Three Rules Of Leveraged Investing

How did rich people get that way?  One word:  leverage, which according to Investopedia is

“The use of various financial instruments…such as margin…to increase the potential return of an investment.”

Employing leverage, also known as Other People’s Money by pop-finance books such as Rich Dad Poor Dad (note:  While I’m not a huge fan of RDPD overall, author Robert Kiyosaki does a good job of discussing the benefits of leverage), is the easily the quickest road to riches.  Borrowing money to purchase investment real estate, start a small business, or buy a large position in the next Microsoft (good luck with that!) are all examples of leverage.  If things go your way, you can make a lot of money very quickly.  But leverage doesn’t necessarily refer only to financial instruments.  You can also leverage your skills (write software to automate a tedious process), other people (hire an employee to do marketing for your business), and leverage your time (delegate non-core responsibilities to others).  Of course, leverage cuts both ways as those who purchased bubble real estate with little or nothing down can personally attest.  While inexperienced investors should avoid leverage due to the risks involved, there are situations where borrowing to purchase an investment can make good sense.  To that end, here are three rules of leveraged investing.

1. Never Accept Negative Cash Flow – When borrowing for investment purposes, it is paramount the current income from that investment is sufficient to completely pay your current borrowing costs.  This applies whether you’re borrowing to buy investment real estate, government bonds, or a dividend-paying stock.  Never purchase an investment on margin that doesn’t pay for itself month-by-month.
2. Diversify, Diversify, Diversify – This is a situation where even relatively modest amounts of volatility can ruin you if you’re not careful.  Never use leverage to buy an investment that will comprise more than 5-10% of your total net worth.  I realize with larger investments that require a lot of capital such as real estate this will be difficult to manage at first, but you should always strive for greater diversification.  You may only be able to afford one investment property at first, but don’t stop there.  Continue expanding (prudently, of course) until you own multiple rentals along with a sizeable stock and bond portfolio.  Diversification is much easier with stocks:  just buy a broadly-diversified ETF or two.
3. Don’t Expect Miracles – While leverage can certainly enhance your returns significantly, it’s not a get-rich-quick scheme.  It will still take years of sustained effort to amass anything close to a fortune.  If your expectations are too high, it’s more likely you’ll get impatient and take on too much leverage, increasing your chances of disaster.