Introduction

Investors can use borrowed money to increase the size of an investment position without providing the full amount of capital themselves. While borrowing can increase potential returns, it can also significantly increase potential losses.

Leverage risk is the possibility that borrowing or using financial instruments that create leveraged exposure will magnify both gains and losses. Because investors remain responsible for borrowed funds and related costs, leverage can cause losses to exceed the amount that would have occurred without borrowing.

Understanding leverage risk can help investors recognize how debt, margin, and other leveraged strategies can affect investment outcomes.

1. What Is Leverage?

Leverage involves using borrowed money or financial instruments to increase exposure to an investment.

For example, an investor with $5,000 may borrow an additional $5,000 to purchase $10,000 worth of investments. If the investment increases in value, the investor's return on their original $5,000 can be larger. However, if the investment declines, the loss is also magnified.

Leverage can be used by:

• Individual investors.
• Companies.
• Financial institutions.
• Investment funds.
• Real estate investors.

2. How Does Leverage Magnify Gains and Losses?

Leverage increases the size of an investor's position relative to their own capital.

For example, suppose an investor uses $10,000 of their own money to purchase $20,000 of an investment by borrowing $10,000.

If the investment increases by 10%, the position gains $2,000. Before considering interest and other costs, that represents a 20% return on the investor's original $10,000.

However, if the investment falls by 10%, the investor loses $2,000, representing a 20% loss on their original capital.

This illustrates the central characteristic of leverage: it magnifies the impact of price movements on an investor's own capital.

3. What Is Margin?

Margin refers to borrowing money from a brokerage firm to purchase investments.

When investing on margin, an investor uses their own money as part of the investment and borrows the remainder. The securities in the account may serve as collateral for the loan.

Margin can increase purchasing power, but it also creates additional risks and costs.

If investments decline significantly, the investor may be required to provide additional funds or securities to maintain the required account level. This can force an investor to sell investments at an unfavorable time.

4. What Is a Margin Call?

A margin call occurs when an investor's account no longer meets the brokerage firm's required minimum level of equity.

The investor may then need to deposit additional funds or securities, or reduce the position.

Margin calls can become particularly challenging during periods of sharp market declines because investors may be forced to sell investments while prices are falling.

This can turn temporary market declines into realized losses and make it more difficult for an investor to recover.

5. What Are the Costs of Leverage?

Borrowing money to invest generally involves costs that can reduce investment returns.

These may include:

• Interest expenses.
• Brokerage fees.
• Financing costs.
• Transaction costs.
• Other account-related charges.

For example, if an investment generates a 6% return but the cost of borrowing is 5%, the potential benefit of leverage may be relatively limited before considering other costs and risks.

Investors should therefore evaluate the net return after financing costs, rather than focusing only on the investment's gross return.

6. How Does Leverage Affect Risk?

Leverage can increase the financial consequences of relatively small changes in an investment's value.

Without leverage, an investor generally cannot lose more than the amount invested in a traditional purchase of a stock. With borrowed funds, however, losses can extend beyond the investor's initial capital because the borrowed amount still has to be repaid.

The greater the amount of leverage used, the greater the potential sensitivity to changes in the underlying investment.

Conclusion

Leverage allows investors to increase their exposure to an investment by using borrowed money or leveraged financial instruments. While this can magnify potential gains, it also magnifies potential losses and introduces additional costs and obligations.

Margin requirements, interest expenses, market volatility, and the possibility of forced selling can make leveraged investments significantly more complex than unleveraged investments.

Before using leverage, investors should understand how much risk they are taking, how financing costs affect potential returns, and how their investments could perform under unfavorable market conditions.