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Leverage: Friend Or Foe?

When you use leverage, you borrow money to invest in assets, wagering that your investment gains will outpace your borrowing costs. Leverage can multiply the gains that a given amount of capital can otherwise generate. But in exchange for the money you borrow, you’ll often have to put up collateral – usually the asset you’re purchasing.

Of the many forms of leverage, the one familiar to most Hong Kong people is the mortgage, where we borrow from banks around 50%-70% of the total property cost, using the property as collateral.

Another common form of leverage is stock margin trading.  Say you have $10,000 to invest.  If your broker sets a “stock margin ratio” of 60%, you’ll be able to purchase a stock portfolio of up to $25,000, with the broker/bank forking over the extra $15,000 – 60% of the total invested amount – as a loan to you. Since your capital is now $25,000 instead of $10,000, your gains on that investment will multiply. Of course, you need to deduct the borrowing costs and handling fees from the gains.

Leverage is also commonly available for forex investments, which operate similarly to stock.  In this low-interest-rate era, many private banking services also offer low-cost leverage to high-net-worth individual clients toward the purchase of various investment products, like high-yield bonds or bond funds.  Investors can pocket the gap between the yields and the low borrowing rates.

Understandably, leverage is great news for enterprising investors, including those who have relatively little investment capital. As Fools, we are more concerned about the long-term sustainability and value growth of our investments.  Is leverage relevant to us at all?

The answer depends on how your comfort with risk

Margin trading’s big risk lies in the possibility that your portfolio might lose money.  When stock prices go up, margin traders have plenty of cash to pay back what they’ve borrowed, and everyone is happy.  But if stock prices fall, the broker might activate a “margin call.”

When a margin trader’s stock portfolio decreases in value, the maximum amount they can borrow falls, too. And if it falls too far below the original amount that investor borrowed, the broker can force the investor to add more cash to their account to cover the shortfall. If the stock keeps falling, the broker can sell the investor’s holdings to recoup their debt, potentially leaving the investor with nothing.

Obviously, margin trading won’t work well for Foolish buy-and-hold investors.  Stock prices will naturally move up and down over time, which might trigger multiple margin calls. There’s no point in trying to boost your long-term gains if, in return, you could lose everything over a short-term stock swoon. Unfortunately, most people who trade stocks on margins tend to make short-term speculative buys during bull markets. When those bulls inevitably – and often suddenly – turn into bears, these unwise investors can suffer steep losses.

However, when you’re not using leverage for speculation, and you’re leveraging an asset whose value remains relatively stable over time, leverage can be a useful tool in our financial planning.  Property mortgage is a case in point.  But even in that situation, you need to evaluate the related risks – particularly whether property prices and interest rates are rising or falling, and most crucially, whether you can actually repay the loan.

In short, leverage could be a great friend, or your worst enemy. It all comes down to how and when you choose to use it.

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