What is Leverage?

In today's episode of “Saving and Investing”, Michael Fischer explains a concept I've heard mentioned a lot, but have never understood. The term “leverage” is used in many financial books and articles, often referring to real estate investments. The concept has always puzzled me, even when I looked it up. Michael's explanation is short and to the point. Leverage makes perfect sense now.


What is leverage? (2:48)

 

A simple example of financial leverage: Say you have $10 that you want to invest in a stock. If you invest that $10 and it goes up 10%, you've made $1. However, if you're able to borrow an additional $90 to purchase that stock, you'd have $100 total to invest. If that stock goes up 10%, you've made $10. This is leverage: borrowing money to magnify returns. (Of course, losses are magnified as well.)


Principles of leverage (3:25)

 

A home mortgage is a common example of leverage in practice. In general, a homebuyer has only a small amount of the purchase price. Most of the money for the transaction is borrowed from a bank. House prices tend to increase with time. By using leverage to purchase a house, we're able to magnify our return on equity.

Why do I like Michael's video series so much? (And make no mistake: I love it. I'm learning a lot.) Because he's able to present these financial concepts clearly, in a way that makes sense. Compare his succinct definition of leverage to the definition at Investopedia:

1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

2. The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged.

Huh?

On Monday, Michael explains financial statements. Then he dives into stocks, bonds, and financial markets!

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MyOwnMillions
MyOwnMillions
13 years ago

Many investors (traders) use leverage in their brokerage account in the form of buying stocks on margin. This is very dangerous though since you are mangnifying your the dollar amount and increase your risk by borrowing money for a higher net return. Do you remember the bad feeling you had when your stocks went down? Just multiply that by 1000x when those stocks you bought are with borrowed money. Buying a house on mortgage is generally a good idea because real estate eventually will go up assuming you are patient enough but other forms of investment might not always go… Read more »

muntz
muntz
13 years ago

please take this for what it is worth – but this guy’s stuff is verrrrrrry basic and poorly presented. How can you write a finance blog and not understand EXTREMELY basic concepts such as leverage? I like a lot of the stuff here, but I’m starting to question the value of any minute spent here…. Now, I have a CFA and an MBA and I apologize for the harshness of my comments. Despite all the work I’ve done in finance, I still realize that I have a lot to learn and seek out other resources. But come one dude –… Read more »

J.D.
J.D.
13 years ago

Jerry, you have some good points. I hope I have some good responses. 1. Of course this stuff is very basic. It’s meant to be. I’m presenting it as part of Financial Literacy Month. It’s meant to be a foundation upon which other stuff can be discussed. Neither Michael nor I are pretending this is anything other than basic financial information. Actually, that’s the point. 2. I don’t write a finance blog — I write a “personal finance” blog. There’s a subtle but important difference. I have no background in finance. I’ve struggled with money all my life. I’m beginning… Read more »

MyOwnMillions
MyOwnMillions
13 years ago

Blogs are a medium to share our knowledge and learn together as opposed to teaching everyone what exactly should be done.

People like us write blogs to give others a way to learn (either linking to others’ posts or sharing what we know). I like this blog because JD is honest and write interesting articles that I can learn from, not necessarily because I think JD is an expert in personal finance or holds a Masters in Finance.

I will continue to support this blog.

KM
KM
13 years ago

Leverage is not evil as long as one understand the concept of risk and money management. I would recommend anyone considering leverage (for example 4X in stock day trading to 10X in forex trading) to do careful analysis and study of it beforehand.

As usual, the rewards will come to the ones with an hedge (e.g. the ones who study, work hard, and are expert in their field) -)

You can be lucky once or twice but consistent positive average return requires more than luck!

muntz
muntz
13 years ago

fair enough, but if you don’t understand the most basic principles of finance then why would you write a finance blog?

i agree that jd is honest. however, after his admission that he doesn’t understand his subject, how can you possibly accept anything he writes?

The Digerati Life
The Digerati Life
13 years ago

Not everyone who has a pf blog is necessarily an expert at ALL things financial. Many people do it to share what they know, track their own progress, be accountable to themselves, get support from a community. I enjoy JD’s blog immensely as he is one of the best writers and not to mention, nicest bloggers around. Many of the things we write about are basic but are great reminders to others. Kudos to those of us as well who remain honest about what we do and do not know, and have the modesty to admit things.

MyOwnMillions
MyOwnMillions
13 years ago

I believe you will agree that we will go nowhere in this argument. I can understand your point of view but I just want to say that JD has worked hard and this blog has become quite popular and successful. This is because of his the work and thought he has put into his articles and the way he allows his readers to relate to him, as opposed to pretending to be the expert in this subject. I applaud that.

Dave
Dave
13 years ago

@ muntz

Sir/madam — you, me, everyone who comments at this site are just “ants” swimming around in the “afterbirth” from what J.D. has created here. For what it’s worth, I was linked to J.D. Roth’s work via millionaire businessman Marshall Brain, creator of the web site How Stuff Works, one of the most popular and respected web sites in the world today … Mr. Brain found enough value in J.D.’s work to bother POSTING about it on his own personal blog. So, yeah.

RJ
RJ
13 years ago

Part of the greatness of this blog is travelling with JD through all sorts of real-life questions and struggles dealing with finance. JD tirelessly provides all sorts of sources in a variety areas related to finance, frugality, and related topics; but at the same time, he makes it perfectly clear that he’s a layman who’s trying to educate himself for life. Does a person have to be an expert in order to share his quest for self-improvement? I hope not. There are plenty of people out there who have already “made it” and who are willing to share their success… Read more »

Wesley
Wesley
13 years ago

“ants”, swimming in the “afterbirth”…um, ok there Dave. I enjoyed the article alot…I thought it was very informative, but the comments on this one are going in a very strange direction. We start off with a shameless plug for another site, then to a troll, then ants in afterbirth…hmmm.

Good article, odd comments.

DC Economist
DC Economist
13 years ago

While I too hold advanced degrees, I can find alot of worth here. Even if the leverage discussion is basic, its a useful review. In dancing, one occasionally retakes the basics to reaffirm one’s dancing base.

I don’t understand where muntz’s hostility comes from. JD clearly stated the the encyclopediac definition confuses him but Michael youtube program does not.

If JD and co here weren’t providing solid information or advice, I wouldn’t spend time here.

I strongly suggest that the basics, no matter how far afield and expertish we are, are nothing to scoff at.

rhbee
rhbee
13 years ago

Some effort has been made here to waste our time by leveraging the conversation away from the point of this blog which was to aid all of us in gaining a clearer understanding of the term. One aspect that hasn’t been discussed is the way that the language which puzzled JD “A firm with … more highly leveraged.” can also seen from a linguistic approach to represent the macho language of Wall Street where being heavily indebt can somehow by the sleight of word change be seen to be a sign of strength and business acumen. As someone who has… Read more »

db
db
13 years ago

Perhaps this information is basic to somebody with an MBA or masters in Finance. Fortunately, not everybody in life has pursued these degrees (Why fortunately? because we thrive on having people with a diversity of interests.) To somebody without such advanced business training, this may well be the first time they’ve been exposed to such a discussion on some of these topics or it may be the first time that information has really clicked for them. Some people don’t retain information as well when they read it versus when they hear it for example. I don’t understand where this hostility… Read more »

Beau
Beau
13 years ago

Nothing wrong with getting readers to think a little about the concept of leverage in financial matters. Without leverage the wheels of commerce would grind to a halt in some cases, but of course it’s a double edged sword. Leverage can be the crack cocaine of speculative investment junkies who might do heavy trading on margin or in option accounts eventually succumbing to heavy losses. You still want a solid underlying asset to form the basis of any leverage, and getting a mortgage to buy a good house makes sense. Please keep up the dialogue J.D., and continue to share… Read more »

Jonathan
Jonathan
13 years ago

Muntz, what you should really be worried about is reading stuff from bloggers or writers who act like they know something but in fact, really don’t. Personally, I think THAT is what really hurts the personal finance blogosphere.

J.D. never does this, not at least from what I’ve read, which is something that I really respect.

We are all learning.

BxCapricorn
BxCapricorn
13 years ago

An option allows a person a leveraged approach to buying or selling stocks. An option is defined as the right to buy or sell a particular security for a specified price on or before a specific date. The specific date is known as the Expiration Date. You’ll hear the pontiffs on CNBC talking a lot about a stock moving due to the upcoming Expiration Date for the options on that particular stock. To confuse you a little more, the stock, when part of an option, is also known as the “security” or the “underlying”. An option is a nice tool,… Read more »

Jon
Jon
12 years ago

I have a question regarding leverage I thought I’d throw out there. I’ve discussed this with my wife, but she doesn’t like the sound of it: I get offers from my credit cards (all at $0 now!) to transfer a balance at 0% for 12 months. There is a balance transfer fee of 3% however. My idea is to use this money, pay the 3% fee and invest it in a Certificate of deposit. Now my credit union offers 11 month certificates at 4.75apy with a dividend of 4.65% and dividends are credited monthly. Lets say I “leverage” my credit… Read more »

Linda
Linda
10 years ago

Well then isn’t leverage the same as playing the lottery?
It is basically gambling right?
I’m trying to learn what leverage is also.
I thought it was power, an advantage, a strategic position that will more than not bring success.
From reading here it is described as good or bad.

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