Home > Uncategorized > Availability Of Leverage Increases Risk

Availability Of Leverage Increases Risk

January 31, 2012 Leave a comment Go to comments

This statement is not surprising: “if you borrow money to invest in stocks, you are exposed to a risk”. This statement is surprising: “if you can borrow money to invest in stocks, even if you don’t, you are exposed to a risk”. The reason for the difference is that most people don’t understand economics. While the risk isn’t exactly the same, many of the same things are happening when there is increased borrowing whether you take part or not.

I’m finally getting the chance to read Lifecycle Investing (which I heard about recently). It talks a lot about borrowing to invest and makes the comparison to housing where we don’t wait until we’re 50 and save up the full price of a house. This allows us to spread out our housing market risk since the market will go up and down over the 50+ years that we own one or more houses.

In both stocks and housing we can borrow money to purchase more. Both have seen an increase in the amount we can borrow. At one time people would borrow a small portion of the price of a house or even borrow as much as they had saved if they were really pushing it. Now people complain if they need more than a 5% downpayment. In stocks there have been varying amounts of leverage available at different times but it seems like large market players have been able to borrow more in the last 10-20 years than they could before. And both markets have experienced more risk and volatility in the last 10-15 years.

The reason is the same as when government affordability programs don’t make things more affordable. If buying a house required a 30% down-payment, some people would find it easy and others would struggle. If the government stepped in to make it more affordable by allowing people to buy with a 15% down-payment, people with a minimum down-payment could suddenly afford to spend twice as much on a house.

Since people don’t always make a strict economic calculation of the lifetime value the house provides, anyone who wanted to get a little more than they could before would spend more. And since it’s not the total amount you spend that counts but how much more you spend than others, the competition would soon lead everyone to spend twice as much. In the end people would end up struggling just as much to buy a house with a lower down-payment if the price increase balanced it out.

The same thing works with just about anything. Take student loans for example. It’s hard to go through an election cycle without someone talking about making things more affordable for students due to rapidly rising tuition. Now imagine there were no student loans, and guess what tuition prices universities and colleges would set. If they are too expensive for students to attend they aren’t gaining much.

When more leverage is available for things like stocks and houses, someone will borrow more, pay more, and increase prices. There’s also a chance that they will do this when it’s not a good move or when prices are too high already. Increasing prices that aren’t supported by fundamentals mean increasing risk that they will return to normal. So even if you buy a house or a stock without borrowing money, the chances are greater that the price will go down because others have borrowed.

This doesn’t mean all leverage is bad. When something important like houses, stocks, or education can’t be paid for with a loan it’s safer because the price is too low since many people who would benefit from it can’t afford to buy. And when you don’t borrow you don’t have the risk of paying back a loan when you’ve lost the money. But if it is possible to borrow it will affect you one way or another. If you vote for policies that increase leverage for everyone you are increasing your financial risk!

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