Mechanically speaking, leverage is the advantage gained by using a lever (Dictionary.com). In finance, the general definition of that lever is equity (an investor’s money) gained by using other people’s money (debt) to buy and control bigger assets at negligible expense.
Here I’ll try to give a quick overview of the traditional definition and usage of leverage, but will focus on making an (obvious) point that there are safer ways to “leverage” an investor’s capital than simply getting into debt.
LEVERAGE IN FINANCE
Say you got a few bucks in the bank. Just barely making ends meet but those few bucks you have squirreled away is just waiting for your genius to turn the tide of fortune. Alright, that’s another kind of leverage which we won’t go into here…
Say you have saved up a few bucks, got a steady job and decide to make good use of that saving and income for the coming golden years. How do you turn those few bucks into something you can brag about?
How do you give it muscle?
The traditional [common?] approach is to get into debt – the good kind of debt where you’re forced to save and invest. Get into property.
LEVERAGE AND PROPERTY
A sensible kind of leverage most of us would make without thinking much of the downside would be buying a home.
We got that 20% deposit saved up. Got that stamp duty and conveyancing fees. Got that steady job that pleases the bankers (and the in-laws)… and off we go, starting a family and owning that home.
Even at the current insane level of $1M+ for a run-down, detached 3-bedder in Sydney’s western suburbia (before fees and charges)… a $650k one-bedroom apartment to call your own… yea, recent property prices is just crazy. It won’t end well. But that’s off-topic. So you have $200K+ in savings to purchase that average $1M property to put down some roots… that right there is pretty good leverage – to put down 1/5th the cost to “own” something that over a couple of decades, with continued repayment of interests and principles, you can, usually, see very good capital appreciation when you sell and move into that retirement village.
But 20 years? At retirement? That’s so long, and so boring.
Imagine if you put out some $90k deposit to purchase a $600k property. Within three years its market value goes to $900 or $1M. Not counting the interests and other minor expenses, seeing how if you’re in Australia you can claim any and all losses against your personal income so the taxpayers are chipping in… That’s using $90k to gain returns at some $300k to $400k.
Good leverage, no?
Do you feel lucky?
If we’re lucky, and don’t under-estimate the power of luck in fortunes, we might buy a property or two then “suddenly” (10 years later) the market skyrockets and we feel like geniuses with serious capital gains as proof.
If we’re unlucky and that $600K property goes negative; we lose our job or our cash flows got disrupted short enough for the bankers to drag us to market… what was a perfectly sensible thing to do – buying a home to put a roof over ourselves and our family – can turn out quite badly.
If we’re unlucky enough to have purchased multiple investment properties, all heavily mortgaged, and then the proverbial happens. There won’t be much sympathies but the pain will still be very real.
WHAT TO LEVERAGE WITH PROPERTY
“Fortune favour the bold”. “No pain. No Gain”…. No Risk, No Rewards… and other jingoism that needs a whole lot of qualifiers to really be taken intelligently, or at least not to the detriment of your financial health.
To safely leverage in property is the same as safely leveraging in anything: don’t over-stretched, don’t over-do so that if life or the market goes sideways you’ll lose everything.
The safest investment in properties would be to acquire the asset at a price where the rent more than compensate the expense and pays either a profit now or a much larger capital gain in the future. Tax and other state welfare from friends in high places aside, end of the day you’d want to only invest in assets with reasonable assured net returns.
While that sound pretty basic, and I suppose it is, there are prices being paid for property investment where the maths does not add up – just gut-feel and a sixth sense that the property value will just rise, and rise.
To invest at a price where you are making loses (even after the generous tax minimisation schemes are cooked up) with only a hope and a prayer that someone else will come along to take it off you at a higher price… That’s not investing, that’s speculation.
That’s also not to say that speculation always end badly… just that it is best to know, and capable of accepting (the reality as well as the consequences) that you are speculating. That way, you can speculate more intelligently, more cautiously… and only does so on rare occasions (with money you can afford to lose).
Of course all these are sensible and I am sure we all know without needing to read it from someone like me. Just that the thing with market mania and bubbles is that no one who’s in it ever really see that it’s happening (to them). I guess that if they do, there wouldn’t be any bubble.
So be aware and question our own judgment and thought processes. Know which part of the investment equation is real and tangible, which part is more or less speculative.
LEVERAGE ON THE FINANCIAL MARKET
There’s margin lending, options, derivatives and a bunch of financial contracts and instruments out there. Most involve the investor/speculator putting upfront a small amount with the larger amount to be paid (or received by them) later.
The most common leverage seems to be margin loan – where your broker would lend you money to buy more shares on top of what your savings could afford. They’ll demand collateral, fees and interests… and if the share price goes up, you win; if it goes down beyond the LVR (Loan to Value Ratio), they’ll give you a call to top up, sell out and possible take all your collateral and its kitchen sink.
There’s Short Selling… where you borrow shares you don’t own, sell them with the expectation that it will go down. If it does go down and you decided to close the position out, you’ll pocket the profit after fees and interests. If the share price goes up… up because your reading of the financial statements weren’t very good; up because the market does know what it’s doing, or being manipulated (for longer than your account can handle the broker’s demand); up because it came down but is about to be taken over… the upside on such bets are 100% at best; the downside losses are, theoretically, unlimited.
Don’t put yourself in a position where things will have to both go right, and going right where thousands or millions market players also agrees with you, and agrees at around the same timeframe you lock yourself into… It just doesn’t sound sensible, not even for the big market makers let alone us little “retail” investors.
MY KIND OF LEVERAGE
Use the company’s business and position as leverage.
Never use your money as leverage – they’re paper thin and tins and copper aren’t that much stronger either.
FREE MARKETS, FREE TRADE, DEMOCRACY AND FREEEEDOOMMMM
Despite what we might’ve read in the free press, taught at school and shown at the movies… practically all the countries and gin joints in the world are ran and managed for the rich ruling elite and their corporations.
I say “practically” because there are places where the ruling elite is the one single family with various lords, mandarins and their “state own” enterprises and principalities.
In more advanced societies, the monarch and his/her imperial majesty are either a puppet head of state or were gotten rid of some generations ago. Replacing that power vacuum with “the people” or “the electorate”… Power and riches remains in the hands of the new class of lords, barons – through their corporations.
That’s not passing on judgment and such things normal decent human being tend to do. As capitalists, I guess you either open your own business to serve clients and customers to your own liking; or getting into bed with companies that has the most money and start rationalising how great work are being done for the good of humanity. That or you “grow up” and look beyond good and evil towards an enlightened position where money resides, try to get the money and do some good with it.
Having rant all that, imagine a big giant company that have come a long, long way from its very humble beginning to now crush the dreams and work of today’s humble beginners; to dictate state and government policies; to receive corporate welfare and involve in the electing and firing of politicians who aren’t very good at saying the right words but doing the right thing.
Imagine you, or me, having the equivalent of a few bucks, somehow could get to share in the gains and profit of that enterprise.
That’s better than any ant being able to lift however times its own weight.
Imagine that not only are you and your few bucks able to get into, and out of, such enterprises the moment you can see deteriorations, the moment you can find better opportunities.
That’s an ant that lifts many times it own weight, then use that strength and compound it over and over until it grows so big Hollywood make some cheesy movie about it.
As Buffett advised, don’t turn that kind of leverage and advantage into an inherent disadvantage.