How Investors Can Limit Risk When Using Leverage

By Moe Zulfiqar

Leverage, at its very core, is borrowing money to invest. If investors want to use leverage in their portfolio, it can be very risky. My friend, Mr. Speculator, who I met not too long ago, disagrees with this claim; he thinks it’s the greatest invention: “With leverage, your gains can be huge and your portfolio grows much faster,” he said.

As usual, Mr. Speculator isn’t very clear about a very important concept of investment management.

While Mr. Speculator is in favor of taking leverage, I tend to be very cautious about it. At the end of the day, it’s all dependent on the investor and if they want to take on leverage or not.

Leverage can be both beneficial and troublesome for the portfolio; it’s a double-edged sword investors really have to be cautious about. What it does is maximizes the gains, meaning profits are much bigger, but it increases the magnitude of losses as well, making them become massive really quickly.

Consider an investor who has $100.00 to invest and knows that he or she can purchase 10 shares of company XYZ. Now, if we assume over a one-month period that shares of XYZ go up by 10%, then without borrowing money to invest, this investor’s return will be 10%, or $10.00.

On the other hand, if we assume the investor borrows $100.00 on top of the money they already had, their gain would be 20%, or $20.00. This is because they had doubled the money—great, right? But if the investment goes down 10%, their loss will be 20% as well.

Is leverage necessary for the portfolio?

Investors who are investing for the long run should avoid borrowing money for investment, because it can wipe out the gains already made in the portfolio. This, in turn, can be a major setback that could force them to hold back on their plans, be it retirement, an education fund, or anything else for that matter.

Here’s what investors really need to consider before they use leverage: it’s great when it works in their favor, but when it works against them, their portfolio suffers.

For example, if an investor uses it and loses 20% of their portfolio, then their portfolio will have to increase by 25% just to break even.

If investors insist on using leverage in their portfolio, they should make use of risk management. One investment strategy investors should employ is making use of stop losses. This way, they are able to control their downside in case the trade doesn’t work in their favor. One thing they might want to note is that sometimes, stop losses may not be as effective; in options, for example. In that case, investors should use mental stops and know when to take the loss.

This article How Investors Can Limit Risk When Using Leverage was originally published at Daily Gains Letter