Post #10 Many a ship has sunk in the sea of leverage

Archimedes was so fascinated by leverage that he said he could move the earth with it. All he had to find was a big enough lever and a fulcrum to place it on.

In the world of investing too, many are swayed by the lure of leverage. So, how does it work?

The mechanics

Tom is an investor with $1,000. He wants to invest it in the market. If he can manage a return of 25% he would earn $250. He wonders if somehow he can earn more.

His broker Barry offers a solution. Barry says he would lend Tom an additional $3,000 as "leverage". Furthermore, Barry assures Tom that whatever Tom earns on this $3,000 will be for Tom to keep, just that he would need to keep an "eye" on Tom's investments. Why Barry wants to keep an eye will become clear in moment but for now Tom is enthralled by this proposition and accepts the $3,000.

Case I: Market rises 25%

Well, the value of Tom's investment $4,000 ($1,000 original + $,3000 borrowed) becomes. $5,000. Out of this he returns $3,000 to Barry and nets a cool $2,000. To Tom, his $1,000 doubled to $2,000. He is elated.

Case II: Market falls 25%

Now, the value of Tom's investment has dropped to $3,000 from the original $4,000. Remember, Barry has been keeping an eye, and Barry feels if Tom loses more, Barry won't get his $3,000 back. So, Barry liquidates Tom's position and barely gets his $3,000 back. Meanwhile, Tom is holding an empty bag. To him, his $1,000 disappeared in thin air.

So what, you ask

As we saw, with a leverage ratio of 3:1, a +25% market return doubles an investor's wealth while a -25% return erodes 100% of investor's wealth. What is the issue?

You see, this is a game which one can afford to lose only once. Because when one loses, he/she loses 100% of their wealth. So, it takes only a single big loss to offset all previous gains. One could be winning for 10 years and one loss, boom, everything goes for a toss.

Even a smaller but significant loss like a loss of 80% is devastating because after incurring a loss of 80%, you have to earn a profit of 500% just to break even.

The solution

In investing, before being able to thrive, an investor has to learn how to survive. The principle of inversion can be of great help. Instead of focusing on "How do i select the next 10-bagger?"/"How do i double my money in next three years", an investor can ask "What choices can cause me great trouble?"/"How do I avoid those?".

An investor must take all possible choices and throw the worst ones out, and then throw the bad ones out. Remember, over the long term, the returns of an investor will not depend on how stellar the best decisions were but rather on how lethal the worst decisions were. 

Hope that was useful. See you in the next one!! ❤️

Disclaimer: The contents of this article are for information and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice.