If you want to earn more from your portfolio, it may be time to leverage. Leverage involves borrowing money to create higher returns. While borrowing money may sound like a bad idea to some, by leveraging your portfolio, you can enhance your earning and earn favorable tax treatment.
If you are ready to take on the risk, leveraging your portfolio can be a great way to earn big. If you are confident in the investments you are making, then you should have no issue in borrowing the money, especially when the reward can be so high.
What is Leverage?
Leverage occurs when borrowed money is used to invest and expand a firm’s asset base and generate returns. Leverage is also the term used to describe the amount of debt a firm uses to finance assets. With this logic, when a property or investment is considered highly leveraged, the item has more debt than equity.
When the idea of leverage comes to mind, you may think of margin, a similar idea. Leverage and margin are not the same, despite being interconnected. Leverage is the act of taking on debt. Margin is the debt or borrowed money that is used by a firm to invest in other financial instruments.
With a margin account, an investor can borrow money from a broker for a fixed interest rate and purchase securities, futures, or options. These investors are highly anticipating high returns. With a margin, an investor can create leverage.
For example, if a manufacturing company borrowed money to build a new factory it would be able to increase its production and its profits.
A leveraged portfolio operates the same way. An investor who uses borrowed money for some of their securities has a leveraged portfolio. There is some obvious risk in doing this because it could result in loss and the investor would be responsible for repaying the borrowed capital. On the other hand, the security invested in could result in gain and the investor would easily pay the debt and earn a profit.
Most investors aren’t going into debt in order to leverage. Many are utilizing the technique in order to manage their cash flow. Instead of using the entire investment amount from their own money, they borrow some to invest. This way, the investor is able to use the remaining capital to make other investments and even diversify the portfolio.
Understanding the Risk
Everyday we take risks, even when it comes to our money. We know that when we make an investment, we are opening ourselves up to the potential for loss.With a leveraged portfolio, an investor can earn an disproportionate amount on their earnings. Unfortunately, this means there can be a disproportionate amount of losses as well. If the asset doesn’t earn enough returns, the amount of interest can overwhelm the investor.
How Do I Leverage My Portfolio?
There are several ways one can leverage their portfolio. Here are a few we’ve gathered:
By using a margin loan, an investor is borrowing money from a broker to purchase more stock shares. The loan is used to increase potential gains. The amount of the loan usually depends on the type of security being purchased.
When it comes to stocks, investors can borrow up to 50% of the value of the security that is being purchased. For example, if an investor pays a certain amount in cash into their account, they can borrow that same amount of margin in order to purchase more stocks.
ETFs are easy to purchase using traditional brokerage accounts. They are also eligible for margin, meaning investors can leverage their positions. Another advantage of ETFs is that they cost less. Since ETFs are traded as securities, the price of transaction is lower than the forex market.
Leveraged ETFs are like other ETFs with a difference. The portfolio managers of a leveraged ETF handle the leverage creation to make the funds return a multiple of the index. This can be 1.5, 2, or even three times the index.
For example, an investor is interested in leveraging a large-cap stock and chooses to invest in a 2x large cap ETF. If the index returns 10%, the investor earns 20% from their investment. Consequently, if the index declines 10%, they lose 20%.
Investors can find leveraged ETFs in most asset classes, making it easy to invest. All account mechanics are dealt with by the portfolio manager. Like some other leveraged investments, the amount initially invested is the amount an investor can lose.
An option is when an investor purchases or sells put or call option on a stock without any ownership in the security. This method provides the most leverage, meaning it created the largest debt. The cost of entering the position and gaining leverage is the premium paid for the option. Luckily, the premium that is being paid is the most the investor can lose.
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