore experienced investors also use some form of leverage in other financial instruments such as Forex.
Traders sometimes use leverage as a strategy to trade larger amounts in Forex and to profit from the fluctuations in exchange rates.
Let’s assume that an investor decides to trade 1 lot of USD/SGD. The standard lot is about $100,000, which may be ten times more than the capital in the investor’s account. In this case, the leverage amount is 10:1.
Therefore, the investor is able to take a much larger position with just a fraction of the money i.e. 10%.
If the trade moves in his favor, his $10,000 investment would result in a higher rate of return since it is X returns + $100,000. Sounds good?
The reverse is true when the trade moves slightly against him. In this example, a mere 5% move against him would have wiped out half of his capital.
Possible Risks In Using Leverage?
As with all investment tools and strategies, due diligence is necessary.
There are several factors to consider such as the general market trend, the macro political and economic environment, your time horizon and your knowledge and experience of both the financial instrument and the particular market you are in.For a start, novice or amateur investors are strongly advised not to be overly reliant on leverage for more volatile instruments like derivatives and stocks.
Those with a longer time horizon, stronger holding power and adequate investment know-how will stand to gain from using leverage correctly especially with its key advantage of being able to use borrowed money to maximize their investment returns.
However, if used incorrectly, leverage will amplify your losses.