I was asked about financial leverage the other day and ended up explaining it all on the back of a scratch piece of paper.
Because nearly any idea is a good idea for a blog post, I will archive it here too so that I have this post to point to later.
Financial leverage is simply borrowing to increase the overall return of a portfolio.
I mean, assume we are looking at two different assets to invest in: A rent-home and publicly traded ExxonMobil stock.
The rent-home cost $100,000 – and pays a 10% return.
The ExxonMobil stock can be bought in any amount – and pays a 5% return.
Now assume you have $100,000 of money to invest.
The question is: How can this $100,000 be invested to achieve the highest rate of return?
If all $100,000 is invested in the rent-home, the investment will annually produce $10,000.
This yields a 10% return. (10,000/100,000 = 0.10)
If all $100,000 is invested in ExxonMobil stock, the investment will annually produce $5,000.
This yields a 5% return. (5,000/100,000 = 0.05)
But what if we use financial leverage?
If $20,000 is invested in the rent-home – the other $80,000 borrowed thru financing – the income is still (approximately) the same, but the return is higher.
This yields a 50% return. (10,000/20,000 = 0.50)
Then we invest our remaining $80,000 in ExxonMobil stock.
This yields a 5% return. (4,000/80,000 = 0.05)
So of our total portfolio, $20,000 is earning a 50% return and $80,000 is earning a 5% return.
Calculating the weighted average yield of this gives us a 14% return.
20,000 * 0.5 = 10,000
80,000 * .05 = 4,000
14,000/100,000 = 0.14 = 14%
A higher return is achieved by leverage than was possible through either original option.
Obviously, more leverage could be used to achieve an even higher return, but this is a trade-off along the traditional risk/reward line.
Understand: Debt can be bad too.