Leveraged investing means investing with borrowed money. You can invest more money than you have and let compound interest work its magic longer.
Professional traders see leverage as an efficient use of trading capital because they can trade larger positions with less capital. They think it can reduce risk, as it allows you to spread your money over more trades.
But it’s not just the pros that use leverage. Most people simply use it as a way to increases investment returns.
You borrow money so that you can invest a larger amount up front. It’s a way to start your investing journey with more money than you have. This gives compound interest a bigger piece of the pie to work with for longer.
The saying money makes money comes to mind.
Lets say you have £10,000 in savings which you invest and it goes up 25% so you make £2,500. Pretty good, but what if you borrowed £30,000 from the bank so you end up getting 25% on £40,000.
In that case you’ll make £10,000. Borrowing money has quadrupled your winnings and doubled your money at the same time.
No wonder people like it.
Where people typically borrow to invest
There are plenty of places where people use leverage.
Any brokerage account will likely offer some form of leverage and it’s not unusual to see spread betting platforms offering leveraged trades of 400/1 i.e. you could trade the equivalent of £4000 for just a tenner.
Of course they charge you a little for the privilege, but I doubt you’d care about that if the trade went your way.
Though not everybody uses spread betting platforms, leveraged investing is a lot more common than people realize.
Anybody who takes out a mortgage is essentially using leverage. You borrow money to invest in a house, which you expect will go up in value.
Yes, there are other reasons to buy a house but most people expect the value to increase over time.
The Credit Suisse Global Investments Returns Yearbook 2018 shows annualized real returns for property in different countries.
Historically, UK houses have beaten inflation by about 1.8% a year.
A house with a 25% mortgage is effectively leveraged 4/1, which means your average return increases to about 7%. Not to mention the extra you’d get if you rented the property out.
So lots of people out there are getting nice investment returns from their property using leverage without even thinking about it.
Another place where you can easily come across leverage is investment trusts. One of the most famous investment trusts of the moment is Scottish Mortgage.
I bet a lot of investors in that fund aren’t even aware the fund is currently leveraged about 9%.
In fact, some investors wouldn’t feel comfortable with leverage, but that is likely to be one of the reasons the fund has managed to crush its benchmark over the last 5 years.
£100 would have turned into just over £250 if you had invested in Scottish Mortgage, whereas investing the same amount in a fund that tracked the benchmark FTSE All-World Index would only be worth around £175.
Lots of exchange traded funds (ETFs) use leverage too. A particularly well known example is the Direction Daily S&P 500 3x Shares ETF (SPXL), which seeks to produce three times the return of the S&P 500 on a daily basis.
Basically you are investing in US stocks with bells on!
And in hindsight that would have been a pretty good thing to do over the recent decade because US stocks have been roaring. You can see the results below based on a $10,000 investment back in 2009.
Investing with and without leverage compared
The table below shows the numbers behind the graph:
Leveraged investing vs investing without leverage
| Fund | Final Balance | Compound Annual Growth Rate | Max. Drawdown |
| SP500 3x | $210,029 | 33.64% | -49.16% |
| SP500 | $40,125 | 14.15% | -18.17% |
Source: Portfoliovisualizer
By using 3x leverage a compound annual growth rate of 33.64% means you end up with five times as much money as you would have done had you invested in the standard non leveraged ETF.
Investing $10,000 back in 2009 turns into over $210,000 using leverage, whereas you are only left with $40,000 by investing without it.
Why you shouldn’t use leverage
That said, you’ll notice I added a little Max. Drawdown column to the graph. This is the maximum drop experienced over the time period. It’s worth thinking about the consequences of this for a minute.
The SP500 dropping 18% would be enough to put some people off investing all together, but the near 50% drop from the leveraged ETF is a big warning sign for even the bravest investors.
Yes, it recovered and came back stronger. But stock markets aren’t guaranteed to recover, at least not in the short term. Japanese and Chinese investors are a long time from their markets’ peaks.
Anybody who’d invested with leverage at the peaks of their markets would still be nursing losses a decade later in the case of China and decades later in the case of Japan.
And the thing is the S&P500 has been known to drop half its value during major crashes.
It doesn’t take a genius to work out what might happen if you were leveraged 3 to 1 when the markets crash big time. 400/1 doesn’t even bear thinking about!
Crashes and bull runs
Who knows when the next crash will come. The US market has been enjoying a bull run for a record time period. The longer it goes on the more likely a crash will come. The bottom line is, investing with leverage is risky.
Even Investment Trusts which only tend to use a little leverage are considered risky. Remember, I’ve already mentioned Scottish Mortgage Investment Trust are leveraging about 9% right now.
Just 9%! If leveraging is so good why don’t they use more? Of course because they know using leverage comes with serious risk.
Scottish Mortgage Investment Trust has been going for over 100 years. It’s safe to say the guys running are experienced investing professionals. Serious investing professionals who obviously don’t think it’s a good idea to use too much leverage.
And they aren’t the only ones. There’s a long list of serious investing professionals that would caution about using leverage, but perhaps the most compelling of them all is Warren Buffet who has this to say on the subject.
My partner Charlie says there are only three ways a smart person can go broke: liquor, ladies and leverage. Now the truth is — the first two he just added because they started with L — it’s leverage.
Warren Buffett
Think about a 400/1 trade going against you. You could lose all your money in a blink of an eye.
The bottom line is. If you don’t borrow money the worst that can happen is you lose all your money. Losing borrowed money is worse because it leaves you in debt.
We’ve all heard about people getting into trouble with their finances. I think it’s a pretty safe guess the vast majority have something to do with borrowing money.
Long Term Capital Management
Many smart people have been destroyed by leverage, but perhaps the most famous example were the collective genius that formed Long Term Capital Management (LTCM).
A single hedge fund that needed to be bailed out by a consortium of Wall Street banks in order to prevent global financial meltdown. The fund was inches away from collapsing the global financial system in 1998.
They weren’t just in a position to bring themselves down, they were poised to bring the whole world down.
LTCM comprised some of the brightest, most experienced professionals in the industry. It even had a couple of Nobel-prize winning economists in its ranks. These were anything but amateurs.
And unlike many hedgfunds they weren’t making money from their expensive fees. They were in fact using their own money. Much to dismay of their original investors (but no doubt later relief) they returned their original investors money and just used their own.
The very fact they didn’t need outside investors money or the fees it generates shows how rich they already were. In other words they were risking their own money for more money which they probably didn’t need anyway.
So how did a bunch of the brightest, richest most experienced financial professionals you are ever likely to come across nearly bring down the global financial markets and in the process lose all their own money?
You guessed it, leverage! LCTM used highly leveraged trading strategies.
They worked for a while until one day they didn’t!
Your options
Investing with leverage is definitely risky, but not all risk is equal. In this article we’ve covered three leveraged investing options:
- Investing in a leveraged fund
- Using a spread betting platform to carry out leveraged trades
- Borrowing money to invest
All three of these have risks, but these risks aren’t the same.
When you invest in a leveraged fund like an ETF or Investment Trust the risk is that you’d lose your money faster than if there was no leverage used.
In fact, I’m sure it goes without saying that the more leverage you use the quicker the losses in the bad times.
When it comes to watching your bank balance drop to zero, 3/1 leveraged ETFs are gong to beat 9% leveraged investment trusts hands down. And 400/1 spread betting trades are going to blow the other two out of the water.
That said, the worst that should happen is that you lose all your money. Now, losing all your money isn’t fun and some people never recover from it, but for most people it could get even worse when you borrow money to invest.
Borrowing money to invest
Investing in leveraged funds and doing leveraged trades doesn’t actually require you to borrow any money. In other words, you only use and lose the money you have.
If you have £100, you can buy £100 worth of shares in a leveraged fund. The leverage is hidden in the fund. In the same way you can only leverage £100 400/1 on a spread betting platform. You can’t leverage £200 if you only have £100. Again the leverage is effectively hidden in the trade.
Outright borrowing money to invest is a little different.
If you could get your hands on a very low interest very long term loan to invest, then perhaps this would be the best option. In fact, it’s an option a lot of risk adverse investors would probably consider.
But the thing is, most people can’t get their hands on cheap long term loans for anything other than property (which we’ll come to later), certainly not for stock market investing.
Instead the only option available to most people is a margin account.
Margin account
With a margin account your brokerage platform lends you the money against the value of your account with them. The bigger your balance the more they will lend you, and herein lies the problem.
The very fact that your balance is based on investments makes it risky. If stocks go down, so will your balance, and in turn the size of loan you are eligible for. So whereas one day you could be eligible to borrow one amount of money, the next day you might not be.
And unlike your friendly mortgage broker, who will generally let you keep your mortgage no matter how much your situation changes as long as you make your repayments, your stock broker won’t. They can request repayment of the loan within 24 hours.
All brokers will need a minimum balance to lend upon. If the market moves against you so that your balance drops below that amount, you need to add enough money to make up the shortfall, otherwise your stocks could be sold.
It wouldn’t matter so much if you have the cash to add, but the problem comes from the fact that people may not have the cash to add.
In fact, it’s more than likely that they won’t have the cash to add, because if they did they wouldn’t have needed to invest using margin in the first place.
Without cash to add, stocks are going to have to be sold at just the wrong time. You wouldn’t need to be selling the stocks if their value hadn’t dropped dramatically, which means you are forced to sell at just the wrong time when stocks at their cheapest.
And I’ve not even mentioned the interest payments! Brokerages don’t lend you money for nothing.
It doesn’t take too much imagination to see how people can get in a serious mess using this approach.
The bottom line
If you’re brave, have done your research and are happy with the risks then maybe you could think about using leverage.
But most of us shouldn’t use leverage for investing in financial markets. The increase in the size and speed of losses is going to be too big a risk for most investors in most situations.
Probably the only place leverage makes sense for vast majority, is taking out a mortgage when purchasing property.
That’s the one area where you can get your hands on a very low interest very long term loan to invest.