Leverage: Double-edged Sword or Executioner’s Axe?

Leverage – it’s when you use borrowed money to make an investment, in the hopes that the profits from the investment will exceed the cost of the borrowed funds.  Usually it’s portrayed as a double-edged sword – leverage can cut in either direction.  If the investment proves profitable, the leverage allows you to enjoy a larger return than you otherwise would’ve had.  On the other hand, if your investment fails, then you’re on the hook for the borrowed money.

A common example of leverage is purchasing a house to rent.  You buy the house with some of your money (the down payment) and make up the difference with a mortgage (borrowed money or leverage).  If your investment works according to plan, you will have a renter cover most or all of the expenses and the house may even increase in value while you own it.  If the investment fails to live up to expectations, say, if your fail to find a quality tenant, or if the real estate market collapses, then you’ve lost not only your investment, but your neck is on the line for the money you borrowed.

So here’s my opinion on the matter.  Most of the time, when I hear of someone’s investment plan, the plan usually consists only of what will happen if everything is right.  Like the plan above (Buy rental house at good price, rent to responsible tenant, sell at a profit), it’s long on the positive generalities and short on the negative specifics (buy house at reasonable price, rent to a person who appears responsible but turns out to be a slow-paying or no-paying rabbit hoarder,* and then experience a major down-turn in the real estate market.)  Frankly, I rarely hear a plan that has made allowance for what will happen in the event of failure.  This leads me to think of leverage not as a double-edged sword, but as an executioner’s axe.  Sometimes it falls, many times it doesn’t.  And, if you stick your neck out too far, you get your head chopped off.

What do you think of leverage?  Let me know in the comments.

*  I am not kidding.  Do a youtube.com search for “bunnie hoarder.”

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