Leverage: how sensible people go broke

Leverage is borrowing to invest more than you have. It multiplies returns in both directions, which sounds fair until you notice that the downside compounds against you and the upside does not. It is how mathematically sophisticated people go spectacularly broke.

The mechanics

Put in £10,000, borrow another £20,000, and you control £30,000: three times leverage. If the asset rises 10%, you make £3,000 on £10,000 of your own money, a 30% return. Wonderful.

If it falls 10%, you lose £3,000, which is 30% of your money. If it falls 33%, your entire stake is gone while the asset itself is still worth two thirds of what it was. The asset did not need to fail. You did.

Why it kills

• Margin calls arrive at the worst moment. When prices fall, the lender demands more collateral precisely when your assets are cheapest and your cash is scarcest. You are forced to sell at the bottom. The temporary loss becomes permanent.
• You lose the ability to wait. The entire edge of a long-term investor is the freedom to outlast a drawdown. Leverage sells that freedom for a slightly faster ride.
• The cost never sleeps. Interest accrues whether the position works or not. Time stops being your ally and becomes a bill.

Leverage does not change your expected return. It changes the probability that you are still around to collect it.

When it is defensible

Leverage is not always madness. A mortgage on a house is leverage, and it is broadly sensible, because the asset is stable, the loan is long-dated, and the lender cannot demand repayment because the price dipped. That last clause is the entire difference. Margin on equities has none of those properties.