You may have heard the term leverage in the world of investing. But do you really know what leverage is and how to use it? In investing, leverage is a strategy that involves using borrowed capital to increase potential returns—but it also comes with greater risk.
In this article, we’ll take a detailed look at how leverage can be a powerful tool to boost an investor’s purchasing power. You’ll also get insights on how to use it strategically, along with helpful formulas to calculate leverage ratios. So, keep reading!
What Is Leverage?
According to Investopedia, leverage is the use of borrowed funds to increase potential returns. In investing, leverage is commonly used to buy assets larger than your available capital. In other words, leverage allows you to control more assets than the money you actually have.
For example, if you have IDR 10 million and want to buy a house worth IDR 50 million, leverage enables you to borrow IDR 40 million from a bank to cover the rest. This way, you acquire a IDR 50 million asset with just IDR 10 million in capital.
However, keep in mind that using leverage also increases the risk of loss. If the asset’s value decreases, you still need to repay the debt. So, leverage should be used wisely and cautiously.
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How to Use Leverage
There are several ways to use leverage in investing. One common method is buying stocks on margin. This involves borrowing money from a broker to purchase more shares than your current funds allow.
For instance, if you have IDR 5 million and want to buy stocks worth IDR 10 million, you can borrow IDR 5 million from your broker. If the stock price goes up, your profit will be greater than if you had invested your own capital only.
However, if the stock price drops, you still have to repay your broker. So, it's important to fully understand the risks associated with using leverage in stock trading.
Advantages and Disadvantages of Using Leverage
Leverage offers both benefits and risks. Here are some pros and cons you should consider before using leverage in your investments:
Advantages:
- Allows you to increase your potential returns from investments
- Expands access to markets and investment instruments that might otherwise be out of reach
- Reduces the need for large initial capital to make investments
Disadvantages:
- Can increase the risk of losses
- May accelerate losses if asset prices drop
- Can lead to higher costs in the form of interest or margin fees
Leverage Formula
The leverage ratio compares the amount of borrowed funds to the investor's own capital. The basic leverage formula is as follows:
Leverage = Borrowed Funds / Equity
For example, if an investor has IDR 10 million and wants to invest in assets worth IDR 50 million, they would need to borrow IDR 40 million. In this case, the leverage used is:
Leverage = IDR 40 million / IDR 10 million
Leverage = 4
From this example, we see that the investor used 4x leverage—meaning they borrowed 4 times the amount of their own capital to make the investment.
But remember: the higher the leverage, the higher the risk of loss. That's why you must carefully evaluate your strategy before applying leverage to your investments.
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