Advantages and Disadvantages of Leveraged Investing

Introduction

Leveraged investing is the use of borrowed money, or leverage, to increase potential returns from an investment. Leveraged investments are a type of speculation that can offer higher returns, but also carries risks. Some investors argue that using leverage can help them achieve better performance than the traditional buy-and-hold approach. This article will discuss the advantages and disadvantages of leveraged investing.

Advantages of Leveraged Investing

Leverage can increase potential returns

The main advantage of leveraged investing is that it offers the potential to magnify returns. Leverage allows investors to commit less capital, while adding potential to increase the return on their investment should the asset appreciate in value. For example, if an investor puts $2,000 toward a leveraged investment that increases in value by 25%, the investment returns $500 — but the returns are multiplied by the amount of leverage used. If the leverage is 2:1, the investor now earns $1,000 on their original investment, doubling the potential return. ¹

Leverage can help investors grow their capital faster

By using leverage, investors can potentially increase their capital more quickly than by investing directly with their own money. Leverage allows investors to use the same finite capital multiple times and reduce the amount of time it takes to grow their wealth over time. This means that investors can potentially start making a larger return faster than with a buy-and-hold strategy.²

Leveraged investments can be hedged against other investments

Leveraged investments can be hedged against other investments, which can offer protection if one asset class performs poorly. By hedging against other investments, investors can reduce their risk and limit the potential return they can earn. For example, if an investor puts $2,000 into a leveraged investment that is hedged against the stock market, they are protected against losses should the stock market go down. ³

Disadvantages of Leveraged Investing

Leveraged investments carry a greater risk

One of the main drawbacks of using leverage is that it increases the risk of losses. Leverage magnifies potential gains, but it also magnifies potential losses. If the value of the asset decreases, the investor's losses are multiplied by the amount of leverage used. For example, if an investor puts $2,000 towards a leveraged investment that decreases in value by 25%, the investor suffers a loss of $500 — but with leverage, the losses are multiplied. If the leverage is 2:1, the investor now suffers a loss of $1,000 on their original investment. ⁴

Leveraged investments can be hard to manage

Leveraged investments can be difficult to manage due to the need to actively adjust portfolio positions to take advantage of market movements. Leveraged investments require more attention and active management than traditional buy-and-hold investments. Investors must constantly monitor and adjust their leverage to ensure returns are maximized and losses are minimized. ⁵

Leveraged investments can increase exposure to market volatility

Leveraged investments can increase exposure to market volatility. Leveraged investments can magnify the effects of market volatility, and investors may be unable to take advantage of market gains due to the increased risk. Investors must be aware of the increased exposure to market volatility when using leveraged investments. ⁶

Conclusion

Leveraged investing can be a useful tool for investors, as it offers the potential to magnify returns and grow capital more quickly. However, leveraged investing also carries a greater risk, and can be difficult to manage. Investors must be aware of the potential gains and losses they may experience when investing with leverage in order to make an informed decision.

References

1. Investopedia, "Leverage", Accessed April 15, 2021
2. Investopedia, "Advantages Of Using Leverage In Investing", Accessed April 15, 2021
3. The Balance, "Hedging for Beginners", Accessed April 15, 2021
4. Khan Academy, "Risks of leveraging", Accessed April 15, 2021
5. Financial Edge, "The Advantages and Disadvantages of Leveraged Investing", Accessed April 15, 2021
6. Dalbar, "The Negative Benefits of Leveraged Investing", Accessed April 15, 2021