Thoughts on Leverage in Personal Investing
With the financial meltdown; personal leverage in investing has gotten a bad wrap. Lets examine the types of leverage and than discuss the types of behaviors that led many to get burned.
There are several types of leverage:
1. Overspending on your credit cards---ie financial leverage to drive personal consumption
2. Maxing the amount of your mortgage to get the biggest house for your current salary
3. Borrowing money to invest in real-estate
4. Borrowing money to invest in a business
5. Borrowing money to invest in liquid investments (ie. stock markets)
6. Using your "buying power" to invest in equities
7. Lending your shares out for a fee to others who would like to short them.
There are probably others, but these types of leverage cover ones that most people will encounter.
#1 & #2 are about personal consumption. The first is just a bad idea. Buying an item that starts losing money the moment you buy it and paying 18+% per annum for the privilege is just plain bad. If you need to do this to put food on the table than that is another story. Unfortunately, for most people in the US, this is about consumption of non-necessity type of goods (ie. non-food items). There are plenty of articles on why this is bad, do a google search for "credit card debt stories".
#2 -- is a common misnomer. Buying a house is also personal consumption although it is commonly thought of as buying an "asset". If you look at financial accounting rules, the house is an asset -- for your bank (the one that provides your mortgage). A house is not an asset! It is a "home". The building depreciates and looses value. The land may gain value. But, does it gain sufficient value to not only cover the building depreciation but also any improvements you may make as well as the interest you pay on it? In today's environment, this is not an easy answer. We can look at financial calculators or build fancy excel sheets to prove this--but at the end of the day, don't think of your house as an "asset" unless you are willing to sell it at a moment's notice and move if the market makes your asset profitable or if your asset looses value just like you would for any equity investments you may have.
#3-#6 are truely about investing. #3-#5 involve borrowing money at a (typically) variable interest rate and investing it in something that will hopefully provide a return above that interest rate. The pros and cons on these will be discussed later.
#6 is a very different type of leverage--and something that you will find in your brokerage accounts if you try to buy/sell options. Brokerage companies will compute the "risk" of your cash & equity holdings in terms of the loss of value based on volatility and call it "Initial Maintenance Margin" or something of this type. They will also calculate an "Available Margin" which is the additional value that your positions have today beyond the "Initial Maintenance Margin". What these mean is that basically, if you have $X of equity, they will allow you to borrow $Y against $X as long as you maintain a minimum of $Z of value in your account where $Z is often less than $X.
But, what makes this different from #6 is that you can use this value to sell options which impact "borrowing power" but do not require you to actually borrow any money. When you sell an option, depending on the type of option, you are telling the person you sold the option to that you will be the other end of the trade if/when they wish to exercise their option. For this privilege, they will pay you a fee upfront and your brokerage company will calculate the risk on the option being exercised and add that to your "Initial Maintenance Margin" and reduce that amount from your "Available Margin".
#7 is another very different type of leverage...one that the average investor rarely sees and one that institutional investors take advantage of all the time to either juice their returns or increase their own profits. It involves lending shares (that are owned by the lender) to others. The buyers will typically use these shares to create short positions and in return will pay a fee to the lender and also give the lender cash collateral equivalent to the value of shares lent. Only in very rare cases does the lender not get back their stock (ie. their brokerage company goes out of business)--as the brokerage company acts as an intermediary and is the counter-party (not the actual borrower). If you have a brokerage company (like Interactive Brokers) that is transparent about this--they will give you a percent of the fee for borrowing. If you don't (most brokerage companies), than you will not ever be told about this--but they will lend your stock and keep 100% of the fees. If you have an equity account and positions that have any sort of short interest, this is the most risk-free way of leveraging your returns.
With the financial meltdown; personal leverage in investing has gotten a bad wrap. Lets examine the types of leverage and than discuss the types of behaviors that led many to get burned.
There are several types of leverage:
1. Overspending on your credit cards---ie financial leverage to drive personal consumption
2. Maxing the amount of your mortgage to get the biggest house for your current salary
3. Borrowing money to invest in real-estate
4. Borrowing money to invest in a business
5. Borrowing money to invest in liquid investments (ie. stock markets)
6. Using your "buying power" to invest in equities
7. Lending your shares out for a fee to others who would like to short them.
There are probably others, but these types of leverage cover ones that most people will encounter.
#1 & #2 are about personal consumption. The first is just a bad idea. Buying an item that starts losing money the moment you buy it and paying 18+% per annum for the privilege is just plain bad. If you need to do this to put food on the table than that is another story. Unfortunately, for most people in the US, this is about consumption of non-necessity type of goods (ie. non-food items). There are plenty of articles on why this is bad, do a google search for "credit card debt stories".
#2 -- is a common misnomer. Buying a house is also personal consumption although it is commonly thought of as buying an "asset". If you look at financial accounting rules, the house is an asset -- for your bank (the one that provides your mortgage). A house is not an asset! It is a "home". The building depreciates and looses value. The land may gain value. But, does it gain sufficient value to not only cover the building depreciation but also any improvements you may make as well as the interest you pay on it? In today's environment, this is not an easy answer. We can look at financial calculators or build fancy excel sheets to prove this--but at the end of the day, don't think of your house as an "asset" unless you are willing to sell it at a moment's notice and move if the market makes your asset profitable or if your asset looses value just like you would for any equity investments you may have.
#3-#6 are truely about investing. #3-#5 involve borrowing money at a (typically) variable interest rate and investing it in something that will hopefully provide a return above that interest rate. The pros and cons on these will be discussed later.
#6 is a very different type of leverage--and something that you will find in your brokerage accounts if you try to buy/sell options. Brokerage companies will compute the "risk" of your cash & equity holdings in terms of the loss of value based on volatility and call it "Initial Maintenance Margin" or something of this type. They will also calculate an "Available Margin" which is the additional value that your positions have today beyond the "Initial Maintenance Margin". What these mean is that basically, if you have $X of equity, they will allow you to borrow $Y against $X as long as you maintain a minimum of $Z of value in your account where $Z is often less than $X.
But, what makes this different from #6 is that you can use this value to sell options which impact "borrowing power" but do not require you to actually borrow any money. When you sell an option, depending on the type of option, you are telling the person you sold the option to that you will be the other end of the trade if/when they wish to exercise their option. For this privilege, they will pay you a fee upfront and your brokerage company will calculate the risk on the option being exercised and add that to your "Initial Maintenance Margin" and reduce that amount from your "Available Margin".
#7 is another very different type of leverage...one that the average investor rarely sees and one that institutional investors take advantage of all the time to either juice their returns or increase their own profits. It involves lending shares (that are owned by the lender) to others. The buyers will typically use these shares to create short positions and in return will pay a fee to the lender and also give the lender cash collateral equivalent to the value of shares lent. Only in very rare cases does the lender not get back their stock (ie. their brokerage company goes out of business)--as the brokerage company acts as an intermediary and is the counter-party (not the actual borrower). If you have a brokerage company (like Interactive Brokers) that is transparent about this--they will give you a percent of the fee for borrowing. If you don't (most brokerage companies), than you will not ever be told about this--but they will lend your stock and keep 100% of the fees. If you have an equity account and positions that have any sort of short interest, this is the most risk-free way of leveraging your returns.
