Leverage Is Not Your Friend

Leverage Is Not Your Friend

Jason Zweig, the noted Wall Street Journal columnist, noted recently that between the first and second quarters of 2012, the Federal Reserve’s measure of margin loans at brokerage firms rose 9%, to $161.8 billion, the highest level in nearly four years.  The high-water mark was $386 billion in August 2008—two weeks before the collapse of Lehman Bros. unleashed the financial crisis.

A margin loan, for those that don’t know, is a loan against the value of a brokerage account that can be used to buy additional securities, at rates often below those you could get on other secured loans such as home-equity loans.   Imagine buying a stock for $1000, borrowing $300 against the value of the stock, and then buying $300 more of the same stock.  If the stock goes up, you’ve increased your return by an additional 30% on that same $1000 investment!  Borrowing money to increase your investment returns is what’s called leverage.

Leverage can be found in various areas of our financial lives.  In real estate, for example, it’s essential.  That’s because few would-be homeowners have amassed sufficient cash to be able to buy a house outright.  The mortgage loan industry is one of the factors that make home ownership possible.  And a mortgage enhances your returns as well.  If you buy a house for 50% down and the price increases by 3%, you’ve actually realized a 6% gain on your investment.  That’s pretty enticing!

However, prices don’t always go up, even in real estate.  Remember 2008?  And when prices are dropping, leverage can become ugly.  Your losses are multiplied the same way that your returns were multiplied during the good times.  And not just that.  When you’re holding a margin loan and the price of the underlying securities drops, you have to invest more money to get the margin back into an acceptable range.  If you don’t have cash lying around (and you probably don’t if you’re the type to utilize margin loans in the first place), you’re forced to sell some of your holdings at a loss.  That’s what killed Lehman.

When things are going well economically, leverage appears not only benign but even beneficial.  It increases consumer spending and pumps up the bottom line of the financial services industry.  In fact, what’s driving the recent rise in investment leverage are low interest rates and investor confidence.  But remember the old adage: what goes up must come down.  I wouldn’t recommend utilizing leverage for your investments at any time.  And with the S&P 500 up over 17% so far this year, if there was ever a time to be conservative with equities, this is it.

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