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Leverage – and why novice investors should avoid it

 Voleo

January 25, 2017

Educate Yourself to Avoid Excess Risk

This week, Voleo’s Marketing Advisor forwarded me a promotional email for a trading site that might as well have come from a casino.  Their message gloats about bonuses, focuses on leverage and suggests trading speculative products. Questionable trading sites target people who are interested in taking risks but may sweep up others who believe there’s an easy path to riches and are unfamiliar with the use of leverage.

Let me help to clarify this for you…

hammer-and-nail

The concept of “leverage” in the literal sense is straightforward and enables you to do more with less work. For instance, think of pulling a nail out of a piece of wood with your bare hands versus doing it with the claw of a hammer.  In the financial world, however, leverage should be applied sparingly until you are a sophisticated investor.

Why?

Leverage in investment situations is the ultimate double-edged sword. Get it right, and you can make a lot of money. Get it wrong, and it you could lose it all. Seriously.

As an example, assume you have $1000 of your own money available for this particular investment and that you have access to leverage (a ‘margin loan’) to buy stock.  You can either:

  1. Invest $1000 in 10 shares at $100 each, or
  2. Invest $1000 plus $1000 of margin, enabling you to buy 20 shares at $100 each.

This magnifies your gains or losses, as each would be doubled (less the additional cost of borrowing, known as margin interest, which costs you no matter which direction the shares move).

In an extreme case, the use of leverage could cost you much more.  Take Valeant (NYSE:VRX) on what was a terrible day in March 2016, when its share price dropped in half.  If you use margin on a day like that, your entire equity value may get wiped out, plus you’d be responsible for excess losses.  Nobody wants to receive that margin call!

There are other and more risky ways to enhance your ‘buying power’ or leverage, which many brokerage firms are eager for you to pursue. Some products earn them higher fees, and of course the more you borrow, the more money they make.

Certain trading platforms even have the audacity to offer you access to margin and charge you a monthly fee whether you actually borrow or not – which is like a bank charging interest just for having a line of credit!  In a twist of irony, one popular brokerage that offers this “service” is named after a famous thief. You can’t make this stuff up.

Key Takeaway

Over the long run using leverage might be part of an effective strategy for a sophisticated investor, but it isn’t for novices or the faint of heart. Using leverage when buying equities for short term trading is gambling. Consider it as such.

 

Ready to start investing sensibly?  Voleo is available in all states where you can form a team, split commissions and benefit from your combined intelligence.