The basic definition of “Leverage”is the mechanical advantage available from using a “lever”this idea has been expanded to apply to other types of advantage such as money, finance and even positional advantage.
The Classic Example of Leverage…
As a child I would often go to the playground and play on the “See-Saw” aka. “Teeter-Totter” it was a board fixed in the middle that allowed two kids (one on each end) to ride up and down based on their weights being equally balanced. The device didn’t work all that great if one kid was considerably larger than the other one. The heavier kid would crash to the ground while the lighter kid would be launched into the air. This occasionally resulted in injuries and the adding of springs to teeter-totters in playgrounds.
Before the elimination of old-fashioned teeter-totters, some playground equipment manufacturers developed a movable center. Rather than being fixed at the exact middle there was a bracket with three slots. This allowed the board to be moved to make one end longer than the other. And this is where “leverage” comes into play. By placing the heavier kid on the short end, a smaller kid could easily balance a much larger kid. Thus giving us a simple example of “Mechanical Leverage.”
The Greek Mathematician and Philosopher Archimedes said, “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world. ” illustrating the advantage of leverage and the fact that the longer the one side, the greater the mechanical advantage gained.
The Second Type of Leverage
Another type of leverage is that of personal relationships, often one person is said to have some sort of leverage with which to influence (or move) another. This could be akin to blackmail or simply personal influence due to respect for another’s opinions, knowledge, etc.
But the major type of leverage we are concerned with is financial leverage. The simplest form of financial leverage is created through borrowing.
Most homeowners use leverage without even knowing it
A common form of leverage used by homeowners is a mortgage. Through the use of a mortgage a person can buy a house by putting down a small fraction of the value of the home and borrowing the remainder.
Suppose you buy a house valued at $100,000. and you pay $100,000 in cash for it. Two days later, someone offers you $110,000 and you take it. You have made $10,000 on your $100,000 investment or a 10% return in a few days. This is not bad.
100% Return with Leverage
But, suppose you buy a house valued at $100,000. and you put down $10,000 of your own money and borrow $90,000 from the bank. At this point you “own” a $100,000 house.*see footnote
If the house increases in value to $110,000 you could sell the house and repay the the bank their $90,000 and you would have made $10,000 profit. But rather than a 10% profit, you have made a 100% profit on your initial $10,000 investment. This is the value of financial leverage. Through borrowing, you are able to lift a much larger load ($100,000) with a smaller amount ($10,000). So you get the advantages of investing $100,000 while only actually having $10,000 to start with.
In this example, since you borrowed 90% and put down 10% your multiple was 10. Instead of making 10% on your $100,000 investment you made 100% on your $10,000 investment.
*Foot Note: In actuality you only control the ownership of the home. A good argument could be made that the bank actually owns it because if you stop making your payments the bank can still take possession.
The Disadvantages of Leverage
Unfortunately, leverage can also work against you. Leverage does not simply improve the returns on an investment it multiplies them. If the investment moves in your favor you make a multiple of what you would have made. But if it moves against you, you lose a multiple of what you would have lost (in percentage terms).
If the house you purchased for $10,000 down and a $90,000 mortgage decreases in value to $90,000 you still owe the bank their $90,000. So you have lost your full $10,000 investment and the bank has lost nothing. Thus rather than making 100% on your $10,000 investment you have lost 100%.
Other Forms of Financial Leverage
In the stock market there are a variety of forms of leverage available. The first is very much like borrowing to buy a house. It is called “Margin and is simply borrowing money from your broker in order to buy stock. In this case leverage works exactly the same as in a mortgage except that you may be limited to lower multiples i.e. instead of being able to borrow 90% you may only be allowed to borrow 50% or less depending on the volatility of the stock.
You can control more shares through the use of options than you could through direct purchase. For instance, each option contract controls 100 shares for a limited time. So if you have $1000 to invest you could buy 20 shares of a $50 stock or alternatively you could buy 20 option contracts trading at 50¢. This would cost you (20 x 50¢ x 100) and it would allow you to control 20 x 100 or 2000 shares. This form of leverage does not multiply your risk on the downside like borrowing or margin does. The most you can lose in options is 100% of your investment. But in exchange you have a limited time before your option contract expires and your odds of loss are thus much higher.
Other Names for Leverage
Financial leverage can be called by other names including “Gearing” in the UK and “Solvency” in Australia.
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Photo Credits: By Tom Raftery