Everyone is upset about the word debt. But do you know you can use debt to make money!
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Debt can be used as leverage to multiply your returns exponentially. Leverage is using borrowed money to increase your return on investment. Leverage can allow you to achieve returns that you thought were impossible, but at a greater risk of losing your capital. These 5 ways will tell you more about how debt can make you richer.
Margin Investing: Investing on margin allows you to buy a higher dollar amount of stock than you actually have money for. For example, if you had $50,000 in your traditional brokerage account, you could leverage your investment and open a margin account. A margin account allows you to only put up a max of 50% of the purchase price of a stock. You would have $50,000 in cash and an additional $50,000 would be loaned to you from your broker. Your $50,000 investment gives you $100,000 worth of buying power. You could use this money and buy $100,000 worth of stock.
If the stock price appreciates then you can pay back the loan and pocket the profit. That sounds great! The negative is that if the equity in your account falls below a certain value, your brokerage firm can issue a margin call. What is a margin call? Your broker can liquidate your entire position in a stock leaving you broke.
Leveraged ETFs: Leveraged ETFs allow investors and traders to amplify their returns by getting long or short on a particular index. Fund companies like Proshares offer leveraged ETFs that let investors multiply returns (and losses) 200% and 300%. These funds let you invest in specific indexes, bonds, commodities, or sectors. Leveraged ETFs are attractive because of the extraordinary profit potential. During market booms, you can achieve returns with leveraged ETFs that other investors dream about.
The problem is that the same way that leveraged ETFs work for you is how they can work against you. Unless you are great at trading in and out of these funds, leveraged ETFs can magnify losses by wiping out your entire investment in a few days.
Hedge Funds: As we all learned during the financial crisis, hedge funds are some of the biggest users of leverage. Hedge funds are famous for generating abnormal returns by using leverage. Many hedge funds lever up to 10 times their total assets. Billionaire hedge fund managers like John Paulson have used leverage to turn accredited investors into multimillionaires.
However, if the fund manager’s investment thesis is wrong, this can drive a hedge fund out of business and lose the capital of all investors.
Short Selling: Have you ever watched a financial program on television and heard that it’s time for you to short the market? Short selling is a popular way of betting against a particular security by borrowing shares from an investor and selling them in hopes that the shares decline.
Short sellers like Bill Fleckenstein have made a fortune by properly timing declines in stock prices. The downside to short selling is that losses are unlimited which means that short sellers can lose much more than the initial investment.
Currency Trading: Currency trading allows investors to control large blocks of currency with a small amount of money. Currency investors can lever up their accounts 100:1. The pros of currency trading are that you can take a small amount of money and turn it into significant sums very quickly. George Soros is known as the “man who broke the Bank of England” netting $1 billion by betting against the pound. Conversely, currency trading has the potential to clean out a trader’s account in a matter of minutes.
Although debt can be a great way to make money these are risks associated with taking on debt .
Using debt as part of your investment strategy can introduce substantial risk including:
- Borrowing could increase potential losses
- Your losses could exceed the amount initially invested
- The value of your investments purchased using debt may not increase, or if the value does increase, it may not be sufficient to cover the costs of the loan such as interest and fees
- You may need to sell your investments sooner than intended to cover your interest, fees and charges
- If you are unable to repay your loan, the lender may have the right to sell your assets to cover outstanding repayments, interest or fees
- You may be liable to pay more tax.
In conclusion, given the level of risk associated with an investment strategy that incorporates debt, it is important to consider which approach is right for you. when it comes to taking on debt, there is always risk, but if managed well, efficient debt can help you to build your wealth over time.