What is Financial Leverage?
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When talking about investments, leverage refers to the use of debt.
If you have a margin loan, you can buy shares in XYZ blue chip company, and borrow up to 70%. This means that as an investor, you only need to provide a 30% deposit and can borrow the remaining funds from the margin loan provider.
Leverage allows you to increase your total exposure to investment markets. While providing you with the potential to build a larger and more diverse portfolio, you are also increasing your exposure to financial risk.
Let's say that there are two investors, Investor A, and Investor B. They each have $5,000 to invest in the stock market. Investor A buys $5,000 worth of shares. He can now sit back and relax. His funds are in the market, he can leave them there for as long as he wants, and pay no ongoing fees.
Investor B, decides to leverage his investment with a margin loan. He is comfortable with a leverage of 50%, which enables him to invest $10,000 in the market. He has used $5,000 of his own money, and borrowed another $5,000 from his margin loan provider. The loan costs him 7% per year in interest.
After one year, Investor A has contributed $5,000 to his portfolio, Investor B has contirbuted $5,350. Investor A has no ongoing costs, while Investor B has paid an additional $350 in interest, in exchange for doubling his market exposure. This is shown in the table below:
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From the above we can see that Investor B has used $350 and has gained an extra $5,000 of investments. It looks like a great deal, but it is only suitable for investors who are willing to accept the risk of leverage.
On the surface, paying $350 for $5,000 worth of investments, sounds like a great deal, but, in the world of investments, there is no such thing as risk free returns. While Investor B has invested twice as much as Investor A, he has also incurred additional costs.
Investor B needs to recoup his costs. The market would need to deliver a return of 7% for him to match the returns achieved by Investor A in a non-leveraged portfolio. This is his break even rate.
The table below shows the performance of each portfolio with varying market returns:
