The Risks of Leveraging in Investments - dummies

By David Stevenson

Clearly the main leverage risk for you as far as your investment portfolio in the UK is what happens if you borrow too much money and the cost of leverage starts to work against your investment.

The vast majority of investors think that a leveraged asset (that is, one bought through leverage) is always riskier than an unleveraged asset (that is, you haven’t borrowed to buy), even if the leveraged asset has low risk and the unleveraged asset is highly risky. Yet in reality the key issue may not be the use of leverage, but the risk of the underlying asset.

Leverage can be risky but it’s just one risk among many. You need to understand all the risks of investing an asset (bond, equity, commodity or currency) and work out whether the potential reward for taking that risk is worth it. But no one gets a free lunch (except maybe celebrity chefs) and you rarely make a positive return without taking some form of risk.

Determining leverage risk

To help understand leverage risk, consider this simple example:

  • Scenario 1: Investor A puts her money into FX (that is, currency) based assets, which typically move up and down by no more than 5 to 15 per cent over a few months, or even a year. This investor decides to gear up her returns by using 2 times leverage; that is, for every £1 she puts in from her own money, she borrows another £2 from someone else.

  • Scenario 2: Investor B buys into very volatile commodities that can increase and decrease in price by more than 50 per cent in a matter of a few months, but doesn’t use leverage; that is, he invests £1 of cash in the investment hoping for a big increase in value for his financial asset.

Six months later the currency investment in Scenario 1 (say a pair between the US dollar and UK sterling) has fallen by 15 per cent, giving investor A a 30 per cent loss (2 times leverage).

The commodity investment of Scenario 2 has also fallen in value, but the underlying asset is much more volatile and has decreased by 30 per cent in value. Investor B has made a 30 per cent loss, which is the same loss as Investor A, who owns a much less volatile asset.

This example illustrates a classic hedge fund quandary. What’s more risky:

  • A fund invested in a volatile asset but with borrowing leverage of 2 times capital (Scenario 1)?

  • A fund with 100 per cent market exposure and a beta of 3 times but no borrowing leverage (Scenario 2)?

In essence this quandary involves looking at risk using two different measures:

  • The market risk (beta) of the asset being purchased; that is, how much the price of the asset moves in relationship to the wider market.

  • The leverage that’s applied to the investment.

The answer? Neither.

Each tactic – buying riskier assets and increasing the leverage ratio applied to a given set of assets serves to increase the risk of the overall investment. This means that if a portfolio has very low market risk (invested in lower volatility, lower beta assets), higher leverage may be a better idea than investing in an unleveraged fashion in assets that have a higher beta and are much more volatile.

As top fund manager Ray Dalio puts it: ‘If investors can get used to looking at leverage in a less prejudicial, black-and-white way – as in “no leverage is good and any leverage is bad” – I believe that they will understand that a moderately leveraged, highly diversified portfolio is considerably less risky than an unleveraged non-diversified one.’

The relationship between risk and leverage is complex. In particular, when comparing different investments, a higher degree of leverage doesn’t necessarily imply a higher degree of risk.