What is Leverage? It’s why the sky is falling

The sky is falling! The sky is falling!

Bad omens abound. The worst is yet to come. Fear grips, panic spreads. This is just how the last bad one started. Get out while you can. If you’re leveraged, you’re sunk. Ok, so what is leverage? We’ll get to that.

The financial world lives in a space where an economy that grows by 2% is worthy of jubilation. But an economy that shrinks by 2% is indescribably terrible.

Imagine, if you would, feeling joy when your bag of Lays has 100 chips, two chips above the average of 98. Yes!, you exclaim, 100 is just wonderful!

Then the next bag only has 96.

96?

96?!?

Lamentations echo around your dread-filled mind. 96 will ruin you. All the models suggested there would be 98 chips. How could there only be 96?!

Snap back to reality. This chips example doesn’t really make sense on face value, does it? That’s not how we act in our lives. But this is how the stock market acts. How can a 4% differential be so consequential? Why do they act so differently than us?

Bet Big, Lose Big

Leverage is one reason why. Leverage is a fancy term that means people are placing bets using borrowed money.

Wanna get leveraged? Use $10 as collateral, and get a bank to lend you $90 more. Invest the total $100—wisely—and turn it into $110. Repay the bank its $90 plus $2 for loan interest, and keep the remaining $18. Your $10 turned into $18, for a 80% return. That’s phenomenal.

But when the market drops, leverage twists your arm. Let’s say your $100 total hits a 3% drop. Now it’s worth $97. You still owe the bank the $90 plus $2, and you end up with $5 leftover. The market went down 3%, but you took a 50% loss.

That’s why 3% changes make headlines! It’s because some risky investors just saw a huge portfolio change.

If wolves are scared, why aren’t the sheep?

Last week, the stock market took a 3% drop in a single day. China’s central bank made some changes, people who were invested in China got nervous, and those nerves fire and ripple across our global economy. Hence, Apple’s (and Amazon’s and Microsoft’s etc) stock price dropped by 3% in that single day.

But, did Apple become a worse company? Did they sell fewer gadgets, fire key executives, or lose key supply chain vendors? Put another way: did the fundamentals to Apple’s business change by 3% in that one day? No! Absolutely not! None of those fundamentals changed at all in a single day.

So if you’re invested in Apple (or any other asset) for the long term, then what do you have to be worried about daily changes? Should you care? Has Apple’s 5-year future changed at all because China’s bank is playing Monopoly? I say no!

What is leverage? Here’s the takeaway

Don’t let the panic of others infect you. Walk outside and look up. If the sky is actually falling, then why does the stock market even matter? Until that fateful sky sundering day, just chill and let the panic settle out—or maybe even “be greedy when others are fearful,” as Warren Buffett would suggest. If you’re invested long term, then think long term. Panic always subsides. Those who maintain their long-term investments have always come out on top. Don’t be a chicken little.

Thanks for reading the Best Interest blog. -Jesse