The Dangers of Leverage

Want to earn a tantalising 800% return on your investments in a single year? Sure – try leverage. Want to lose 800% on your investment funds in a single year? Well… try leverage too. Welcome to the world of leverage, where you can just as easily win big or lose more than everything you have.

The concept of borrowing money is commonplace nowadays and debt-related financing options for individuals for all kinds of purchases are not hard to come by. For instance, credit cards are easily available to anyone with a pay slip and I even get cheques from my bank every month, asking me to bank them in for a personal loan with “low interest rates”.

In the investing realm, there too exist products that would allow you to, in effect, borrow money to invest. A CFD (contract for difference) is one such product. With it, you could perhaps buy shares with just 10% of the face value of the entire investment and it’s easily available in most brokerage firms.

With all kinds of debt-instruments available, you could even theoretically take out a personal loan and use that borrowed-money to buy CFDs to really juice those returns and earn profits without any real cash outlay on your part.

But Beware!

There’s a saying that goes: There are no free lunches in this world. In the realm of finance and investing, that’s all the more true – there is always a catch and leverage, at the end of the day, works as a double-edged sword.

Let’s run through an example. Imagine you had S$1,000 to invest today. With a theoretical CFD that only requires an initial outlay of 10% of the face value of an investment, you could buy, say, 1000 shares of Singapore’s most geographically diversified bankOversea-Chinese Banking Corporation (SGX: O39), at its current price of S$ 9.61 each. Even though 1,000 shares of OCBC purchased outright would set you back by at least S$9,610 (excluding frictional costs), a CFD with a 10% margin-requirement would only require you to cough up S$961.

So let’s say you now hold the investment for a year, the end of which sees OCBC at S$8.00 per share. If you choose to cut your losses, you’d have incurred a loss of at least S$1,610 [(S$9.61-S$8.00) x 1,000]. Note the phrase ‘at least’ –there are all kinds of charges and frictional costs associated with the trading of the CFD. Some of the more noteworthy ones are the financing charges which the brokerages charge users each time a CFD is purchased. It’s usually based on the contract value of the CFD (it’s [$9.61 x 1000] in our example) and typically comes up to around 6% per annum. Add all that up, and it’s really easy to suffer a loss that are multiples of your investable sum even if the drop in the actual share price of the company is a more mundane 10% or 20%.

The next time you decide to use leverage for your investments, do use it wisely as one bad stroke of luck can wipe out your years of gains and even more.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.