Leveraged Investment: Borrowing Money to Invest

Leverage is an investment strategy that mainly refers to using borrowed funds to potentially gain from an investment. The realized profits will be the difference between the investment returns on the borrowed capital and the cost associated with the interest on that amount. Leveraged investments magnify both profits as well as losses. If the underlying financial asset underperforms, the investors are left to deal with considerable losses.

If you want to know how to leverage your money or learn more about what kind of leverage you can use in your portfolio, then you can read below.

Source of Leverage: Buying on Margin

Leverage can be a powerful tool for investors to potentially enhance their returns, even though it may also come with some risks.

Leverage in investing is usually known as buying on margin. Here, investors can use borrowed funds from an institution (usually banks or brokers) to purchase securities. Buying on margin typically involves a margin account, wherein investors can borrow money to make larger investments by utilizing a small portion of their own money.

A margin account is one of the main types of an investment account. The securities that are purchased and the cash in the margin account will act as collateral on the loan. Lending institutions tend to charge interest on the borrowed amount. Buying on margin may enhance potential gains, but it can also enhance possible losses.

Additionally, you will also owe the lending institution the margin debt amount and the interest. Hence, new and inexperienced investors need to fully understand the risks involved while dealing with this investing technique and use leverage with caution.

Benefits and Risks of Leveraged Investments

Before applying for a debt or leverage to buy investments, it is important to understand the benefits and risks involved. Some of the benefits of leveraged investments are listed below:

• Some investors may choose a leveraged approach to better manage their cash flow as they will be able to contribute only a small portion of their own funds to meet the borrowing costs of a particular financial asset or security. They can utilize the rest of their capital to make other investments and create a diversified portfolio.
• Leverage can give investors more flexibility to invest the money where they want. Investors can increase their purchasing power and potentially invest in more companies at a time, thereby increasing their chances of gaining more profits from such trades.

Even though there are several advantages of using borrowed money for investments, there are a few limitations that individuals should be aware of before opting for one. Read below to know some of the risks of leveraged investments:

• Leverage Risk: There can be substantial risk of loss in leveraged investments (including Foreign Currency Leveraged Investment) or derivatives. Investors who invest through the leveraged option may sustain considerable losses in excess of their margin funds, and in some cases, may also need to immediately deposit additional funds or risk losing their position on the financial security at a loss.
• Price Fluctuation Risk: Using leverage on existing deposits and/or securities such as bonds, notes can be highly speculative and expose the investor to downside risks due to market fluctuations. Investors may also end up losing the value of their holdings in such situations.
• Liquidity Risk: During adverse market conditions, investors may not be able to partially or fully liquidate some of their holdings. Such situations expose the investors to considerable risks.

In Summary

To sum it up, leverage, debt or borrowing money can act as a powerful tool for investors to increase their holdings and potentially gain from their investments. On the downside, if the investment fails, the interest expense and credit risk of default may destroy the shareholder’s value. Hence, it is important to understand various risks involved in leveraging before one can take advantage of its benefits.

Frequently Asked Questions

What does it mean to have a leveraged portfolio?

A leveraged portfolio includes some amount of equity and some securities that were purchased with borrowed money. Using leverage to invest can be risky as the securities may result in a loss, resulting in the investor being liable to bear the loss and repay the borrowed amount along with the interest.

What are the common sources of leverage?

One of the common sources of leverage is buying on margin. Through this method, investors can get a loan from a financial institution and use the leveraged amount along with their cash to purchase more financial securities. This form of investing can help investors gain potential returns if the investments outperform the cost of the loan. However, it may magnify potential losses on the investment as well. Hence, an investor should have the expertise, risk understanding, certain amount of risk tolerance and the capability to monitor the trade carefully.