Alex Rodriguez has hit more than 40 home runs eight times in his career and posted some of the most impressive stats in baseball history. But in August he was handed a 211-game suspension for allegedly using performance-enhancing drugs over many years. The scandal may end his career and kill his chances of entering baseball’s Hall of Fame.
High-priced ball players and other athletes sometimes turn to illegal drugs to boost their gains. Unfortunately, these substances can lead to harmful, even life-threatening side effects. Some investors and advisers can succumb to the same temptation: by borrowing money to invest they’re shooting for explosive gains by taking on explosive risk. Leverage is the steroids of the financial industry.
When leverage goes wrong, it tends to go really wrong. Just ask any investor who has been asked to make a margin call. If you can’t come up with the required funds, your financial institution can force a sale of an investment to bring your account back into line. Since that margin call was likely triggered by the investment going down in the first place, it forces you to sell low.
Instead of margin accounts, you can also take out investment loans, which can be just as dangerous. Imagine borrowing $50,000 to put into an equity mutual fund that drops 30% in one year. Your portfolio would now be worth $35,000, but you still owe $50,000 plus interest. Had you simply set up a monthly contribution to that same fund you would be sleeping a lot better at night. Sometimes, boring is beautiful.
Leverage can be big business for the peddlers. Not only is there money to be made from interest charged on borrowed funds, but the proceeds of the loan go into investment funds that can command high commissions or ongoing fees. It’s an easy way to meet sales quotas.
Unsuitable leverage is one of the most common reasons for investors to file complaints with regulators. Borrowing to invest should be reserved for sophisticated investors with high-risk profiles, high incomes and high net worth, and who have experienced more than one bear market. Even then, it can still be high drama.
Leverage isn’t illegal, but it’s not for beginners under any circumstances. If you want to boost the size of your portfolio when you’re just starting out, concentrate on beefing up your savings rate first. Once you’ve been around the block a few times, you can decide if you want to start dipping your toes into the wild ride that is borrowing to invest.