Leverage is a Double-Edged Sword
These days many people are learning this lesson very painfully. Leverage, as I am discussing it, is the use of debt to lever or increase the purchasing power of your equity.
The painful lessons are being learned by those who got low or no equity mortgage loans where the house is now underwater-- they are trapped. Those who owned stock on margin (effectively a loan), also took a beating. Credit cards are also leverage tools, but I see few applications were it can be used favorable beyond one month (free money-- if paid off in the month).
Let's use the stock margin account as an example:
- You have $5000 to invest in a stock
- You buy 100 shares of a $50 stock in a cash account ($5000) and the stock goes to $55 ($5500)-- you're up $500 or 10%
- Now we are going to use leverage-- a margin account to buy the stock
- You buy 200 shares of the same $50 stock in a margin account ($10000 = $5000 your cash + $5000 borrowed) and the stock goes to $55 ($11000)-- you're up $1000 or 20% (not counting the cost of the margin interest). Margin (or leverage) magnifies your gains.
Now let's look at it the other way around . . .
- You have $5000 to invest in a stock
- You buy 100 shares of a $50 stock in a cash account ($5000) and the stock goes to $45 ($4500)-- you're down $500 or 10%
- Now we are going to use leverage-- a margin account to buy the stock
- You buy 200 shares of the same $50 stock in a margin account ($10000 = $5000 your cash + $5000 borrowed) and the stock goes to $45 ($9000)-- you're down $1000 or 20% (not counting the cost of the margin interest). Margin (or leverage) magnifies your losses.
As you can see from this little example, leverage is wonderful in the case of rising prices, but not so nice in the case of falling prices . . .
Bottomline: Unless you are certain of the direction of prices or your returns, cash is usually the best way to proceed.
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Categories: Money Savers, Personal Finance, Credit, Savings, Investments, Frugality
Tags: Personal Finance Frugality Investments Money Savers Debt Frugal DIY Credit
I avoid short sales for a similar reason. If you buy a hundred shares of a $1.00 stock “long” and it goes down, your losses are limited to the initial $100. If you sell the same $1.00 stock “short”, and then it goes up, your losses may be unlimited!
(See Citigroup (symbol C) for the March 5 to March 18, 2009 period).
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