What is Leverage ?

Leverage is simply a way that you can increase the amount of risk to which your capital is exposed. By using a small investment that is levered, you can make colossal gains if your investment goes up in value, but remember, you can also make colossal losses if the market goes down. The losses can be far greater than even your original investment. The higher the leverage, the greater the risk.

The most common form of leverage that most people use, but might not necessarily understand, is in buying a house. Lets assume a simple world where everyone has 10,000 to use for a deposit, all houses are the same, and everyone can borrow from a bank without a problem.

Scenario 1 – Upside – Huge leverage

I have a 10,000 deposit, and a bank will lend me 8 (cough, splutter) times that for a mortgage. Here, the leverage = 8 I buy a house worth 90,000. Now, banks decide to lend up to 9 times income. My friend now has 100,000 to spend on a house... and I immediately sell my house to him for that price. The profit on the house is 10,000... but the profit on the investment is a whopping +100% !! I almost doubled my money... wow.

Scenario 2 – Downside - Huge leverage

Now lets see what happens on the downside instead. All of a sudden those nasty banks decide only to lend 6 times to new customers. Consequently, they only have 70,000 to spend on a house, and I can only sell my house for 70,000 because no-one has more than that. If I sell now, my loss is a whopping -200%... I have lost my entire investment, AND I owe another 10,000 !!

Scenario 3 – No Leverage

With no leverage it’s simple... If I buy an asset for cash, and that asset price goes up 10%, I make 10%. If it goes down by 10%, I lose 10%. It would have to go down 100% for me to lose everything, and I cannot lose more than I invest. Hmmm... so are house prices solely determined by the amount banks will lend you ? Erm, in this example... yes, but the point of this example is to explain leverage not house prices. In the real world, we know that it’s completely different, and that house prices always go up don’t we... ; - >

Download Spreadsheet to look at how leverage works in Excel

Training Video on "What is Leverage?"