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Originally Posted by Chris C
if you are just your average investor in the long run excessive leverage may hinder more than help as well greatly add to the level of risk.
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One thing I see too many people not taking into account is the ongoing cost of leverage - especially for margin loans.
Example of flawed thinking:
If you have $100,000 invested using $50K of margin loan @ 8.5% interest, then your holding costs are $4250 per year and so you only need to be making 4.25% return on your investment to be getting ahead. Right?
Wrong!
You only need 0% return on your $50K investment to be getting exactly the same result!
It does not work to average your required returns over the equity portion of your investment and the borrowed portion - since this does not take risk into account.
It makes no sense to add leverage if the investment does not cover the costs of that leverage. $100K using $50K leverage @ 8.5% interest must return at least 8.5% to cover costs, not 4.25% ... since I could take that unleveraged $50K and get exactly the same net result from the same investment without any of the associated risk.
To justify the extra risk you really need to be making substantially more than 8.5% return on the investment - especially if interest rates are going to go up!
If the investment chosen is not even capable of making average returns significantly higher than the average cost of leverage, then leveraging into that investment is a really bad idea.
I hope this helps some of our newer members understand leverage a bit more!
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Sim'
This is a general comment only and does not constitute advice. Before making financial decisions you should seek advice from a professional adviser, who can take into account your specific circumstances and investment goals.
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