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ELI5: The Power of Leverage in Investing

black barbell on tile flooring

“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world. ” - Archimedes

A lever is force multiplier. It amplifies input force to achieve greater output force, creating leverage. A seesaw is a lever that empowers a child to lift their parent, a wheel barrow is a lever that enables a gardener to easily move 400lbs of soil.

Leverage is not only a powerful concept in physics, but also in finance. In physics, leverage allows you to lift things not possible with your muscles alone. In finance, leverage allows you to control assets not possible with your savings alone.

The driving force of financial leverage is debt. Mortgages are a familiar example. A mortgage allows you to own a home that otherwise would be beyond your means. Let's demonstrate the power of leverage with an example.

Mary's Mortgage

Mary is looking to buy a home. She has $100k in savings and is considering two options.

Option 1 - Buy a home with her savings alone, a home worth $100K.

Option 2 - Take out a $400K mortgage with a $100K down payment, allowing her to buy a home worth $500K.

With a mortgage, Mary can own a home 5x her savings. Her overall net worth remains the same but her buying power is greatly improved.

Option 1 - No Leverage
AssetsLiabilitiesNet Worth
$100K Home$0 $100K

Option 2 - Leverage
AssetsLiabilitiesNet Worth
$500K Home$400K 

Leverage not only amplifies buying power, it also amplifies returns. If real estate is booming and Mary's home is up 20%, leverage lets her experience a much greater return on her $100K investment.

Option 1 - No Leverage
($100K X 1.2)

Option 2 - Leverage
($500K Home X 1.2)

You transform what would've been a 20% return to a whopping 100% return! With leverage, you 5x your buying power and your return on investment.

That's the power of leverage. Sounds amazing, doesn't it?

Not so fast, leverage allows you to magnify your gains but it also magnifies your losses. If the market instead declined by 20%, Mary would experience the dark side of leverage.

Option 1 - No Leverage
($100K X .2)

Option 2 - Leverage
($500K Home X .2)

With leverage, her losses are magnified 5x. Yikes.

Leverage is a powerful tool, but it's powerful in both directions. The potential of outsized returns are juxtaposed with the risk of outsized losses. In addition, leverage isn't free. Money cost money, so you'll be charged interest on debt. These conditions hold true for all forms of financial leverage. Another common example is buying stocks on margin (i.e borrowed money). Before taking on leverage, be wary of the risks!


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