Using Other People’s Money To Get Rich
I often hear “rules” from investors … sacred guidelines that are never to be broken.
But the problem with most of these absolutes is that the real-world is more complicated than they suggest.
Take the concept of leverage – the idea of using borrowed money to control more of something than you might be able to afford otherwise.
Since leverage amplifies results, and could lead to substantial losses, I hear a lot of people say it’s best avoided at all costs. Always.
I don’t agree. I simply think it’s a powerful tool that needs to be used correctly and in the right scenarios.
Before I get into how leverage might apply to the stock market, let’s just talk about it using a different context: Real estate.
Just about every American is familiar with the concept of flipping houses, which really gained national prominence during the real estate bubble and continues to be featured in a whole slew of TV shows, how-to seminars, and mainstream media features.
The basic process entails buying a property, usually a single-family house, with the intention of quickly re-selling it for a profit rather than renting it or occupying it.
In some cases, especially during the housing boom, you didn’t even need to do anything other than pick a property in a hot market and wait a few weeks.
More recently, the theme has shifted toward buying properties that need various levels of improvement then trying to re-sell them at market prices.
But in all instances, the real unifying factor is carrying the property for as little time as possible. And the key to the biggest profits is by leveraging “other people’s money” whenever possible.
To see why, simply consider two scenarios using the same property:
You pay $300,000 cash for a property. You put in $20,000 worth of renovations. Then, three months later you happily accept an offer at $350,000.
Frictional costs aside, you’ve walked away with a quick $30,000 profit on your $320,000 investment.
That’s a nice return of 9.375% on your invested capital over three months!
You still pay $300,000 for the property. But instead of paying cash, you finance 80% of the transaction.
This second scenario is using the power of leverage.
After all, you contributed only $80,000 of your own money — $60,000 down and $20,000 for the renovations.
But when you sell the house for the same $350,000, you STILL walk away with $30,000 in profits free and clear.
Thus, the overall return on your original investment has skyrocketed to 37.5% … FOUR TIMES HIGHER!
Am I saying you should start flipping houses using borrowed money?
No. I am merely pointing out that leverage can provide an advantage for someone who understands what they’re doing.
Heck, anybody who currently has a mortgage on a property is actually using leverage right now!
There are plenty of ways to use leverage when it comes to stocks and funds, too.
For example, instead of putting up the full amount it takes to buy 100 shares of a stock like Alphabet (currently more than $1,000 a share), you can buy a call option that gives you control of 100 shares for just a fraction of the money.
On top of that, if the trade works out, the return on your investment will likely be multiplied many times over.
And like house flipping, the faster the whole process takes, the better!
In fact, when you buy an option you only have so much time for the investment to work out at all.
If it doesn’t, you’re going to lose the entire amount you spent on the contract.
Fortunately, that’s the most you can lose.
In contrast, a house flipper who financed the majority of a purchase could easily end up owing the bank MORE than the initial down payment.
And that’s something a lot of folks learned the hard way, no matter what the TV shows lead you to believe.
One other thing to consider with options is the fact that you can also buy PUT options, which give you the chance to profit from DECLINING stock prices.
Again, the advantage is that the most you can lose is the amount you spent for the option.
Compare that to another popular way to profit from declining stock prices – short-selling.
When you sell a stock short, you are essentially borrowing shares at current prices and then hoping to buy them back when prices are lower.
However, in this version of leverage, it’s possible to lose far more – far more quickly – than you might anticipate.
So, for me, buying a put option is the better way to use leverage in most cases where you’re looking to aggressively target a stock’s price drop.
And as we discussed in a different issue of The Roadmap, it is also now possible to use leveraged exchange-traded funds to magnify profits (or losses) from all types of different assets, too.
Again, there are advantages and disadvantages to going that route and time will still be a major factor in how well the leverage works (or doesn’t).
But the bottom line is that you shouldn’t automatically assume leverage is always bad.
While it brings a lot of potential issues when used carelessly, it’s also the reason most Americans are able to buy their houses.
To a richer life,
Editor, Rich Life Roadmap