Big economic events, popularized as “black swans”, are known to happen more often than standard economic theory predicts. However, it’s not easy for most investors to figure out what they should do with this information other than to be vaguely worried. One important implication is that leverage is more dangerous than it appears.
Leverage just means borrowing to invest. If you invest $50,000 and it goes up 10%, you make $5000. But if you had borrowed another $50,000 at 4% interest, you’d have made $10,000 less $2000 in interest for a profit of $8000. When investments are rising, leverage is a wonderful thing. However, when investments are dropping, leverage magnifies losses. There is even the possibility of going completely broke if the value of your investments drops below the amount you owe.
In most cases where investors use leverage, they can weather minor storms by paying off the leverage loan with employment income. This way they can wait out stock market tumbles until prices rebound. However, a big enough stock market crash might knock a leveraged investor out of the market completely leaving huge losses. It’s tough enough to watch a portfolio half in stocks get hammered, but it’s another thing to be 200% in stocks and watch them plummet.
Proponents of leverage often talk of Sharpe Ratios and the optimal amount of leverage. These formulas are based on the standard Bell curve and do not give results that are useful for most investors. Be very wary of leverage.