Leverage Part 2: The Dark Side!

So now that you are all hot and bothered about getting an investment loan (aka leverage), let me take you down a notch! (Trust me, it’s for your own good…) :)

Okay, so let’s now say that Greg, who if you remember had learned that he would be $2,000 ahead by getting a loan, decides to calculate a few “what-if” scenarios…

1. What if the investment only earns 6%?

In this case, the investment’s rate of return and the interest on the loan are equal. How much does Greg have at the end of 10 years? In this case the leverage will leave him with just $13,487 at the end of the 10 years. If he had made the annual savings of $1,000 into a 6% investment – he would have $13,972 – almost $500 more.  So in this case the leverage would’ve been the wrong decision.

2. What if the investment makes no money after 10 years?

Depressing, but a lot of investors guide themselves to a 0% rate of return by switching their investments around too much – always a step behind “the next hot pick” (but that’s another story!). Okay, in this case the “straight savings” (putting $1,000 per year) will give you, yep you guessed it $10,000! The leverage? Another no brainer – Greg’s loan for $7,531 doesn’t grow and that’s all he has at the end of 10 years. I think you can see that we’re getting further and further behind with the leverage…

3. What if the investment loses 10%?

We looked at a gain of 10% in Part 1, so let’s look at a loss of 10%.  It would take real skill to lose 10% per year over 10 years – but I suppose it could happen if someone were really clueless… The straight savings will leave Greg with $5,862. Yikes! But if that wasn’t bad enough, the leverage would leave him with $2,626!!!

I think I have built a solid case for why you may want to think twice about leveragingBut there is SO MUCH MORE TO THIS STORY than just the examples I have given. From here on in it’s going to get even wilder (both in terms of potential and volatility).  Near the end of the series on leverages, once I have shown enough case studies to educate you to the level of an average financial advisor (on THIS topic), I will show you some advanced leverage strategies that I use with my clients on a regular basis – but it is much more complex than the stuff we’ve just talked about – because I am not a fan of risk – and neither are my clients!

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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