Avoiding Leverage

With interest rates near all time lows, investors are not only enticed out of cash and bonds into riskier assets like stocks, commodities and crypto, they can also be tempted to borrow money for those investments to magnify returns.  Whether using a brokerage margin account (my broker currently charges between 6.575% - 8.325% depending how much you borrow), home equity loan (I have seen 3% - 5% if you have good credit), or personal loan (6% - 36%, depending on your credit), there are many ways that people can borrow money for investing.   While the returns can be infinite using borrowed money and also sizable, especially if the asset you invest in goes up dramatically (crypto such as Bitcoin or Etherium, or meme stocks such as AMC or GME come to mind), the downside can also be pretty bad since losses are also magnified.  Of course, repayment of the loan will eventually have to happen and without a source of repayment funds other than the investment, it's critical for that asset to at least increase at the rate of interest you are paying, or you will face losses.

Other than real estate, I'm not a big advocate of borrowing to invest, especially with the incredible recent volatility in markets.  In particular, if you are investing in crypto like Bitcoin or Etherium, it's best to use excess cash, buy the dips and hold for the long term.  This helps you avoid getting ruined in one of the deep market corrections that can happen to these assets (indeed, we just had a 50% correction recently).  It seems that many crypto speculators who use 100x leverage regularly get wiped out, whether they are long or short, due to the volatility.  Why risk all that when you can just buy and hold?  

The downside to using a brokerage margin account is that stocks can drop dramatically in a downturn and the brokerage can change their margin limits on individual stocks during periods of market volatility, the combination of which could quickly result in a margin call and either having to come up with cash or having to sell your stocks at a loss.  Even professional investors can blow themselves up with leverage - look no further than the $30 Billion Archegos debacle.  

Another form of leverage is stock options.  Buying call options or selling put credit spreads are common ways to speculate on the upside of an individual stock, however you can easily lose your entire investment if a stock trades lower than the strike price prior to expiration.  In my personal experience with these types of investments, this has happened way more often than I expected - possible market manipulation?  I prefer to take the other side of the trade, selling call options on stock I already own.   This strategy capitalizes on the demand for call options and allows you to collect premium while having a fair chance of earning the full premium at expiration and keeping your stock.  This is like being the "house" at a casino - let everyone else gamble with options and go for the sure thing.  Worst case, you get exercised and get cash for your stock - as long as your call strike price is above your cost basis, you'll never lose money.  Of course, the stock you own may drop to a level where selling calls may not make sense, but at least with owning stock you simply wait for the value to recover.  Many technology stocks that had very attractive valuations and call premiums a few months ago have suffered this fate, with the recent rotation of the stock market out of growth and into value.  Like all seasons, this season too shall pass and better days will lie ahead for growth stocks, so if you are holding shares (versus options) in good companies, you have the staying power to wait for the ultimate recovery.

No matter how tempting it might be, avoiding leverage in investing to me is as fundamental as diversification.  Believe me, I have learned the hard way many times and (other than real estate where it makes a lot of sense) I avoid leverage at all costs, even if I'm "missing out" on a great opportunity.  That takes a great deal of discipline, but staying disciplined in your investing approach will ultimately allow you to achieve your goals in the long run and sleep better at night.

I hope you find this post useful as you chart your personal financial course and Build a Financial Fortress in 2021.  To see all my books on investing and leadership, click here.  
  

Stay safe, healthy and positive.