The Amateur Financier

Welcome to a special week-long series where we take a look at some prominent economic theories.  Don’t worry, it won’t be nearly as horrifyingly dull as it sounds; this is still the Amateur Financier, after all.  Plus, it’s always good to have a little background when you’re reading about things like ‘monetarism’ or ‘Austrian school economics’, or as in this case,

Keynesiansim

Founded By

John Maynard Keynes was a British economist whose most influential book, The General Theory of Employment, Interest, and Money was written as a response to the Great Depression.  He was involved in British politics before and during World War Two, and helped to create the International Monetary Fund and the World Bank before his death in 1946.  He was also married to a Russian ballerina, Lydia Lopokova, a fact I mention just in case you ever need to defend the sexiness of economists.

Just Look at That Sexy Mustache

The Theory

Keynes’ major insight was that the government could have a impact on the economy, working to stabilize it.  The results of private decisions and private enterprise could be inefficient, due in part to slow response of prices and wages to changes in supply and demand.   He also viewed recessions and depressions not as regular parts of the business cycle, but as problems that needed to be solved, most readily via government intervention.

One of the major parts of Keynes’ philosophy is the need for counter-cyclical economic policies, attempts by the government to counteract the excessive lows and the highs in the economic cycle.  During recessions, for example, he advocated government spending to help prop up businesses and give a boost to the economy, while during boom times, the government should rein in market extravagances by increasing interest rates or decreasing government spending.  In this way, the government would be a counterbalance to the business cycle, helping to stabilize it.

Two of the other ideas that Keynes helped to popularize are the multiplier and the paradox of thrift.  The multiplier argument maintained that spending could have a bigger effect than the initial amount spent. If the government provides for $10 million in payments, for example, the benefits to the broader economy can end up being much more than $10 million.  The initial recipients of the money will likely spend or invest it, with companies that will in turn spend or invest it, and so on.  The initial $10 million may lead to many times the economic benefit, as the money works its way through the system.

The paradox of thrift, on the other hand, maintains that while saving is good for the individual, if done in aggregate, it can be harmful to the economy as a whole.  Decreased spending leads to decreased demand, decreased demand can lead to lower economic growth and possible downsizing, potentially decreasing the total amount saved due to anemic growth and lower incomes.  The paradox is, while saving is good for the individual, saving too much can be bad for the economy.

Criticism of Keynesianism

One of the major philosophies opposed to Keynesian economics is Monetarism, another school of economic thought (which we’ll cover in more depth tomorrow).  Their major criticism has been that governments are, if anything, even worse at responding to fluctuations in the economy than the private sector.  By the time the government recognizes the problem, formulates a response, and puts the response into practice, the problem may have become greatly exacerbated, or it may have disappeared.  The monetarists lean towards a much less expansive role for government in economic policy, which is counter to the more interventionist Keynesian economic thought.

Keynesian policies also come under attack from Austrian School economists (again, more on them later this week), who denounce the Keynesian focus on the collective group rather than the individual.  They maintain that focusing on broad government action rather than micro-economic factors leads to collectivism and mis-spending of capital.  They also maintain that programs that start as temporary fixes to counterbalance an economic downturn can turn into permanent, expanding government programs that grow to consume larger and larger portions of government spending.

There’s also historical evidence (as noted below) that Keynesian approaches to boosting the economy are far from sure things.  In a deflationary environment, such as during the Great Depression, putting more money into the system (which Keynes recommends), can serve to counteract the forces of deflation and boost the economy.  However, in downturns with high inflation, such as the ‘Stagflation’ of the 1970’s, a further increase of money into the system will only aggravate the problem.

A Brief History

Keynes and his theories rose to prominence in the midst of the Great Depression, where the idea of the government ‘priming the pump’ to boost the economy was one already being taken up by Roosevelt, among others.  The success of government spending (either in the form of New Deal programs or military spending during World War II) at lifting the economy was considered to be proof of Keynes’ concepts, and they were put into practice in America and elsewhere through most of the forties, fifties, and sixties.

As mentioned, though, Keynesianism was unable to cope with the economic stagnation and inflationary climate of the 1970s.  From the Reagan administration (and its contemporaries in other countries) until 2008, Keynesian ideas and methods of dealing with the economy were pushed to the side, superceded by monetarism and supply-side ideals.  Attempts to use government as a cushion against the rises and drops of the economy were curtailed in favor of a philosophy of letting the economy run with as little government intervention as possible.

However, with the economic downturn of 2008, there’s been a resurgence of Keynes and his approach to economics in public life.  The great amount of spending by the US government over the past few years in an attempt to spur on growth is right in line with Keynesian monetary policy.  (We’ll have to see how if Keynes is still in fashion when the recession abates and Keynesian economics dictates that the government should cut spending to slow down the economy.)

Three Sentence Summary

Keynesianism stresses the need for government to serve as a counteracting force to the excesses of private economy.  The main thrust is that the government can counter the economic excesses of the private sector, spurring on growth when it’s slow and restraining over-zealous government expansion.  Recently, such interventionist ideas have become more common, in wake of the economic problems of 2008.

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Last year, Pennsylvania had a rather nasty budget impasse.  It made national news, and generally annoyed every Pennsylvanian who would rather be famous for our delightful groundhogs than the intractability of our leaders’ political fights.  One way the politicians finally were able to work out a solution that appeased everyone (or at least shut them up long enough to get the budget passed) was to increase the state tax on cigarettes.  Various commentators, from the papers to NPR, referred to the cigarette tax as a ’sin tax’, which brings us to the obvious question: what is a sin tax?

Taxing Sin Done Right

Put simply, a sin tax is a tax on sin.  You probably guessed that, though, so let’s look a bit deeper.  The idea behind a sin tax is that there are some activities that we, as a society, consider undesirable.  Cigarette smoking is a common example, although things like using alcohol or even sugary foods and drinks have also been included or considered as possible subjects of a sin tax.  We could ban them outright, the way we with illegal drugs, but that costs a great deal of money to enforce and restricts people’s right to smoke, drink alcohol, or eat a Twinkie if they so desire (lump those rights all under ‘pursuit of happiness’).

What if there were an alternative, a way to keep something legal but discourage people from using it?  One way might be to make it more expensive; if the cost of a package of cigarettes goes up, a smoker is going to be less likely to purchase as many packs.  Adding a tax to cigarettes makes them more expensive, decreasing how many cigarettes get purchased and smoked (and generating income for the government, as well).

Sin, in convenient stick form

There are several advantages to sin taxes, particularly from the government’s standpoint:

-Politically Easy: Creating a (balanced) budget is hard, particularly when government spending is up and tax revenue is down (just look at the legislators in Pennsylvania).  No politician wants to be responsible for cutting a popular program, but no politician wants to raise taxes either, because raising taxes on a broad swath of the voting public is a good way to get unelected.  Sin taxes, which by nature only target a certain group of individuals, are a good way to raise taxes and keep your office, too.

-Profitable: Taxes do serve a purpose, of course; without them government wouldn’t be able to do everything that we ask of it.  (We can have a discussion of governmental effectiveness even with tax money to fuel it another day; today, let’s just focus on the sinning and the taxes.)  Sin taxes, as with any taxes, are able to provide the government with money, which of course means the government likes to have them as an option.

-Steer People Toward Good Behaviors: The difference between sin taxes and most other types of taxes is that sin taxes encourage better behavior from people.  By making the ’sins’ more expensive, people should logically choose to avoid them, opting for something less expensive and more sin-free.  If the government imposes a sin tax on bowling, for example, miniature golf could see a rise in participants; in the same way, the government can ‘nudge’ people away from whatever activities are considered improper.

All this sounds pretty good; why not get rid of those pesky income and sales taxes and simply tax sins to meet all our governmental spending needs?  Well, there are some drawbacks, as well:

-Makes the Government Dependent on Sinners: One problem with making a sin tax a major (or even minor) source of income is that the government then has a perverse incentive to keep people sinning.  As mentioned, Pennsylvania only managed to solve its budget crisis in part due to more revenue from smokers and cigarette taxes; if all the smokers in PA suddenly quit (or started bumming cigs from out-of-state friends), we’d be facing another budget shortfall next year.  Whether they admit it or not, this means that PA lawmakers need smokers to keep smoking (and paying taxes on) cigarettes; with that in the back of their mind, how hard are they really going to try to stamp out smoking?

-Can be Regressive: Since the taxes are the same on each pack of cigarettes regardless of the income level of those purchasing the pack, lower income people will end up spending a higher percentage of their money on the taxes than higher income people.  Two different pack-a-day smokers will spend the same amount in taxes (let’s say $1000, just so we have a number), but that represents a much larger portion of a $20,000 a year income compared to earning $100,000 each year.  (That’s before we even get into the argument that poorer people are more likely to smoke, drink or otherwise ’sin’ than richer people, making them more likely targets of this tax already.)

-Involves Government Regulation of Personal Behavior: Even ignoring the economic effects of the tax itself, there’s still the little matter that sin taxes involve the government deciding which behaviors are good and which are bad, and attempting to punish the bad ones.  Since these behaviors are personal and affect only the individual*, why should the government be able to dictate its preferences of how to act?  (*Alright, this is an oversimplification; something like smoking can impact people other than the smoker, through second hand smoke and the effects of smokers in health care plans, among other things.  There are alternatives that address those issues (rules about where smoking is permitted and higher premiums for smokers) without the need to resort to taxing all cigarettes sold, though.)

The Final Word on Sin (Taxes)

So where does all this leave us when it comes to sin taxes?  They’re probably here to stay.  Remember that first ‘pro’ point, ‘Politically Easy’?  That alone will ensure that some form of sin taxes stay around in some form for the foreseeable future.  Also, compared to some of the alternative methods of dealing with unwanted behaviors, such as banning them the way we do with illicit drugs, legalizing, taxing, and generating profit from ’sinful’ activities seems downright sensible.  Compare cigarette use to marijuana use, for example; which generates more profit for the government in the form of taxes, and costs less to regulate and control?

If I had just one wish when it came to sin taxes, it would be that governments wouldn’t depend so highly on them for income.  If the behavior is so sinful that we need to stop it, why should the government be in a position of depending on it for revenue?  I’d like to see politicians opt instead for the politically harder but less moral-twisting approach of getting rid of sin taxes and relying on other taxes to generate income.  If they do opt to continue the taxes, though, I’d love to see the money be funneled back into programs designed to truly eliminate the sin; not only do you get the sin tax money out of the general public coffers, but you deliver a one-two punch to whatever behavior you’re attempting to eradicate.

I’ll bet you a carton of cigarettes that that never happens, though.

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I’ve discussed options briefly in the past, as part of my Investing 101 series.  While they can be useful as a way to profit from market movements without owning the underlying stocks, they can get a bit tricky.  To help you understand who profits from different option related situations, let’s go over a few examples.  (Don’t worry, there’ll be pictures soon!)

Calling in the Profits

As you hopefully remember from the aforementioned Investing 101 post, calls are options that enable you to purchase shares of stock at a particular value (the strike price) at some point in the future.  (Either at the expiration date, for European-style options, or at any time before or on the expiration date, for American-style options.)  You might be tempted to assume that after you have bought a call option, all you need to do is wait for the price of the underlying stock to go above the strike price, exercise the option (that is, buy the stock at the strike price), and bingo, instant profit by buying at a discount.

Well, that’s not quite the way it works.  In order to get someone to agree to sell you the stock at a particular, fixed value (which is known as writing a call), you have to give them an incentive (read: money).  This is called the option premium.  But that’s not the end; you also have to factor in the money you are paying to the brokerage in order to match you up with a call writer, the commission and other transaction costs.  All told, the price for you to break even on your option transaction (and make as much profit as if you simply bought the stock and held it while it rose in value) is found like this:

Break-Even Price (Calls) = Strike Price + Option Premium + Commission and Transaction Costs

If the price of the stock when you exercise the option is between the strike price and the break-even price, you (our option buyer) will be able to buy the underlying stock for less than the current market price, but the savings you get will not be enough to make the whole process (buying the option, then exercising it and buying the stock) profitable for you.  For a graphical representation, take a look at this (click the picture to expand it):

If we go from left to right across this chart (following the increase in stock prices) we see:

• Red: The call writer gets to pocket the option premium, and doesn’t have to part with his stocks.  Good for him, bad for the call buyer.
• Yellow: The call is exercised (it is ‘in the money’, meaning the strike price is less than the market value) but the savings on the buyer’s part don’t cover the cost of the option.  The call writer gets the strike price for the stocks, as well as some profit from writing the call, although not as much as if the stocks stayed below the strike price.  The call writer’s profit decreases the further to the right you do in the yellow area.  (Actually, because of the commissions charged by the brokerage, the far right area of the yellow section is one where neither the writer nor the buyer profit.  As a result it’s possible for opinions to be a lose-lose proposition (at least for everyone but the brokerage).)
• Green: The call is exercised, and the total cost to the option buyer is less than the cost of purchasing the stock at the new, higher price.  The buyer profits, and makes more profit the higher the stock price goes, while the call writer makes less profit than by holding and selling the stock outright.

Where are you Putting that?

Puts, in case you forgot, are essentially inverse calls; rather than allowing you to buy a stock at the strike price (regardless of the current market price), puts enable you to sell stock you own at a given price, regardless of the current market value.  Buying a put is a way to profit when your stock goes down in price, without having to sell the stock and buy it back later.  Of course, as with call options, puts have a premium and commission costs associated with them.  However, because you expect the price of your stock to go down (or are trying to insure against such a fate), when calculating the break-even price, we need to subtract these costs from the strike price:

Break-Even Price (Puts) = Strike Price – Option Premium – Commission and Transaction Costs

It might seem a bit odd, if you’re used to regular stock investing, but when buying puts, the more the stock price declines, the more profitable the put becomes (as it forces the writer to buy the stocks at a much higher than current price).  To see how this works in graphical form:

As you can see from this chart, the lower the stock price, the more profitable the put option.  If we go from right to left:

• Green: Below the break-even point, the put buyer can force the put writer to buy the underlying stock at the strike price for more than current market value, also netting enough profit to more than cover the cost of the option.  The buyer benefits, while the writer has to pay an overpriced amount for a declining stock.
• Yellow: The put is exercised and the put buyer can force the writer to buy the underlying stock for more than current market value, but not enough to cover the cost of the option.  The further to the right you go, the more profit from the option premium that the writer gets to keep.  (Again, the area right next to the green portion of the grid is one where, due to commissions, neither party will actually make a profit.)
• Red: Above the strike price, the put writer gets to both keep the premium and not have to buy the underlying stock.  The put writer benefits, while the put buyer is out the option premium and commission costs.

One final point about options before we call it a day.  You might be wondering why anyone would bother to buy options, when there are two areas of our graphs, the red and (most of) the yellow, where selling yields a profit.  Well, there are several reasons; first, no matter how the stock price moves, the only profit you can get from selling options is the option premium.  By way of contrast, when buying an option, you can get spectacular profits if the stock shoots into the stratosphere (with a call) or drops to nearly nothing (with a put).  Second, if you find yourself on the wrong on of one of the aforementioned greatly profitable deals (and did not buy back your option), you could end up selling a spectacular stock for a song or forced to buy a crummy one for much more than market value; whereas the option buyer will only be out the option premium and commission costs if the trade breaks badly for him or her.  Finally, if you are working with American-style options, all you need is one day when the option you sold goes into the green territory, and you can find yourself losing your profit.

What’s the moral here?  Don’t underestimate the risk with options, particularly when selling them; unlike buying options, you’re abdicating your ability to control when (or if) the option is exercised, leaving you to the mercy of the option buyer.  But don’t forget if you choose the buying path that you need to not only need to be concerned about the strike price, but also the break-even price.

Options aren’t for the lazy or weak of stomach; if you decide to invest in them, be sure you understand everything, including all the ways you could lose money (ESPECIALLY all the ways you could lose money) and only put a small portion of your portfolio at risk, at least until you become an options expert.  (And even then, only use options when needed.)  Good luck, and happy investing!

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If you are a mutual fund investor, you’ve probably heard talk of the Efficient Markets Hypothesis (EMH, not to be confused with EMT or Emergency Medical Technician) being bandied about at one point or another.  In a nutshell, EMH maintains that the stock market and similar markets are efficient.  That is to say, the price of a stock at any given time will express ALL the information available about the stock at the time, and will usually match the fair value of the company.

Obviously, not every stock will exactly match the fair value of the underlying company at every moment; if they did, there would be little change in stock prices on a daily basis, rather than the swings that we see.  EMH holds that these variations are random and unpredictable, and will revert to fair value as a result of investors attempting to exploit the deviations from fair value.  In a liquid, large market with low costs and people looking to gain advantage from these (temporary) variances, the stock price will soon revert to fair value, at least until the next inefficiency arises.  While it’s possible for some investors to benefit from these inefficiencies, doing so depends on luck and not skill, according to EMH.

As with any such hypothesis, of course, there are challenges to EMH.  The most obvious examples are investors such as Warren Buffett who proved able to beat the market repeatedly.  There are also runs on the market, both on the upside (such as the tech boom) and the downside (as during 2008) where investors end up distorting the market in ways that pull prices away from their fair values in a concerted way.  That the stock market is efficient is far from a settled fact.

Efficient Markets and the Individual Investor

All this might seem like just an academic argument, but it has some very real consequences for your portfolio.  If the EMH theory is correct, your best (and in fact, only sensible) investment is in index funds; barring some lucky (and unpredictable) breaks, neither you nor a mutual fund manager can hope to beat the market, and the best you can do is match the market gains while spending as little money as possible.  If EMH does NOT hold, then beating the market via skill could be possible, and finding good stock investments or a solid mutual fund manager looks more reasonable.

So, which is it; do EMH principles apply or not?  I hold that the answer depends on what segment of the stock market we are considering.  Remember, there are several points that need to be true for markets to be efficient:

-Liquid: It should be possible for shares to be bought and solid easily, enabling the price to easily move back to the fair value for the stock.
-Large: A large market both increases liquidity and helps to ensure that information is widely disseminated, enabling changes from fair value to be easily discerned.
-Low Costs: Low costs increase the liquidity of the market, as well as decreasing the shift in value needed for the investment to be profitable.
-People Looking to Profit from Variances: Without people buying undervalued stocks and selling (or shorting) overvalued ones, the stock prices will stagnate, preventing the stocks from returning to fair value.

The closer a particular segment of the stock market is to meeting these criteria, the more efficient it will be.  For large cap stocks, the market is pretty dang efficient; the market for the AT&Ts and Wal-Marts of the world is large, liquid, and filled with people who will pounce on undervalued or overvalued stocks, pushing them towards their fair value.  On the other end of the spectrum, penny stocks tend to be illiquid, have a small market, and typically have added fees that increase the investment costs; all of which point to a really inefficient market that could potentially be exploited by a savvy investor.  (Although, I’d tend not to recommend penny stocks, as the lack of regulation and easy manipulation by unscrupulous charlatans makes the penny stock market highly risky.)  Most other markets fall somewhere in between; small-cap stocks are going to be less efficient than large-caps, but more efficient (and I would add, safer) than penny stocks.

What does this mean for your portfolio?  If you seek market inefficiencies, look for shares that are rather illiquid (think small cap); it’ll be longer before the market as a whole attempts to change the incorrect valuation, allowing the them to get further from the fair value (and potentially increasing your profit, with a well-chosen stock).  When investing in larger-cap stocks, don’t expect market adjusted to drastically and permanently shift your investment value, all public news will be priced into the stock already.

If you’re more of a mutual fund investor, you’ll likely have an easier time finding mutual funds that beat their respect indexes if you look at smaller cap funds.  A fund manager limited to picking from the S&P 500 for the companies in which the fund invests will have to deal with a liquid market keeping the valuations from getting too far out of touch with the fair market value. Larger cap investments should be considered more for the expected growth and possibly dividends.

The Efficient Markets Hypothesis provides some insight into the method behind creating index funds in the first place.  Whether you believe it’s a fact of investing life, think it’s a load of crock, or somewhere in between will impact just how much of your money you want to put into actively managed investments.  Regardless, the more you learn, the better an investor you’ll become, so enjoy the new knowledge!

(Image Taken from The Daily Gazette at Swarthmore)

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Yesterday, we talked about the use of leverage when investing, and how it can amplify your returns, whether positive or negative.  In addition, we saw how the interest charged by your brokerage on the borrowed money will lower the returns you make from the borrowed money, regardless of how the investment fares.  If I haven’t scared you away from using borrowed money (buying on margin) yet, here’s another concern: the possibility of a margin call.

In brief, when you borrow money in order to buy securities such as stocks, you need to ensure that you own enough of the underlying security to meet the requirements of both the Federal Reserve Board (FRB) and the exchange on which you purchase the security.  The FRB sets an opening margin requirement of 50% equity in Regulation T, meaning that would every dollar you pay towards purchasing a security, you can only borrow another dollar.  So, if you have $10,000 you want to invest and qualify for a margin account, you can borrow $10,000 from the brokerage to buy the security.

However, once you own the securities, the prices can go up and down, as with any investment.  If the price goes up, the percentage of the securities that you own will increase; however, if the prices fall, you will end up owning less than fifty percent of the underlying security (because the amount that you owe to the brokerage will remain the same, meaning only your share amount will rise or fall).  Both the New York Stock Exchange and National Association of Securities Dealers set minimum margin requirements of 25%, meaning for every dollar in security equity that you own, you can own up to three dollars of the investment held with borrowed money.  (Individual brokers can set stricter requirements, however, so you have to check to ensure you know the rules governing your investments.)

If the value of your securities falls so that your percentage of equity does meet these requirements, you will receive a margin call from the brokerage.  At that point, you will need to either invest more money to bring your equity share up to the minimum requirements, or sell the security (at a loss).  If our example investment suffered a loss of 40%, dropping to a total value of only $12,000, you would hold 17% equity ($2,000 equity divided by a $12,000 total investment) and would be receiving a margin call.  If you couldn’t invest enough new money to bring your stake up to 25% (or your brokerage’s required percentage), you would have to sell the security, pay back the $10,000 and the interest owed, and have less $2000 left of your original $10,000 stake.  Some brokerages may even sell your securities automatically, something else you know about your brokerage before you consider using margin.

Besides showing another example of how using margin can amplify your losses, margin calls can also lead you to sell securities that can rise later.  If our example stock recovers from its decline and goes on to increase in value, not only will the margin call have caused you to sell your shares for a loss, but you will miss out on the upside.  Using borrowed money means that you will need to play by the rules set out by the brokerage, even if they cause you to lose money.

All of this makes using margin rather risky, more so than regular stock investing.  What can you do to avoid the threat of getting a margin call?  Here’s three possibilities:

1) Don’t Use Margin Investing – The easiest way to avoid a margin call is simply to avoid using borrowed money at all.  You will be giving up the upside of using leverage, and will have less money to buy your desired securities, but you won’t have to worry about the whims of your brokerage.

2) Use Less Than the Maximum Margin – You can try to find a middle ground between absolutely no borrowed money and using all the leverage available to you.  If you don’t max out the amount of marginal funds you use, you won’t be as vulnerable to falling stock prices.  In our example, if you only borrow $5,000 in addition to your $10,000 stake (giving you 67% equity) and the stock price declines by 40%, the total value of the investment will be $9,000 ($4,000 as your equity and $5,000 in borrowed funds).  That’s about 44% equity in the fallen investment, more than enough to meet the requirements of the exchanges (although, maybe not your brokerage, if they have a high margin requirement).  Having less borrowed money exposes you to less market risk of falling investments.

3) Keep some money set aside in case of margin calls – If you do decide to use the maximum amount of margin possible and your brokerage will allow you to put more money into your investments during a margin call (rather than automatically selling them), you can keep a portion of your money aside in a safe account dedicated for covering margin calls.  This allows you to take advantage of the benefits of using leverage through a margin account, but with added insurance in case your stocks decline.  (Although, if I had enough money to cover my margin investments, I would just skip using margin investing, invest the money outright and not worry about the rules and complications that come with using borrowed money.)

Any of these methods would allow you to protect yourself from the risks of using margin investing; which one you choose will depend on your own tolerance for risk and investing philosophy.

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Chances are, if you have done any financial reading, you’ve heard the term ‘leverage’ being tossed around.  In truth, leverage is just a fancy word for using borrowed money to purchase investments.  The advantage of using leverage is that you can potentially amplify your profits, increasing the return you can get by using your own money alone.  The downside is that you could potentially lose much more more money if your investments turn against you, possibly more than you initially put into the investments.

Let’s consider an example to see how this works.  You’re considering a particular investment, and trying to decide whether to use leverage or not when you make the initial investment.  For this particular hypothetical investment, the maximum amount of leverage you can use is 10 times your investment (that is, for every dollar you invest, you can borrow an additional nine dollars for a total investment of ten dollars).  This is more leverage than you can employ with stocks (which is limited to 2x leverage, where half of the money you put up has to be your own), but much less than with FOREX, options, and many other forms of speculation.  The interest charged on the borrowed money for our example is going to be 6%, just to have a nice round number, and we’re going to hold the investment for a full year, again, to make the math easier.  (In reality, leverage as a technique to enhance your investment returns is usually limited to day traders or others with shorter time frames, but I’m just trying to show a simple example of leverage in action.)

First, let’s look at a good example, one where the investment rises by ten percent, a reasonable amount of profit to expect after one year:

The upside of leverage: enhancing your profits

(Click to view a full-sized image)  Here, we can see the advantages of leverage in full effect.  If you simply invest $100 without any leverage, you’d generate a handy $10 profit from your investment (notwithstanding any transaction fees for buying and selling the investment).  With leverage, though, you’d have invested $1000, ten times as much, and after you paid back the borrowed $900 and the $54 in accrued interest, you’d net a cool $46 in profit (or 46% return on your investment) .  (Note: thanks to the interest charged on the borrowed money, you don’t earn ten times the profit as you would earn without leverage; the interest rate is an important consideration when considering leverage.)

So far, so good, right?  Leverage leads to greater profits; why not use it?  Well, let’s look at the downside of leverage, what happens when the investment goes against you:

The downside of leverage: increasing losses

This time, without using leverage, you would lose $10 when the market value of your investment decreases, a ten percent loss to correspond to a ten percent decrease in the asset value.  With leverage, however, the ten percent loss causes you lose your entire $100 stake in the invest.  But that’s not all: remember, you need to return not only the $900 you initially borrowed, but also one year’s interest for our particular example.  All told, you need to pay back $954; when you add the interest you pay on your leverage to your own losses, you end up losing $154 on your $100 initial investment, for a total investment return of -154%.  The only way to really ensure that you make money off of leverage is to be the broker or bank lending out the money for leverage; in both of our situations, the lender made 6% profit on the borrowed $900.

Does this mean you should not use leverage?  Maybe; certainly, you should be very, very careful when using leverage.  Use it sparingly, if at all; as mentioned, with stocks, you can only borrow an amount equal to your own invested money, and you should probably borrow less than that full amount, anyway.  Make sure to monitor your investments closely; if your stake in the investment gets too low, your lender may require that you invest more money or sell some of your holdings (in what’s known as a margin call, which we’ll discuss more tomorrow).  Above all, ensure that you don’t take more risk than you need or want to take to meet your goals.

This is just a basic overview of leverage and using borrowed money to make your investments; tomorrow, we’ll cover more on this topic.

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