Leverage Using Other People’s Money
“When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”
That was Warren Buffett in his 2010 shareholder letter. For those unfamiliar with leverage, let’s step back a bit and explain the topic.
Investopedia defines leverage as, “The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.” In other words, it’s borrowing other people’s money in an effort to increase your future gains. Here’s the hope everyone has when using leverage: Instead of starting my business slowly with this initial seed money of $100,000, I’m going to borrow $400,000 and my now $500,000 will allow me to expand quicker and become more successful. Those who I borrowed the $400,000 from will also see quicker returns on their investment and everyone wins.
Sounds great in theory, right? And like Warren Buffett said, if it works, you look like a genius. But here’s what could also happen: You borrow $400,000 your company struggles. You pour more money and still nothing. You lose it all. Your loss is now much greater than it would’ve been if the you had not leveraged money — leverage magnifies both gains and losses.
Many people may look at leverage as betting on themselves to succeed, but it’s not as simple as that. There are so many other aspects that go into success or failure. The economy could have a sudden downswing for example and no matter how good your business idea was or how successful it would have been, there’s nothing you can do about a market crash.
Yale University professors Ian Ayres and Barry Nalebuff would disagree with Mr. Buffett, however. They produced a study called Life-Cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk in which they argue that leveraging your money starting in your mid 20s will leave you with 90% more money when you turn 65 than conventional investment strategies. For example, they suggest a strategy of a 25-year-old who has $5,000 to invest should borrow (or leverage) another $5,000 and put the whole $10,000 in a stock market index. That person should do the same thing for another 15 years or so before slowly deleveraging in his 40s. The worst-case scenario, according to the two professors, is that you retire with only 30% more than the conventional investor.
However you intend to use leverage, you should strongly consider the risks involved before doing so. Talk to a financial advisor you trust. Clearly there is no right or wrong answer when a genius investor and highly intelligent economists from Yale are at odds. Do what feels right for you. Be aware of the consequences and learn to live with whatever decision you make. Leveraging money is gambling, plain and simple. You could win big, but you could also lose big.