Warren Buffett, one of the most successful investors of all time, is famous for discouraging people from using leverage to boost their investment returns. However, Buffett himself has in fact employed leverage along his way to becoming one of the richest people alive. If used correctly, leverage is an effective and savvy investing tactic that can increase one's wealth materially over time. Here, we discuss what leverage is and how smart investors can use it to boost their returns without exposing themselves to an irresponsible amount of risk.
How Leverage Works
Borrowing money in certain circumstances can be prohibitively costly, but it can also be used to generate strong profits in the stock market. "Using leverage" means borrowing money for an investment in an effort to magnify one's returns.
For example, say one has Rs. 5,000 of cash to invest in a stock. But, instead of just buying Rs. 5,000 worth of stock, one decides to borrow Rs. 15,000 to buy a total of Rs. 20,000. If the stock goes up by 10%, one can make Rs. 2,000 of profit (minus interest owed on the borrowed Rs. 15,000) instead of Rs. 500 one would have made on only investing Rs. 5,000. In other words, using leverage would result in a return of 40% (Rs. 2,000 profit ÷ Rs. 5,000 cash invested), excluding interest, instead of only 10% (Rs. 500 ÷ Rs. 5,000).
Although this sounds like a fantastic way to make money in theory, Buffett discourages leverage because it can be a double-edged sword. If the stock in the above example instead drops 10%, one would lose Rs. 2,000 or 40%, and he would still have to pay back the lender (plus interest). So, how do smart investors like Buffett use this technique while minimizing risk?
Leverage Shouldn't Be Pure Gambling
Before diving into the question, it is important to note that careful investing is not the same as guessing whether the roulette wheel at a casino will land on red or black. Savvy investors are able to identify a disconnect in an asset's fair value and its current market price. Therefore, it is important to focus on how much a stock is truly worth versus guessing whether its price will go up or down.
Given the risk of potentially magnified losses from using leverage, one should only consider its use for high-conviction ideas with a wide margin of safety – a combination of conservativeness and aggressiveness. One should only invest if there is a large value-to-price disconnect even based on conservative estimates. Investing aggressively into such opportunities will maximize gains and minimize risk.
Warren Buffett has done this by using "borrowed" money from his insurance companies' clients (an insurer collects insurance premiums upfront, but typically doesn't pay out claims until much later). He has used such funds to purchase high-quality, franchise companies (like Coca Cola) when their shares were cheap (such as during financial crises). In fact, some studies have highlighted that his returns would not have been as spectacular without this combination of conservativeness and aggressiveness in his investing strategy.
How to Use Leverage Smartly
If one of the best investors of all time has used leverage successfully, it's worthwhile to consider how an average investor can use it for his own portfolio.
To echo an earlier point, an average investor should use leverage selectively. As we demonstrated, leverage is a double-edged sword, and exposing oneself too much and too often could result in serious losses. One should only employ leverage on a select set of opportunities for which one has the most knowledge, understanding and conviction.
Next, an average investor should consider different leverage tools depending on his opportunities. For example, trading on margin or with CFDs (Contract for Difference) is more suitable for longer-term trades that are aimed at a gradual closing of the value-to-price gap. It can also be lucrative to buy dividend-type securities on margin, so long as one has confidence in the underlying issuer's ability to uphold its payouts. On the other hand, using options can be an excellent way to boost returns if, again, one has high conviction on certain events happening in the short term (such as a company beating earnings estimates).
Last, it may be advisable to start using leverage when one is young. There are a number of reasons why leverage is more appropriate for people in their 20s than for those closer to retirement. First, young people have less capital they can invest, and are therefore underexposed to the stock market, which has been a huge engine of growth over time. And, those in their 20s can afford a higher risk tolerance as compared to older cohorts – losing money early on can hurt, but it won't ruin your life. However, losing a big chunk of your retirement portfolio can be devastating.
Overall, investors should always be knowledgeable about what they buy. Notably, high-probability outcomes don't always turn out, so never invest more than one can afford to lose. But, if one invests conservatively and carefully over time, leverage has the potential to be a very profitable tool.