On our left shoulder, every one of us has a silky smooth reddish man with a beard almost as pointy as his horns. He’s got a strong jaw, endless confidence, and we kinda like the sound of his voice in our ear. It’s exciting when he comes around and always a thrill to hear his next idea. He goes by many names, but you recognize him when you see him.
“Debt is not a bad thing! It’s fun and exciting! I call it leverage! Let’s amp up those wimpy little returns!!!”
He’s smooth talking and charismatic with devilishly handsome looks. He shouts on…
“PETAL TO THE METAL! You can do better! You’re gonna be RICH!!!!”
He’s not wrong either. Example 1 is a simple math problem which explains why leverage is so extremely powerful. Take a look.
|Say you invest in a $10k asset that returns $2k per year:
So, using 90% leverage in this case gives us a 200% return vs 20%. This is 10x the rate of return.
Remember option 2 is just a $10k example of leverage. What if we did it with $100k or $1M?! It’s easy to see how seductive investing like this can really be. I find this is the math commonly done among real estate investors.
The “no consequences” hype man from above stops doing math right here. But there’s more to the story.
On our right shoulder, is the 3rd Decade angel with her long, forever flowing, shiny, brown hair… She arrives more consistently and right on time. Her voice is melodic and sweet. Her ideas are never thrilling; instead, they are strong, noble, and everlasting. Her words wrap around us like a warm blanket. Everything works out when she’s making our decisions.
“Leverage works on the way up, but it also works on the way down.” “Any time you take on debt, you take on risk.” “Life is long, and investments go up and down in value.”
A wise investor will ALSO know this math below.
So, what happens when our same asset goes down 50% in value?
|Here you invest in the same $10k asset, but this time you sustain a 50% drop in value:
As you can see, 90% leverage, in this case, gives us a 500% loss vs a 50% loss.
“Only when the tide goes out do you discover who’s been swimming naked”
– Warren E. Buffett
A key learning here to remember is that a 50% loss is difficult, but you can live through it. Another way of saying it is you lost half your money. A 500% loss can be a catastrophic event which takes everything from you. The reason is because 500% means that you lost all your money plus an additional 4x that amount. This is a quick way to end up owing money you cannot pay.
If, for example, you buy a $100k house with $10k down and the home drops $50k – the bank can foreclose and sell the house at $50k and come after you for the additional $40k you owe.
So, which one will you listen to? It is a choice we all have each day. The 3rd decade angel urges you to stay away from all debt you can, but especially heavy business debt, trading on margin, and highly leveraged real estate investments. These areas represent the roulette table of personal finance. They are also the quickest path to financial ruin.
Warren E. Buffett’s thoughts on leverage:
“If you’re smart you don’t need it, and if you’re dumb, you have no business using it.”
All you need is behavior, knowledge, and time.
Author Bio: TK is a past 3rd Decade graduate who lives and breathes the philosophy taught in class. He avidly researches personal finance and investing topics, and occasionally contributes thoughts here on the blog.
He graduated cum laude from the University of Arizona with his BSBA. As a longtime saver and investor, his net worth today is higher than the total number of dollars earned in his lifetime. He keeps his annual living expenses around $10,000, owns his house free and clear, and has zero personal debt.
TK currently resides in Tucson, AZ with his wife, and works full-time as a firefighter.
You can message him here.