Leverage As An Investment Strategy

Leverage makes your investment riskier and more volatile but when there is an increase in value, you can make amazing gains

Leverage is one investment strategy that every one of us might have used in one way or the other. It is as simple as a farmer who borrowed money to start his farm, a company using debt to finance its assets so as to yield more returns, or a house owner who took a house loan or a mortgage to buy a house.

The idea is using borrowed money as the capital or funding towards investing in a security or a portfolio. The borrowed capital is what helps to increase the potential return of an investment and as an investment strategy it can work both in the short term and the long term.

This is because if the return on the total value that was invested in the security (which could be a combination of your own cash together with borrowed funds) is higher than the interest paid for the loan, you make good profit.

Leverage can work in different investment strategies. The commonest example of leverage is when getting a house mortgage. The borrowed funds are used to purchase a home and/or renovate it so as to increase its overall value.

Interest on the loan taken could be as high as 20% but the investor or home owner can sell the home in a couple of years when its value has appreciated and make as much as double the value of the home.

Conditions like time value of money would be considered as well. Another example is in foreign exchange investment, where an investor can borrow money from a country at an interest rate of 5% and take the borrowed funds to another county that pays a 10% interest. You make gain on the investment when you do so.

In investing in the stock market as well, a long-short manager can borrow to deposit an amount say N1 million with his broker to buy 1 million shares of N1 each. He or she can then sell the 1 million shares at N2 per share. With this, he can return the borrowed funds and make a return of 50%.

This takes us straight to the disadvantage of leverage. If the value of the shares decrease to 0.5Kobo instead, he would not only lose his initial capital that was borrowed, he would need to pay more to clear the debt. Simply put, leverage makes your investment riskier and more volatile.

Where a company uses more borrowed capital to fund its investments, it is said to be highly leveraged. That is, it has more debt than equity. When the leverage is high, the risk of the investment can be high.

When your investments are of themselves not so risky or even risk free like treasury bills, it makes sense to use leverage as long as the profit is more than the expected interest rate. If you are investing in stocks, leverage is too much of a risk to add to it. If it safer to use equity to finance it.

Written by Lawretta Egba