The element of leverage in an investment is like yeast–it's the ingredient that can help your investment expand. We define leverage in the financial world as the use of borrowed funds to a) magnify financial returns; or b)reduce the capital invested in a company and, in some cases, the nature of the investor's liability.
Let's begin with an example. Today you buy 1000 shares of XYZ Company stock at $1 per share. Your investment is $1,000. Next week, you sell all your shares for $1.05 per share. You receive $1,050 for your initial investment of $1,000—a gain of $50 (or 5%) on that investment. But let's suppose instead that you buy those same 1000 shares on margin—an example of leverage in a stock investment.
In that case you would invest only $500 and your broker would loan you the other $500. You still buy and own 1000 shares. At the end of next week, when the stock value is $1.05 per share, you sell and receive $1,050. Of course, you have to repay your broker the $500 you borrowed, but you get to keep $550. That's the same $50 gain, but now it represents 10% on your original investment of only $500.
Our example, naturally, has been simplified, and requires certain cautions. First, your broker will want to receive interest on the amount of the margin loan, and that interest will diminish your overall gain. Second, there is no guaranty that your investment will increase in value. In fact, if the investment you've leveraged decreases in value, your percentage loss on investment will be greater because you still have to pay the loan back in full.
Using the element of leverage in an investment is clearly not for the faint of heart. You must carefully weigh the potential upside gain against the downside risk. Like the other eight elements, it's importance to you when choosing an investment will depend on your own personal circumstances. Look to your age, knowledge, experience and position in the Wealth Cycle (see "Jerry's Corner"–The Wealth Cycle) to help you determine how you would rate an investment's leverage.
On the chart to the right I've supplied my own ratings for various investment categories on a scale from zero to ten. In this case, a "zero" would indicate that the investment has no leverage ability, or it does not meet our definition of leverage—more about that later. A "ten" would be an investment that has the best potential to produce a magnified return because of its leverage element.
While you may be able to borrow against your funds in a savings or money market account, loans on these types of investments do not actually meet our definition of leverage. Remember, leverage is the use of borrowed funds to magnify an investment's return. Unlike our stock margin loan example, you generally do not borrow against a savings account to purchase (or invest in) that account in order to increase its potential return. Thus, although a savings account can be used as collateral for a loan, it doesn't meet our definition for leverage in an investment.
Rental Real Estate, on the other hand, is an excellent example of the effectiveness of leverage in an investment. In the ideal case, someone else (your tenant) contributes monthly to the increase in your equity when his or her rent covers the interest and principal amortization on your loan. Thus, even if the value of the property remained constant, your equity would continue to rise by the amount of debt reduction.
While many consider leveraged investments to be most appropriate for younger investors, there are notable exceptions. The most obvious is the individual approaching retirement with less than adequate savings. He or she is facing the possibility of drastic lifestyle changes in order to be able to retire. Instead, this individual may risk the use of leverage in order to attempt to generate higher returns over say a ten or fifteen year period.
Only your individual circumstances can determine the value of the leverage element of an investment. Some people will only make use of their home's leverage. Still others may use this tool in a variety of investments as they journey toward financial freedom.
Elements of Investment
Elements
Savings & Money Markets
Stocks
Bonds
Limited Partnerships
Real Estate
Commodoties
Home
Risk
8
6
7
2
5
2
9
Management
8
7
7
9
4
5
7
Flexibility
4
8
7
1
5
2
7
Liquidity
9
8
7
1
6
1
7
Cash Flow
4
5
6
1
7
1
7
Rate of Return
4
7
5
6
7
8
8
Appreciation
0
6
0
5
7
7
8
Leverage
0
7
9
8
8
9
8
Taxes
-
-
-
-
-
-
-
Total
-
-
-
-
-
-
-
|
|
Moorman and Company, an accounting and personal financial management firm based in Palo Alto, serves the San Francisco Bay Area, Peninsula, and Silicon Valley from Hillsborough to Saratoga-Los Gatos, including Atherton, Menlo Park, Los Altos, Los Altos Hills, and Cupertino.