Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======Leverage====== Leverage (also known as 'Gearing') is the strategy of using borrowed money to increase the potential return of an investment. Think of it like using a physical lever to lift a heavy rock—a small amount of effort can produce a much larger result. In finance, your own money is the effort, and borrowed money is the lever. This tool allows you to control a much larger asset than you could afford with your own capital alone. For example, by putting down 20% on a house, you use leverage to control 100% of the property's value. While this can spectacularly amplify your profits if the investment performs well, it is a treacherous double-edged sword. The same power that magnifies gains will also magnify losses, potentially wiping out your entire initial investment and even leaving you in debt. ===== How Leverage Works: The Double-Edged Sword ===== The concept of leverage is best understood with a simple story of two investors, Prudent Penny and Risk-it-all Randy. Both have $10,000 to invest in a stock they believe will rise. * **Penny's Path (No Leverage):** Penny invests her $10,000 directly into the stock. If the stock price increases by 10%, her investment is now worth $11,000. She made a $1,000 profit, which is a 10% return on her capital. Not bad! * **Randy's Route (With Leverage):** Randy also invests his $10,000. But he then borrows an additional $90,000 from his [[broker]] through [[margin trading]]. He now controls $100,000 worth of the stock. If the stock price increases by 10%, the total value grows to $110,000. Randy repays his $90,000 loan (we'll ignore [[interest rates]] for a moment), leaving him with $20,000. He started with $10,000 and ended with $20,000, doubling his money for a 100% return! This is where the magic seems to happen. But what if they were wrong about the stock? If the stock //decreases// by 10%, Penny’s investment is now worth $9,000. She has a paper loss of $1,000. She's unhappy, but she can wait for the stock to recover. Randy’s $100,000 position, however, is now worth only $90,000. He still owes his broker the full $90,000 he borrowed. His initial $10,000 has been completely wiped out. He has lost 100% of his capital from just a 10% market move. Even worse, if the stock dropped 11%, he would owe the broker more than the investment is worth. This is the brutal math of leverage. ===== Types of Leverage in Investing ===== Leverage appears in many forms, both in the companies you invest in and the tools available to you as an investor. ==== On the Company Level (Operating & Financial) ==== Companies often use leverage to finance their operations and growth, which is something a value investor must carefully analyze. * **[[Financial Leverage]]:** This is the most straightforward type. A company takes on debt (by taking loans or issuing [[bonds]]) to fund its activities. The hope is that the money can be used to generate profits higher than the cost of the debt. A key metric to watch is the [[Debt-to-Equity Ratio]], which shows how much debt a company has relative to its shareholder equity. A high ratio can be a red flag, indicating financial fragility. * **[[Operating Leverage]]:** This relates to a company's cost structure. A business with high fixed costs (e.g., factories, heavy machinery) has high operating leverage. Once it sells enough products to cover those fixed costs, each additional sale is highly profitable. Airlines and car manufacturers are classic examples. While this can lead to explosive profit growth in good times, it can cause devastating losses during a downturn when sales fall below the breakeven point. ==== On the Personal Level (Investor's Leverage) ==== These are ways an individual investor can directly apply leverage. * **Margin Trading:** As seen with Randy, this involves borrowing money from a brokerage to buy more [[stocks]] than you could with your own cash. It's incredibly risky due to the threat of a [[margin call]], where your broker forces you to sell your holdings at the worst possible time to cover your loan. * **[[Real Estate]]:** Using a [[mortgage]] to buy a home or investment property is perhaps the most common and socially accepted form of leverage. It works because real estate has historically been less volatile than stocks, and the loan is secured by a physical asset. * **[[Financial Derivatives]]:** Instruments like options and futures have leverage baked into their structure. For example, buying a [[call option]] allows you to control the equivalent of 100 shares of a stock for a fraction of the price of buying the shares outright. This offers huge upside potential but also the very high probability of losing your entire premium paid. ===== The Value Investor's Perspective on Leverage ===== For followers of value investing, leverage is treated with extreme caution. The goal of a value investor is the long-term preservation and steady compounding of capital. Leverage is the enemy of this philosophy. [[Warren Buffett]]'s partner, [[Charlie Munger]], famously quipped that there are only three ways a smart person can go broke: "liquor, ladies, and leverage." Buffett himself has consistently warned investors to never borrow money to buy stocks. Why the strong stance? - **It magnifies mistakes.** Value investing is about having a [[margin of safety]]. Leverage eliminates that safety net. A small analytical error or a bit of bad luck, when leveraged, can lead to the permanent loss of capital—the cardinal sin in investing. - **It robs you of staying power.** The market can be irrational for long periods. A value investor's greatest advantage is the ability to wait. Leverage introduces a ticking clock. A margin call can force you to sell a great company at a terrible price simply because of short-term market panic. - **It's unnecessary for great results.** A true value investor believes that fantastic returns come from buying wonderful businesses at fair prices and holding them for the long run. The underlying success of the business should drive your returns, not a dose of financial adrenaline. While value investors are wary of personal leverage, they meticulously analyze a company's debt. A company with a strong competitive advantage and stable cash flows might wisely use a modest amount of debt as part of a smart [[capital allocation]] strategy. But a heavily indebted company is seen as fragile and best avoided. ===== Capipedia's Bottom Line ===== Leverage is a tool of immense power. Like fire, it can be used to create great value or to cause absolute destruction. It is not inherently good or evil, but it is unforgiving of the slightest error or overconfidence. For the average long-term investor, the lesson is simple: **avoid personal leverage.** The risk of being forced to sell at the wrong time and suffering a permanent loss of your hard-earned capital is simply not worth the potential for accelerated gains. Focus your energy on finding high-quality companies and let their business performance do the heavy lifting for you. True wealth is built on patience and the power of compounding, not on the precarious foundation of borrowed money.