Leverage & Wealth Creation
How huge fortunes are made
This article will discuss the underlying theme of how most (all?) big fortunes were made. When I first discovered that there is something that most big and small fortunes have in common I was very amazed. Basically everyone that made a fortune used leverage in some form or the other. Leverage is commonly associated with risk, but when it is used consciously and prudently it is the most powerful tool available for wealth creation. What makes it even more important is the fact that leverage can be applied universally across all businesses, to investing in stocks and real estate, in your profession and even in day to day life.
But what exactly is leverage? In finance leverage refers to the use of borrowed funds, which will result in a higher return on equity. But the concept of leverage can be understood more broadly. For example an entrepreneur can use leverage by employing people that work for him, which is actually why all of the richest men are entrepreneurs. Even with the highest paying job you could never earn as much, because without leverage you would have to put in all the hours by yourself. Leverage is also the reason why many people became rich by investing in real estate. In real estate it is easy to borrow money, because the property acts as security for the loan. Loan amounts of 80% are very common and can even be as high as 100% (or higher) were you only have to pay the closing costs. Another example of leverage from day to day life would be leveraging your time. This is achieved by hiring other people to do your less productive tasks, so that you free up time to focus on the more productive tasks yourself.
Implications of Leverage for Investing
This article was meant to be a quick food for thought about leverage. It is really important to always keep this concept in mind, because it can be applied to so many different areas of life and business. In this last paragraph I want to briefly discuss what the implications of leverage are in the area of investing. Leverage can help you to drastically increase your returns. However it is important to be careful with it. When you invest in stocks you have to consider the high volatility and the high likelihood that the company you are buying is already levered. When the company has debt on its balance sheet they already use leverage so buying their stocks on margin can quickly increase leverage too much. The best piece of advice is to always protect the downside. Imagine the worst downside scenario and how your levered portfolio would react to it. If you keep in mind what could go wrong and rather use too little leverage than too much, it is a great tool to increase your returns. Even a small increase in returns can add up over time and make a huge difference when compounded.