This article is sponsored by Securities Commission Malaysia, under its InvestSmart initiative
Leverage in the context of investments simply means borrowing capital for an investment, and expecting the profits to be amplified.
For example, if Steve would like to venture into the business of selling milk, he would first need to purchase a cow. Having inadequate cash reserves, Steve decides take a loan to make the purchase. The cow subsequently produces milk, which is sold. The sales then generate enough money to cover the interest of his loan, and eventually make profits.
This is a simple way of understanding the power of leverage. Most Malaysians use leverage for real estate investments, but the same concept can be applied to share trading and other investments as well.
Borrowing money to make more money
If used wisely, leverage can be a powerful investment tool. Savvy investors could borrow money to purchase shares to drive higher returns. Here’s a simple depiction of how leverage can be beneficial to your investments:
Leverage allows you the potential to gain significantly more returns as you don’t have to commit a large amount of cash to an investment. This means you don’t have to commit more capital into a single investment, and choose to use the fund to further diversify your investments.
Your best friend and worst enemy
The appeal of maximised gains through a seemingly small capital outlay may sound like a dream come true for any investor. However, in reality, things don’t always go according to plan.
There are many advantages to using leverage in your investments, especially if you have the knowledge and skills to do so effectively.
The first advantage of leveraged investing is the potential for higher returns. Based on the example above, the 12% return definitely pales in comparison to the 59% return obtained through the use of leverage.
Secondly, leverage allows you to control a larger investment through a small initial outlay.
Finally, the third advantage to using leverage is in minimising exposure to loss. With the additional cash obtained through financing, you could diversify your portfolio, significantly reducing your risks. Conversely, without leverage, you’d have all your eggs in one basket.
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