Leveraging

Lesson

Leveraging is a portfolio management technique that involves using borrowed funds to increase the potential return on an investment. However, it can amplify both gains and losses, making it a higher-risk strategy.

Practice Question #1

Which of the following best describes leveraging?

A) Investing in a diverse range of assets

B) Using borrowed funds to increase potential returns

C) Investing a fixed amount at regular intervals

D) Adjusting the proportions of assets in a portfolio

Select an option above to see an explanation here.

A) Investing in a diverse range of assets is diversification. B) Using borrowed funds to increase potential returns is leveraging. C) Investing a fixed amount at regular intervals is dollar-cost averaging. D) Adjusting the proportions of assets in a portfolio is rebalancing.

Terms

Leveraging:: Using borrowed funds to increase the potential return on an investment.
Leverage Ratio:: The ratio of an investment's total value to the borrowed funds used.

Practice Question #2

What is the primary risk associated with leveraging?

A) Inflation

B) Market volatility

C) Amplified losses

D) Interest rate risk

Select an option above to see an explanation here.

A) Inflation is a general investment risk, not specific to leveraging. B) Market volatility is a general risk associated with investing, not specific to leveraging. C) Amplified losses are the primary risk associated with leveraging, as borrowed funds can increase the magnitude of losses. D) Interest rate risk is a general risk associated with investing, not specific to leveraging.

Historical Example

In the late 1920s, many investors used high leverage levels to invest in the stock market, borrowing up to 90% of the purchase price of stocks. When the market crashed in 1929, these investors faced massive losses, and their margin calls contributed to the severity of the Great Depression.

Practice Question #3

Which of the following is NOT a factor to consider when deciding to use leverage in a portfolio?

A) Risk tolerance

B) Financial goals

C) Market conditions

D) Favorite color

Select an option above to see an explanation here.

A) Risk tolerance is an essential factor to consider when using leverage, as leverage increases the risk of an investment. B) Financial goals should be considered when using leverage, as leveraging can help achieve higher returns but also carries higher risks. C) Market conditions should be considered when using leverage, as leveraging may be more appropriate in certain market environments. D) Favorite color is not relevant when using leverage in a portfolio.

Real-World Example

An investor with $10,000 decides to use leverage to increase their potential return. They open a margin account and borrow an additional $10,000, giving them $20,000 to invest. If their investment increases in value by 10%, their return on investment is 20% ($2,000 gain on a $10,000 initial investment), minus the cost of borrowing the additional funds.