Leverage

I want to talk about debt and leverage, and since these are not complicated topics, I'm just going to explain them.

Suppose I allowed you to borrow $100 by putting down a deposit of $10. For argument's sake, I'm a generous guy, and I don't even charge you interest on the $90 that you borrowed. Now, you go and invest that money somewhere. For argument's sake, it's the stock market. At the end of the year, the market returns 5%.

What is your true return?

Well, you made $5, and you only put down $10 so that's 50% return. However, the market only returned 5% so where did the remaining 45% come from?

The answer is leverage.

You controlled $10 for every $1 you put down. That's 10:1 leverage. 10 times 5% = 50%.

Now if the market had declined 3%, you would have a loss of 30%. Same logic: 10 times leverage by -3% = -30%.

And what happens if the market declines 25%? You lose 10 times -25% = -250%, which is to say, you just lost $25.

Where does the extra $15 come from? You owe me $15, and if you don't pay up, I may just send Fat Tony (or its modern equivalent) around to collect it.

And what happens if you can't pay? Well, with Fat Tony, you lose your kneecap but in the modern world, you end up in bankruptcy court.

So leverage magnifies both losses and gains, and if I had charged you interest, the calculations will change (but you get the general picture.)

The key point is that leverage magnifies both losses and gains.

All debt involves leverage. This is an inescapable fact.

There are two key points here:

Firstly, leverage magnifies both gains and losses. Hence it magnifies risk as well.

Secondly, you want to try and use leverage when the odds are in favor of gains rather than losses, and not otherwise. This is a simple probability argument that should be utterly obvious. (A leveraged casino is as much of a "no-brainer" as it gets in the finance world, since the casino has the odds in its favor.)

A non-obvious use of leverage is when people borrow money for higher education. Most likely, it will pay off in the form of higher wages. (However, it may not. You're magnifying risk even though it's not obvious.)

However, it should be easy to deduce a simple corollary from the above two points:

If things are likely to decline in value, don't take on debt to buy it. In an extreme particular, taking on debt to buy depreciating assets is always a bad idea!

Makes sense, right?