Debt is a word that many people are afraid of. There are so many television shows, books, and magazines devoted to teaching people about getting out of debt. While debt can be seen as a negative measure, it can also be a positive one if used properly.
The principal method of using debt to invest positively is the use of leverage to exponentially multiply your returns. What is leverage exactly? Leverage is using borrowed money to increase your return on investment. Leverage can allow you to achieve returns that you thought were impossible but at a greater risk of losing your capital.
Here are five ways that debt through the use of leverage can make you richer.
Key Takeaways
- Although typically considered a negative measure, the use of debt can be a positive one if it is used and managed correctly.
- Debt can be used as leverage to multiply the returns of an investment but also means that losses could be higher.
- Margin investing allows for borrowing stock for a value above what an investor has money for with the hopes of stock appreciation.
- Leveraged exchanged traded funds (ETFs) allow for investing in a fund that uses leverage to track an index.
- Many hedge funds use leverage but are often only available to high-net-worth individuals.
- Short selling is borrowing stocks with the intention of expecting a drop in the security borrowed.
- Forex trading allows investors to control large blocks of currencies with a small amount of capital.
1. Margin Investing
Investing on margin allows you to buy a higher dollar amount of stock than you actually have money for. For example, if you had $50,000 in your traditional brokerage account, you could leverage your investment and open a margin account.
A margin account allows you to put up a max of 50% of the purchase price of a stock. You would have $50,000 in cash and an additional $50,000 would be loaned to you from your broker. Your $50,000 investment gives you $100,000 worth of buying power. You could use this money and buy $100,000 worth of stock.
If the stock price appreciates, then you can pay back the loan and pocket the profit. The negative is that if the equity in your account falls below a certain value, your brokerage firm can issue a margin call. If you can't meet your margin call because you don't have enough funds, your broker can liquidate your entire position in a stock leaving you with losses.
2. Leveraged ETFs
Leveraged exchange traded funds (ETFs) allow investors and traders to amplify their returns by going long or short on a particular index. Fund companies like ProShares offer leveraged ETFs that let investors multiply returns (and losses) between 200% and 300%.
These funds let you invest in specific indexes, bonds, commodities, or sectors. Leveraged ETFs are attractive because of the extraordinary profit potential. During market booms, you can achieve returns with leveraged ETFs that other investors dream about.
The problem is that the same way that leveraged ETFs work for you is how they can work against you. Unless you are great at trading in and out of these funds, leveraged ETFs can magnify losses by wiping out your entire investment in a few days.
3. Hedge Funds
Hedge funds are some of the biggest users of leverage. They are famous for generating abnormal returns by using leverage. Many hedge funds lever up to 10 times their total assets. Billionaire hedge fund managers like John Paulson have used leverage to turn accredited investors into multimillionaires.
However, if the fund manager's investment thesis is wrong, this can drive a hedge fund out of business and lose the capital of all investors. Hedge funds such as Long-Term Capital Management (LTCM), which needed a bailout, were levered up as much as 30 times their assets.
4. Short Selling
Have you ever watched a financial program on television and heard that it's time for you to short the market? Short selling is a popular way of betting against a particular security by borrowing shares from an investor and selling them in hopes that the shares decline.
Short sellers have made a fortune by properly timing declines in stock prices. The downside to short selling is that losses are unlimited, which means that short sellers can lose much more than the initial investment.
5. Forex Trading
Forex trading allows investors to control large blocks of currencies with a small amount of money. Currency investors can lever up their accounts 100:1. The pros of currency trading are that you can take a small amount of money and turn it into significant sums very quickly.
George Soros is known as the "man who broke the Bank of England" netting $1 billion by betting against the pound. Conversely, currency trading has the potential to clean out a trader's account in a matter of minutes.
The Bottom Line
It may go against conventional wisdom because debt is seen as a downward pull on an individual's finances, but if used correctly and managed appropriately, debt can allow individuals to make purchases they wouldn't otherwise be able to, enhancing their returns significantly.
Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circ*mstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.
