Leverage: Boosting Returns, Increasing Portfolio Volatility

Imagine you’re trying to bake a cake, and you want to make it extra large and impressive. You have a recipe and enough ingredients for a standard cake, but you want something much bigger. Leverage in investing is a bit like borrowing extra ingredients, say from a neighbor, to bake a cake that’s larger than you could manage with just your own supplies. In the world of finance, these ingredients are funds, and borrowing them at the risk-free rate is like borrowing them with a very minimal, almost negligible cost, similar to borrowing sugar from a friendly neighbor who doesn’t expect much in return. You then use these borrowed funds to invest even more in what we call a risky portfolio, which could be something like a mix of stocks and bonds that has the potential for growth but also carries some uncertainty.

So, how does using these borrowed ingredients, this leverage, affect your cake’s potential size, or in investment terms, your portfolio’s expected return? Well, leverage acts like a magnifying glass for your returns. If your risky portfolio performs well, like your cake rising perfectly and tasting delicious, the borrowed money amplifies your gains. Let’s say your risky portfolio is expected to return 10% over the next year. If you invest only your own money, you would get a 10% return on that amount. But if you borrow an equal amount at a risk-free rate of, for example, 2%, and invest it alongside your own money in the same portfolio, your overall return becomes greater relative to your initial investment. Essentially, you’re earning a 10% return on both your money and the borrowed money, but you only have to pay a small 2% borrowing cost on the borrowed portion. This difference boosts your return on your original investment.

However, this magnifying effect is a double-edged sword. Just as leverage can make your cake bigger and more impressive if everything goes right, it can also lead to a bigger disaster if things go wrong, like the cake collapsing or burning. If your risky portfolio performs poorly, say it loses 10%, then you’re not only losing 10% on your own investment, but you are also still obligated to repay the borrowed money plus the minimal interest. This means your losses are also amplified. A larger cake is grander, but also has further to fall if it topples.

Now let’s consider volatility. Volatility is like the unpredictability of the oven temperature when baking your cake, the ups and downs in the cake’s texture and appearance as it bakes. A highly volatile portfolio is like an oven that fluctuates wildly in temperature. Leverage also increases the volatility of your portfolio. Think of it this way: if the risky portfolio itself is already somewhat unpredictable, like an oven with temperature swings, adding leverage is like making those swings much more dramatic. Because leverage amplifies both gains and losses, it also amplifies these fluctuations in value. If your risky portfolio’s value typically fluctuates by, say, 15% up or down in a given period, a leveraged portfolio will likely fluctuate by a larger percentage, making the oven temperature even more erratic.

In essence, using leverage is like adding extra fuel to your investment strategy. It has the potential to significantly increase your expected return, like baking a much larger and more impressive cake. However, it also substantially increases the risk and volatility of your portfolio, making it more susceptible to larger losses and wider swings in value, similar to increasing the chances of a baking disaster if the oven becomes too unpredictable. Borrowing at the risk-free rate, even though the borrowing cost is low, does not eliminate risk. Instead, it magnifies the existing risk inherent in the risky portfolio. Leverage is a powerful tool, but like any powerful tool, it needs to be used with caution and a clear understanding of its potential to amplify both the positive and negative outcomes.