Our whole economy has been in the dumps over the past few years due to the use of leverage. Leverage involves using borrowed money to amplify returns. Our goverment, banks, companies, and citizens all used debt to finance their activities. The government relied on debt (Treasury bonds, T Bills) to finance its entitlement programs and national defense. Banks used debt to lever up their assets (derivatives) 20:1 to try and produce extraordinary returns. Companies used debt (commercial paper, bonds) to fund their operations. Individuals used debt (mortages, refinancing) to buy McMansions and finance their lifestyles. Now leverage is becoming popular in the investment industry as well. Let’s take a look at 3 extremely risky investments that rely heavily on debt to generate returns.
1. Leveraged Exchange Traded Funds
Leveraged ETF’s allow investors to get long or short a potential market sector depending on their opinion of the market. Let’s say you believed that the real estate market was due for a rebound. You could buy the ProShares Ultra Real Estate Fund. This fund will generate two times the daily return of the U.S. Real Estate index. Buying this fund would maximize your gain or loss on the index based on its performance each day.
Leveraged ETF’s use debt to multiply the returns that investors receive. Investors gain increased buying power from borrowed money. They have the potential to offer returns up to 3 times your initial investment. However, when you take a closer look at leveraged ETF’s, they clearly aren’t all that they are cracked up to be. Leveraged ETF’s rely heavily on derivatives. These derivatives can be options, swaps, or futures. Derivatives have been in the media spotlight recently due to their potential to destroy wealth.
2. Margin Investing
Investing on margin sounds like a great idea because you can borrow money from your broker and maximize your investment returns. Margin investing also amplifies losses. If you want to know about perils of margin investing, you should watch A Perfect Murder. Michael Douglas’ character lost his entire fortune because of some bad trades made while investing on margin.
Margin investing is dangerous because a few bad trades will lead to a margin call from your broker. Margin calls can lead to the liquidation of your account and force you to sell off your assets. Remember when you buy on margin that you have to repay the entire loan amount plus interest. You could potentially lose more money than you actually have.
3. Currency Trading
Trading currency is one of the riskiest investment strategies going. Currency prices ebb and flow based on market news. Currency trading has the potential to make you a great deal of money in a few minutes. It also has the potential to make you lose your shirt in a short amount of time. Currency trading is a lot like betting. You make predictions about whether a currency will rise or fall.
The problem with currency trading is that you have to sell one currency to buy another. Traders have to take a long/short position. For example, an individual that is bullish on the dollar would get long the dollar and short the euro.
Final Thoughts
As you can see, debt has no place in the investment strategy of the average investor. Leveraging your assets to multiply your returns sounds like a great idea until your strategy turns against you and leaves you with a portfolio awash in red ink.
Photo by: Casey Serin
