A BlackBerry-Inspired Lesson in LeveragingMy old friend who is always chasing the big trades, Mr. Speculator, is at it again.
In a recent discussion with him, he said that “investors should always borrow on the capital they have, so their returns are better…instead of just making a measly two percent, they can make 10%.” In other words: he suggests leveraging your portfolio for higher gains.
I have to give credit to Mr. Speculator, because he has the concept right, to say the least; leverage can increase an investor’s profits substantially, and magnify smaller moves into much bigger rewards.
Consider this scenario: Say you have $1,000 in your portfolio, and you borrow an additional $5,000 from your broker—or anyone else, for that matter—to buy shares of ABC Inc., which trade for $5.00 each. With this sum of money, you will be able to buy 1,200 shares. Now, if the price of the stock goes up in value by, say, 10%, the return on your original investment ($1,000) will be 60% (the stock yields a profit of $0.50, and 1,200 shares gives you a total profit of $600.00).
But Mr. Speculator is forgetting the dark side of leverage—increased loss.
Look at the chart below for BlackBerry (NASDAQ/BBRY), formerly known as Research In Motion Limited, after the company reported a loss of $84.0 million, or $0. 16 per share, for the three months ended June 1, 2013. (Source: “RIM posts larger-than-expected loss, shares plunge,” Associated Press, June 28 2013.)
Chart courtesy of www.StockCharts.com
The share prices plummeted more than 27% at the open after the announcement. Now, consider if you had $1,000 and you borrowed another $5,000 and bought BlackBerry shares when they were trading at $15.00—you would have 400 shares. If you held onto the shares going into the earnings, you would have lost your $1,000 and more: a loss of $1,800, with a buy value of $6,000 and a sell value of $4,200.
And keep in mind that these examples don’t include the broker’s transaction fees and interest rates charged on the borrowed money.
At its very core, leverage is a double-edged sword. If it works in the investor’s favor, it can reward substantially, as Mr. Speculator maintains. But if it doesn’t, then an investor can see their entire portfolio disappear very quickly.
For those who are closing in on their retirement, leveraging heavily can cause significant damage to the portfolio. If they do insist on taking leverage, they must remember not to keep all their eggs in one basket—for example, investing all of their capital, plus the borrowed funds, in just one stock.
When leveraging their portfolio, investors must use proper risk management. They must make use of stops and have loss limits in place. As is evident from the BlackBerry example, if investors don’t manage their trade properly, it can make a huge dent in their life savings.
This article The Priceless Lesson Investors in BlackBerry Received was originally published at Daily Gains letter and has been republished with permission.
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