What works for you can also work against you.
Investing advice is everywhere, but unfortunately, a lot of it is bad -- and even dangerous. One of the most dangerous is the recommendation to use leverage to get a greater return on investments.
Leverage is when you borrow money to invest, and this strategy is often promoted by dubious investing influencers. If you've ever seen the disastrous real estate investing "advice" on TikTok, you've probably heard about how leverage is this amazing tool that can make you big money. It's not just used for real estate, either. People buy stocks and other types of investments on leverage.
Financial advisor Ramit Sethi gives the opposite advice. He recommends that most investors stay far, far away from leverage, and he's 100% right.
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Why Ramit Sethi advises against using leverage
If you're unfamiliar with using leverage to invest, it helps to know exactly how it works. Here are a couple of popular examples of leverage in action:
- Buying real estate: You can purchase a home with a down payment of 20% or less and let the mortgage lender cover the remaining 80% or more. This is the largest amount of leverage available to most people.
- Investing on margin: Many stock brokers offer margin accounts that allow you to borrow money to invest. If your investment increases in value, this amplifies your returns.
Sethi has discussed leverage several times on his Twitter account. He believes that employing leverage shouldn't be a goal for the average investor, because it's an advanced strategy that can go bad quickly. In a recent tweet, Sethi said, "Leverage is lionized on social media without properly explaining the risks."
That's all too true. The people who promote leveraging focus on the potential benefits. The house you invest in could be worth 25% more in a few years! Buying stocks with margin will boost your gains!
They usually avoid talking about those pesky risks. Things like:
- Your real estate investment might not increase in value. If you buy at the peak and the price falls, you could be stuck paying a mortgage for much more than the property is currently worth.
- If you buy stocks on margin, you're on the hook if the price drops. This can trigger a margin call if the value gets too low. A margin call requires you to deposit more money, otherwise the broker will liquidate some or all of the stocks you purchased.
Leverage multiplies gains and losses. The more you borrow, the greater your potential downside. And remember that you need to pay interest on the money you borrow, which cuts into any returns.
You don't need to invest with leverage
Many investors, especially those who don't have large portfolios yet, like the idea of using leverage. Everyone wants to build wealth faster. Leverage may seem like the secret to doing just that.
While this sometimes works out, for most investors, it's an unnecessary risk. There's no safe way to dramatically increase your returns.
You're much better off focusing on a few sound investing and financial habits. These will do a lot more for you than high-risk strategies. Here are the habits to focus on:
- Set aside a portion of your income to start investing. This could be 10%, 20%, or whatever number you're comfortable with. Regular investing is the key to building wealth.
- Build a diversified portfolio. You could do this yourself by investing in 25 or more quality companies. Or, you could pick low-fee investment funds that contain a large number of stocks, such as index funds.
- Grow your income. Look for opportunities to get raises and move up in your career. Making more is the easiest way to invest more and speed up the wealth-building process.
- Stick to long-term investing. Plan to hold your investments for at least five to 10 years. Short-term investing is much more of a gamble.
If you do those four things, your portfolio will grow, and you won't need leverage. It takes time, but it's the surest path to building wealth.
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FAQs
He believes that employing leverage shouldn't be a goal for the average investor, because it's an advanced strategy that can go bad quickly. In a recent tweet, Sethi said, "Leverage is lionized on social media without properly explaining the risks." That's all too true.
What does Ramit Sethi say about investing? ›
Don't Make Excuses To Not Invest
Sethi explains that while most people have financial limitations, they will never get rich simply because they have poor money habits. Anything new can be overwhelming before you do it. But, purchasing your first stocks is how to get over this fear.
Why is employing leverage not a good idea? ›
Disadvantages. If investment returns can be amplified using leverage, so too can losses. Using leverage can result in much higher downside risk, sometimes resulting in losses greater than your initial capital investment.
Why you should avoid leverage? ›
A disadvantage of using leverage is the increased risk. When traders borrow funds to invest in assets, they essentially use debt to finance their investments. That means that if the investments do not perform as expected, the trader may lose their initial investment also, owing money to the lender.
What is the best explanation of leverage in real estate investment? ›
Leverage uses borrowed capital or debt to increase the potential return of an investment. In real estate, the most common way to leverage your investment is with your own money or through a mortgage. Leverage works to your advantage when real estate values rise, but it can also lead to losses if values decline.
How did Ramit Sethi make his money? ›
Most of his wealth is created from his online businesses, including I Will Teach You To Be Rich, Growth Lab, premium online courses, etc. Ramit started his blog IWT (I Will Teach You To Be Rich) in 2004 while studying technology and psychology at Stanford. He started his online journey selling a $4.95 eBook.
Can you be a millionaire from investing? ›
Investing in the stock market remains one of the most tangible ways to become a millionaire. It is available to everyone, and it does not require luck, a rich family background or entrepreneurial genius. The only differentiating factor is the number of years it takes every individual to get to those million dollars.
Why leverage is bad? ›
Risk of Losses: While leverage has the potential for increased returns, it also amplifies losses if the investment performs poorly. If the investment declines in value, the borrowed funds still need to be repaid, potentially leading to financial strain or even bankruptcy.
Is leveraging a good idea? ›
You don't need to invest with leverage
While this sometimes works out, for most investors, it's an unnecessary risk. There's no safe way to dramatically increase your returns. You're much better off focusing on a few sound investing and financial habits. These will do a lot more for you than high-risk strategies.
What is the advantage and disadvantage of leveraging? ›
While leverage can enhance gains when the market moves in favour, it also escalates losses if the market moves against the position. It's important to note that leveraging magnifies risk and isn't suitable for all investors. Sudden market fluctuations can lead to significant losses.
It helps you increase the movement of your dollars through your assets. It also allows your dollars to do multiple jobs, and when that happens you can increase your cash flow. Leverage also gives you access to deals you might not otherwise have.
What is leverage in simple words? ›
to use something that you already have in order to achieve something new or better: We can gain a market advantage by leveraging our network of partners. SMART Vocabulary: related words and phrases.
What are the disadvantages of too much leverage? ›
The risks of leverage
This additional pressure on cash flow can lead to an increased risk of insolvency and bankruptcy during a downturn. It also reduces future funds available to re-invest in operations or distribute to investors.
Why do investors use leverage? ›
If you're confident about an investment, leverage allows you to invest more than you otherwise could and potentially enhance your profits. In addition, some investors may choose a leveraged approach to assist with their cash flow management.
What is the best way to explain leverage? ›
Leverage is the use of borrowed money (called capital) to invest in a currency, stock, or security. The concept of leverage is very common in forex trading. By borrowing money from a broker, investors can trade larger positions in a currency.
How to use leverage to build wealth? ›
By using borrowed capital or debt to increase the potential return of an investment. Leverage allows you to do more with less. It takes three things to build wealth: time, knowledge, and money. You can leverage any of these to amplify your returns.
What does Robert Kiyosaki recommend investing in? ›
Robert Kiyosaki, known for his investing advice and his “Rich Dad Poor Dad” series of personal finance books, has taken to social media again to alert investors about what he thinks they should be doing: investing in gold, silver and bitcoin.
What does Dave Ramsey say about investing money? ›
A lot of people have questions about when and how to invest their money, and that's totally okay! Plain and simple, here's the Ramsey Solutions investing philosophy: Get out of debt and save up a fully funded emergency fund first. Invest 15% of your income in tax-advantaged retirement accounts.
What is a wise saying about investing? ›
Be Patient and Think Long-Term
- “Invest for the long haul. Don't get too greedy and don't get too scared.” ...
- “Waiting helps you as an investor and a lot of people just can't stand to wait. ...
- “The stock market is a device to transfer money from the impatient to the patient.”
He believes that the most important quality for an investor is temperament, not intellect. A successful investor doesn't focus on being with or against the crowd. The stock market will experience swings but Buffett stays focused on his goals in good times and bad.
