Recently, I saw in the news about a university student who borrowed money to buy stocks but ended up losing it all, including his tuition fees. This piece of news got me thinking about the many sides of investing with borrowed money, and what renowned famous investor Warren Buffett said in a TV interview: It is crazy to borrow money on securities.
One should invest within one’s means. But there are some who borrowing to invest because they are short on money, or want to make a huge profit with a small amount of money. Some may open margin accounts, while others may grow their investment capital through private loans, tax loans, property loans, or even student loans.
The term “leverage” may sound advanced and seem like an essential financial skill to master, but in fact, it is about investing with borrowed money. You may hope it multiplies your returns, but it also magnifies your risks.
For example, if you buy a stock with $10, $9 of which is borrowed, the leverage effect will be 10x (10 divided by 1). When the stock price rises or falls by 1%, the leverage effect will multiply the gain or loss by 10 times to 10%. If the ratio of loaned funds to the investment amount is higher, the leverage effect will be greater.
Apart from the leverage effect, the loan is subject to interest payments. When the market goes up, people always assume that the gains or even the dividends will be enough to cover the interest. But nothing is guaranteed in a rapidly changing stock market. As you need to pay back the loan and bear the interests, borrowing to invest is often a short-term trading strategy, one that involves higher risks. If you trade on margin, when the stock price moves against your expectation, you may face a margin call (call for margin deposits), or even the risk of liquidation. With margin trading, investors may end up losing the entire margin deposit and may even have to bear the losses on the margin account.
Learn more about margin trading
Trading derivatives, such as warrants, CBBCs and other listed structured products, are common among retail investors because of their lower costs than buying the underlying assets directly, making it seemingly possible to make big gains with a small capital. Yet these derivative instruments are subject to the leverage effect, and their structures, mechanisms and pricing are very complicated, not to mention their high risks. If you buy derivative products on margin, creating leverage upon leverage, the risks will be considerably high.
