Want to get rich quick?
Want to bankrupt yourself?
In today’s Money Morning we consider leverage – the double-edged sword that can make you or break you.
And we ask whether now is the time to embrace or to avoid it.
How leverage can make you a fortune – or lose the lot
According to the Land Registry, in the fourth quarter of 1997, the average UK house cost £72,723. By December 2017, that figure had risen £226,756.
So, over the course of the last 20 years, which have perhaps witnessed the greatest house price boom in British history, house prices have, give or take, tripled.
A triple over 20 years is good, but it is not extraordinary, and that’s before you take inflation into account. “A triple less inflation” in no way describes the enormous gains some have made in the UK housing market since the late 1990s. So how do we explain them?
Two significant factors are the type of property you buy and the area in which you buy. Period property has seen greater appreciation than new-build. The likes of London, Brighton and Bristol have seen greater gains than Hull, Newcastle or Grimsby.
But, to my mind at least, there is another, greater force at play – leverage.
Let’s say you bought that average UK house in 1997 with a 10% deposit. You paid – excluding costs, and using round numbers – around £7,300. The other 90% – £65,000 – was borrowed.
Let’s assume – and I doubt anyone has done this over the 20-year time frame – you had an interest-only mortgage. You didn’t borrow any more. You didn’t pay any back. You paid the interest; no more, no less. You would owe £65,000 on your £226,756 property, meaning you had £161,756 in equity.
Thus you have turned your £7,300 deposit into £161,756. I make that a 22-bagger.
Even if you factor in interest and other mortgage costs, which I haven’t, that is some appreciation: no wonder that a whole generation of middle-class professionals declare their house to be the best investment they ever made.
Of course, leverage works both ways.
Had that £72,723 house fallen in value by 10%, the owner would have lost all their money. Had it fallen by 20%, not only would they have lost their money, they would find themselves owing the same amount again. Bankruptcy would be a possibility (it’s what happened to many during the 1989-94 house price bust).
A cautionary tale about using borrowed money
The housing market is just one example, but it’s the most obvious means by which ordinary citizens gain access to leverage. Another is by spreadbetting.
Most people have no idea of the risks they are taking on when they spreadbet. Some chance extraneous event can destroy you. In 2015, for example, the Swiss National Bank unexpectedly announced that it would scrap its ceiling against the euro, and the Swiss franc surged.
In total, according to The Daily Telegraph, 370 clients of the spreadbetting firm IG lost £18m in just a few minutes. One teacher from Ireland, earning the euro equivalent of £17,800 a year, found himself facing a loss of £280,000.
I dread to think what he must have gone through.
But what if that bet had gone in his favour? These are the sort of gains that can change lives.
The leverage that some spreadbetting firms offer is extraordinary. Without naming names, I can get £100,000-worth of gold with barely £700 of margin required. I can get £100,000 of oil exposure with less than £1,500 margin required. To hell with it, I can get a full million pounds worth of Dow exposure for little more than £10,000.
Obviously, if the bet goes against me, the amount of capital required to keep the position open will grow very quickly. Sure, if it doesn’t – boy do you make out! But unless you are an extraordinarily good market-timer and you have deep enough pockets and sensible enough risk-management in place to protect yourself should the trade go against you, it is most unwise to be placing bets that large with that little capital..
However, leverage, used sensibly, can work extremely well. That might be the homeowner above who got £72,723 of house price exposure for a £7,300 stake. Or it might be the great Warren Buffet who, according to The Economist, leveraged Berkshire Hathaway’s capital by around 60% and, using his insurance companies, borrowed the money at low cost. Without this leverage “Mr Buffett’s returns would have been unspectacular”.
You could invest a million in the stockmarket. The market goes up 10%; you make £100,000. Or you could invest a million in a leveraged way that gives ten million of exposure. The market goes up 10%; your million is now £2m. Ordinary market returns can become substantial with leverage.
But so can ordinary market losses.
“When leverage works”, says the Sage of Omaha himself in his 2010 shareholder letter, “it magnifies your gains. But leverage is addictive. Once they have profited from its wonders, very few people retreat to more conservative practices.
“And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”
So be warned!
This is the one asset I feel tempted to bet on right now
So how does this apply today?
If you’re going to use leverage, you have to have a plan; you have to have a good reason to make the bet you’re making (in other words, it has to be a high conviction trade); and you absolutely must manage your risk – you have to know your downside before you act on the trade. I cannot emphasise this enough – you do not want to end up like the poor Irish teacher mentioned above.
To me, there’s not a lot that appeals right now.
Stocks don’t seem to me to be in the runaway bull market they were six months or a year ago. There is a pause for breath, it seems, while they decide whether the bear market begins now or later.
With no clear short-term trend, a levered bet is probably a risky one. That, rightly or wrongly, is my reading of stockmarkets. Commodities and currencies seem to be in a similarly undecided mode. Until clearer trends are in place, I would err on the side of caution.
That said – I still like the look of platinum down here at these levels. It is cheap. At around $1,000 an ounce, it is near the top of its current range, but this is a range it could easily break out of.
On the downside I don’t see how it can fall much below $770-$800 – which would be a 20% or so drop from here. On the upside, there is a lot of potential. It’s now more than 50% off its all-time highs above $2,200. Even just $1,325 looks possible in the next year or so.
So on that front, it’s tempting to place a levered bet, with enough capital to weather a drop to, say, $750.
And of course, if you’d rather not use leverage (which is perfectly sensible), then you could play platinum directly using the London-listed platinum ETF – ETFS Physical Platinum (LSE: PPLT).