Warren Buffett, the renowned investor in Omaha, is famous for discouraging people from using leverage to boost their investment returns. However, what people may not realise is that Buffett himself has employed leverage on his way to become one of the richest men alive. If done correctly, leverage is actually not only an effective, but also a savvy investment tool that can increase one’s wealth materially over time. Here, we discuss what leverage is, and how smart investors can use it to boost their returns without exposing themselves to irresponsible amount of risk.
How Leverage Works
To explain it simply, leverage refers to using borrowed money to invest, in order to boost your returns. For example, you have S$100 of cash that you can invest. Instead of buying S$100 of stocks, however, you decide to borrow S$400 from your online brokerage to buy S$500 of stocks. If the stock goes up by 10%, you can make S$50 of profit (minus any interest you owe on the borrowed S$400) instead of S$10 you would’ve made on your original investment of S$100.
Although this sounds like a fantastic way to make money, the reason why Buffett discourages using leverage is that it is a double-edged sword. If the stock you bought ended up declining by 10%, for instance, you would have lost $50 on the original S$100 you had even before accounting for the interest you would have to pay to your lender. Then, how do smart investors like Buffett use this financial weapon in their favor?
Investing With Leverage Is Not Gambling
Before diving into our question, first thing to note is that investing is not equal to gambling. While gambling is purely dependent on odds of certain events happening, investing is more about profiting from disconnect in an asset’s fair value and its market price. Therefore, you should always be preoccupied by how much something should be worth instead of guessing whether its price will go up or down.
Given this, there’s only one good way of using leverage: to increase your returns on your investments: to boost your returns on high conviction ideas with a wide margin of safety. In a way, you could characterise it as a “conservative aggressive” investing. You only invest if there is a big value-price disconnect even based on conservative estimates, but you invest aggressively into those opportunities.
Warren Buffett did this by using “borrowed” funds from his insurance company’s clientele (i.e. an insurer collects insurance premiums upfront, but doesn’t pay out any claims until much later), and using those funds to purchase only high quality, franchise companies like Coca Cola when their stocks were cheap (i.e. during financial crisis, etc.). In fact, some studies found that his returns would have not been as spectacular without this combination of conservativeness and aggressiveness in his investing strategy.
How to Use Leverage Smartly
If the smartest and the best investor of all time has used leverage successfully, it’s worthwhile to ponder what an average investor can do to gain similar benefits from leverage.
First, an average investor should use leverage selectively. It’s never a good idea to over-do it with borrowing money. As we demonstrated earlier, leverage is a double-edged sword, and exposing yourself to its dangers in an oversized and frequent manner is bound to hurt you eventually. Instead, he should only employ leverage on a select set of opportunities for which he has the biggest amount of knowledge, understanding and conviction.
Secondly, an average investor should use different leverage tools depending on his opportunities. For example, trading on margin or with CFDs is more suitable for longer-term trades that are aimed at a gradual closing of the value-price gap. It can also be lucrative to buy dividend-type securities on margin, so long as you have confidence in the underlying issuer’s ability to uphold its payouts. On the other hand, using options can be a phenomenal way of boosting your returns if you have high conviction on certain events happening in the short term, like earnings upgrade or misses.
Lastly, it’s actually advisable to start using leverage when you are young. There are a number of reasons why leverage is more appropriate for people in their 20’s than it is for people who are in their retirement. First, young people have less capital they are able to deploy, and are therefore underexposed to the stock market, which inarguably contributed to a huge chunk of the wealth creation that occurred globally for the last decade. Not only that, people in their 20’s should have a higher risk tolerance than their older counterparts: losing a few hundred to thousand dollars can hurt, but it won’t ruin your life; losing a big chunk of your retirement portfolio can.
In conclusion, investors should always be knowledgeable about what they buy. As long as you invest conservatively and carefully, using leverage can actually be a productive tool.
The article How Sophisticated Investors Use Leverage to Boost Their Returns originally appeared on ValuePenguin.
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