Skip to main content

ELI5: The Power of Leverage in Investing

Image
By
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 
Mortgage		$100K

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
InvestmentReturnROI
$100K$20K
($100K X 1.2)		20%
($20K/$100K)

Option 2 - Leverage
InvestmentReturnROI
$100K$100K 
($500K Home X 1.2)		100%
($100K/$100K)

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
InvestmentLossROI
$100K$20K
($100K X .2)		-20%
(-$20K/$100K)

Option 2 - Leverage
InvestmentLossROI
$100K$100K 
($500K Home X .2)		-100%
(-$100K/$100K)

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!











Labels:

Comments

Post a Comment

Popular posts from this blog

Today's Special: Humble Pie

By
You champion a project, fight for an idea, and then...reality sets in. That churning in your stomach isn't butterflies, it's the realization you've missed the mark.  Pride will puff up your chest, and kick in the "defend at all costs" instinct. But arguing with the umpire never changed a call. Admitting you're wrong isn't a sign of weakness. It can strengthen your professional standing. In a world obsessed with the illusion of infallibility, the courage to adjust course is a breath of fresh air. It shows you're confident enough to be wrong, and adaptable enough to learn from it. Do your research, think critically, and stand behind your decisions. But when the data whispers (or screams) otherwise, don't be afraid to swallow that slice of humble pie. Be the first to acknowledge. Don't wait for someone to point out your mistake. Be open, take responsibility, and most importantly, focus on what you're going to do to address it. Don't dwell ...
Post a Comment
Read more

When Perfect Becomes a Problem: The iCar Story

By
Let's talk about Apple's iCar, or rather, the ghost of it. A decade. Ten billion dollars. Poof. Gone. Like a puff of smoke from a dream that never quite woke up. They wanted to launch a revolution, a fully-formed, flawless chariot. But revolutions aren't born in secret labs; they're forged in the messy, chaotic crucible of the real world. You don't build a movement by hiding in the shadows. You don't create a product people love by ignoring them. You don't change the world by waiting for perfection. It's about the minimum viable. It's about shipping early, shipping often, and listening—really listening—to the people you're trying to serve. Apple built a cathedral of secrecy. A monument to what might have been. And then, they tore it down.  They spent billions on a dream, while ignoring the simple truth: the market doesn't care about your dreams. It cares about solutions. It cares about things that work. So, here's the lesson: stop chasing...
Post a Comment
Read more

Why We Shouldn't Be Afraid of Ambiguity

By
Ambiguity. That fuzzy monster that chases us down darkened hallways, whispering doubts about our roadmap and feature sets. You know the feeling. You constantly wrestle with unknowns: Will users like this? Is this the right direction? Frankly, if you had a nickel for every time the answer wasn't crystal clear, well, you might actually want to chase that ambiguity down the hall. But here's the thing: ambiguity isn't your enemy. It's your dance partner. Innovation rarely happens in a land of perfect clarity. Sure, there's a time for well-defined processes. But when you're creating something new, there are bound to be more questions than answers. The key is to learn to waltz with the unknown .  Embrace the experiment. Don't be afraid to throw some spaghetti at the wall and see what sticks.  Focus on outcomes, not outputs. Don't get hung up on features. What problem are you trying to solve? How will you measure success? Get comfortable with "go...
Post a Comment
Read more