What are the risks of taking on more leverage?

Well leverage can work for or against you.

It all depends on the direction of your absolute returns.

If you generate a positive return, leverage further increases your returns.

If you generate a negative return, leverage further decreases your returns.

For instance, say you bought an asset for $100.

Over the next year, you generate a return of -$10 on that asset.

What was your return? -10% (-$10 / $100).

Now, instead of spending $100 of your own money, say you borrowed $20 from the bank.

So, you invest $80 and the bank contributes $20.

If your asset returns the same -$10 over the first year, how much do you make?

Well, say you sell the asset for $100, pay off the $20 of bank debt.

How much are you left with? $100 – $20 – $10 = $70.

Making $70 on an $80 investment is a -12.5% return.

Now, instead of spending $80 of your own money, say you borrowed $50 from the bank.

So, you invest $50 and the bank contributes $50.

If your asset returns the same -$10 over the first year, how much do you make?

Well, say you sell the asset for $100, pay off the $50 of bank debt.

How much are you left with? $100 – $50 – $10 = $40.

Making $40 on a $50 investment is a -20% return.

Now, instead of spending $50 of your own money, say you borrowed $80 from the bank.

So, you invest $20 and the bank contributes $80.

If your asset returns the same -$10 over the first year, how much do you make?

Well, say you sell the asset for $100, pay off the $80 of bank debt.

How much are you left with? $100 – $80 – $10 = $10.

Making $10 on a $20 investment is a -50% return.

Ouch.

Too much debt can hurt your returns if they are negative.

Bottom-line? Debt goes in both directions. It increases positive returns. It reduces negative