Should You Use Leverage in Your Portfolio?
There’s only one goal when investing in stocks – to make money. With that goal firmly in mind, investors have developed numerous methods and strategies intended to filter out winning stocks and execute trades in a timely fashion in order to maximize rises and minimizes falls in value. But even the most successful investors don’t break more than 12% annually on a regular basis without using leverage.
Leverage in a portfolio can boost returns significantly, but can make losses much larger, as well, making it a tool only for sophisticated investors. By borrowing money at a specified interest rate, investors can use the extra money in the hopes of earning a return greater than that of the interest rate on the loan. For example, if you take out a loan for 5%, but earn 10% on returns, you just profited 5% overall. But it also makes losses harder to handle since you lose not just the money on the investment, but the interest debt on the loan.
Kick your portfolio into overdrive
In order to begin using leverage in your portfolio, you’ll need to open a margin account. This allows you to take out loans to be used for investment purchases and also enables options and other derivatives to be traded. Like all debt instruments, having an excellent credit score gets you the lowest possible rate – something essential in order to boost returns.
So how much can you actually make using leverage? Let’s take a look at an example.
Imagine you have $10,000 you want to invest in a stock and decide to take out a loan for an additional $2,000 at 5% interest to bring your total amount to $12,000. If the stock rises 10%, you’ll have $13,440 – that gives you a return of 13.44%, instead of 10%. The minimal interest of $100 means your official return is $13,340 or 13.34%.
But stocks aren’t the only type of asset that you can use leverage on. Options are another way to boost returns. An option contract allows you the right to buy or sell 100 shares of stock within a set time-frame for a given price. This let’s you minimize risk to the purchase price of the option contract, without having to take on the risk of actually owning the stock. And lets you control 100 shares of stock for a fraction of the cost.
Other than leverage, checking margin debt levels on the exchanges is useful as a metric for gauging the risk and strength of the stock market. Historical data shows that rising margin levels often precedes stock market corrections. The higher the leverage in the market, the more money lost if the market turns south. But using leverage can be beneficial for investors who understand the risks and invest appropriately.