Should You Use Leverage?
Ron DeLegge, Editor
December 15, 2009
SAN DIEGO (ETFguide.com) – Leverage is perhaps one of the most misunderstood concepts in modern finance. Yet, the idea is fairly simple to understand; to obtain magnified gains and to avoid magnified losses.
While the typical investor may be roughly familiar with the meaning of leverage, even professional investors struggle with its significance and correct application. Should you use leverage inside your investment portfolio?
Learning from Leverage
“When you combine ignorance and leverage, you get some pretty interesting results,” quips Warren Buffett. This is true not just at the individual investor’s level, but at the corporate level too.
Bear Stearns and Lehman Brothers, two former Wall Street powerhouses, no longer exist because they overleveraged themselves out of business. These companies became so addicted to leverage - they destroyed themselves and nearly the entire global financial system. At the time, few individuals realized just how dangerous the mis-application of leverage was. Instead of being criticized for taking too many leveraged risks, companies were being rewarded. From 2005-07, Bear Stearns was ranked by Fortune Magazine as one of “America’s Most Admired Companies” for its commitment to risk management and business innovation.
What’s the lesson we learn? Leverage is like fire; it can be used to keep you warm or it can burn down your house.
Using Margin Accounts
One way to obtain leverage is by using borrowed money from your broker to buy securities. This is commonly known as “margin.” And while it can magnify your market gains, it can also expose you to higher losses.
Let's say you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you'll earn a 50 percent return on your investment. But if you bought the stock on margin – paying $25 in cash and borrowing $25 from your broker – you'll earn a 100 percent return on the money you invested. Don’t forget too, that you still owe your broker $25 plus interest.
The drawback of using margin is that if your securities decrease in value the losses can pile up fast. For instance, suppose the stock you purchased for $50 declines to $25. If you bought the stock without margin you’ve got a 50 percent loss. However, if you bought the stock using margin, your loss is a whopping 100 percent, not to mention the interest you still owe on your loan!
During volatile markets, your broker may require you to put up more cash to keep your margin account in good standing. Some investors are shocked to learn their brokerage firm has the right to sell their securities purchased on margin without prior notification or approval. If the securities in your portfolio have been sold after plummeting, you’ve lost out on the future chance they’ll rebound in value.
According to the Securities and Exchange Commission’s Website, “The Federal Reserve Board and many self-regulatory organizations (SROs), such as the NYSE and FINRA, have rules that govern margin trading. Brokerage firms can establish their own requirements as long as they are at least as restrictive as the Federal Reserve Board and SRO rules.” Before using margin, familiarize yourself with the rules.
Funds that use Leverage
Leveraged and short ETFs attempt to magnify their gains and to provide inverse market performance to various stock, bond and commodity indexes on a daily basis. Because they aim to achieve investment results that target the daily returns of their underlying benchmarks, they’re best suited for investors with a short-term time horizon.
One example of this is the Direxion Daily Real Estate Bull 3x Shares (NYSEArca: DRN) which aims to deliver three times the DAILY performance of real estate stocks within the MSCI US REIT Index. If this particular benchmark increases in value by 1% on any given day, DRN tries to obtain a 3% gain. If real estate stocks decline by 1% on any given day, DRN should fall by 3%.
Knowing whether to use leverage is a very simple exercise that boils down to three main factors: 1) Your investment time horizon, 2) Your risk tolerance, and 3) Whether these type of investments match upwith your broader investment goals.
Generally speaking, it’s a bad idea to use leverage to the point of where it can put your entire financial plan in peril.
Also, any investments you decide to buy should always be compatible with your ultimate investment objectives. While this is true for any type of investment it’s especially true for investors that decide to use leverage.