Don't Mistake Leverage for Genius: How Debt Works and Why People Use it

Don't Mistake Leverage for Genius

Updated: May 14, 2020

Originally Posted: September 24, 2018

There are many ways that the figurative sheet can be pulled over your eyes today. It is easy to fall in love with the superficially impressive, the materialistically well endowed. But keep your eyes open and stay on your toes, because things aren't as rosy as they seem at face value sometimes. This whole blog post is about DEBT and why you need to understand how it is used in life and in business so that you don't get bamboozled by those who DO understand it.

To help make my case, check out the following table. It is a graphic that represents the returns of all of the major investment types from 2004 - Today. Glance over it and see the return analysis on the bottom left:

Source: novelinvestor.com

From the chart, you can see that Large Cap Stocks (S&P 500) returned approximately 8% per year over the 14 year period, and Real Estate Investment Trusts (REITs) returned about 9%. This makes it seem like REITs are the better investment (they can be a good investment at the right price!) but I am here to explain a dynamic that I believe will open your eyes to how these returns are SO flawed.

In the markets, when we are comparing investments, we want to check a multitude of financial ratios to get a gauge for the risks involved in any underlying investment. One of the most important (in my opinion) is LEVERAGE. Leverage is synonymous with DEBT. Leverage is when you borrow money and use someone else's capital to do business. This provides a magnification of returns when you are correct, as well as bigger losses when you are wrong.

For example: If you buy a home with the traditional 20% down, you are levering up. No doubt about it. How? Because you are using the bank's capital to fund 80% of your home purchase. That is DEBT, meaning you do not own the home, you own 20% of the equity in the home.

The way debt works is quite simple. Someone lends you money and you pay them back (with interest). So in the case of our home purchase, (lets keep it easy and say we are buying a $100,000 house) we dropped 20% (20k) to buy this home. If the home value goes up by $10,000 in the first year, what is our cash on cash return?

Well because we only paid 20k cash, our paper return is 50%!!! (No wonder people say real estate is such a good investment!) But lets flip the switch, what if the home price plummets 10% the first year? Now you are looking at a 50% cash on cash loss in your first year. (Ouch...)

All this to say that Real Estate is an inherently levered product unless you make your purchases in cash and in full. Most RE transactions are levered 5-10x equity. This means that buyers are only putting 10-20% of their OWN money into a deal. So what does that tell us about the returns listed in the chart above? They are flawed. Not explicitly, but implicitly, because the underlying holdings of each of the investments has a completely different leverage ratio. The average Debt-to-Equity of real estate may be in the realm of 5-10x, while the average Debt-to-Equity of a Large Cap Stock has been about .86x since 1994.

Do you see the difference? With Large Cap Stocks, you are purchasing a product that may return 8% annually versus the 9% of real estate, but it is also less levered, so the REAL returns are actually much greater because those 9% returns of the real estate investment trust are produced by massive debt on their properties.

Now, I understand WHY a company argues for the use of debt. They want to buy something today that they can't afford with someone else's money. But my argument is, why would you want to risk something that you have today for something that you don't need. To explain further, imagine not having a mortgage, or a car payment, or a cell phone lease payment. You wouldn't have to be worried about servicing any debt payments, you would just LIVE your LIFE without worrying about scraping together enough to pay the "bills". Cut the bills out all together! You are leveraging up your life if you have payments on any one of these things. Or on anything for that matter.

It is not worth risking what you HAVE for something you dont need (a ridiculously large house with a mortgage you can barely service, a stupid lease payment on a car, or even payments on a cell phone you can't afford). I recommend buying your products in CASH when possible, the only exception being on your mortgage (15 year mortgages only!).

One more extremely important thing to note is that past performance certainly does not guarantee future performance. Something I took away from Nassim Nicholas Taleb’s book “Fooled by Randomness” was that we may put too much emphasis on statistics. The future will look very different from what happened in the past, and new, seemingly crazy, seemingly random events will wipe out those who are ill-prepared. He calls this “blowing up” in his book, and I find that to be quite a fitting analogy.

This is where I hit you with the "Choose your own path, just understand the risks" cliche. But I REALLY want you to understand the risks of this one. Debt (Leverage) is a magnification tool. You CAN blow up using it. It will turn up the dial on both your returns AND your losses, so really think twice before you finance something with debt. Don’t let your assets turn into smoke.

Note: If you would like to see a regularly updated version of the asset return quilt, check out the Novel Investor’s site here.

MDAS

If you thought this was helpful, terrible, or somewhere in the middle, please leave me feedback in the form of a Direct Message on instagram @MakeDollarsAndSense, or feel free to send me an e-mail/text to the information on my Home Page. I truly appreciate constructive criticism and opposing views, so bring em on!

P.S. New blog posts coming your way every Monday!

Previous Article: Investment Fees are Evil

Next Article: The Difference Between the VTI and VOO ETFs