Risk and Leverage investment risk

Risk and Leverage

Investment risk is real. Looking back at the election, one of the major topics of discussion was Donald Trump’s history of bankruptcies.  It was common to hear him criticized as a lousy investor based on the number of ventures he’s had which have gone to bankruptcy.  And to some degree that may be true.  This article isn’t against or in favor of Donald.  But it is meant to shed some light on how even the ugly side of leveraged investments can put you ahead of someone who uses all of their own money.

Risk and Leverage investment risk

Why people think leverage is risky….

In terms of math, leverage is risky.  It’s other people’s money that can potentially amplify your gains or your loss.  If you are into a venture with 100% of your own money, then a 10% ROI in the venture means a 10% gain for you.  And a 10% loss if the venture loses 10%.

But let’s say you’ve only got 25% of your own money in the venture, and you’ve borrowed the other 75%?  That means a 10% gain creates a 40% ROI on your own capital (before subtracting the cost of financing). On the flip side, a 10% loss results in a personal 40% loss (plus cost of financing.) This is an investment risk. This means that you can make money and lose money a lot quicker….

It’s not that simple…..

Here’s what most investors overlook when it comes to leverage.  We aren’t borrowing from loan sharks who will throw us off a bridge.  Part of the reason Trump can keep growing his wealth is because there are ways to limit your downside even when you do use leverage.

Let’s put ourselves in the lender’s shoes.  They are investors just like we are.  They are looking to make a decent return on investment just like we are.  They are willing to assume risk just like we are.  Competent lenders carefully scrutinize deals as much as the borrower does.  They want you to succeed, and won’t lend to you if they think it’s a bad deal.

They also understand that one of the risks is that you might fail.  And when you do, the assets at risk are already defined upon the deal going bad.  It happens sometimes.  A property flip goes negative, and the lender gets to foreclose on the house.  Even though they didn’t get their full amount of money back, they were able to take ownership of the collateral.   This gives them the opportunity to recoup their losses in other ways.

And even if you lose, you’re still better off than if you lost all of your own money.  The most you had to lose was your 25%.  It’s not like the house was full yours.  You don’t actually lose anything extra by forfeiting it. This is a better way of handling investment risk.

Risk less to make more…..

Why would you risk 100% to make 10%, when you can risk 25% to make 40%? It’s a no-brainer.  That’s why most competent flippers and entrepreneurs look to leverage other people’s money.  And as long as they give it their all, there is no shame in losing.  It’s understood in the game of investing that is not about being undefeated, but having your winners pay for your losers.  And since you have 75% of your capital still free, you can go out and find a couple of more deals that will more than make up for your loss.

Word of warning….

There are right ways and many more wrong ways to do this. Handling the investment risk is quite challenging. The first and most obvious one is having your own personal assets at risk.  Then the loss can be far more severe than just the assets in the deal.  Make sure you work with tax and legal professionals to have the right business entities set up, strong contracts to rely on, and expert advice which will help you stay safe and compliant with the law.

But it’s how real business is done.  Whether you flip property, buy a franchise, or trade leveraged options, it’s about limiting your downside will maximizing your upside.

Did this peak your interest?  Are you looking to do more with less?  Follow along as we share our own customized strategies.

 

About The Author

herbertkoehler

I am a college drop out who found my passion as an investor. I love the many facets of finance, investing, and business. But even more than that, I love sharing what I learn with others.

Share your thoughts......