LEVERAGE means you can buy shares without putting down much of your own money.

TNP PHOTO ILLUSTRATION: SIMON ANG

It gives your investments some pizzazz. Some bang. Some whoop-de-doo. You will see your wealth zip around like a horse at the race track. Make that a horse on steroids.

Say you buy $10,000 worth of shares. You pay only $1,000 and borrow the rest. It is called '10times leverage'.

Here's the lingo: $1,000 is equity and $9,000 is debt. Add them to get the asset's value, which is $10,000 in shares. So far, so simple.

If the share price rises 10 per cent, your asset increases from $10,000 to $11,000. As for your equity, you earned $1,000 on the $1,000 you put up. It's a 100 per cent return.

Gee, leverage looks pretty good. It turned a 10per cent return into 100 per cent.

Can you guess the problem? It can also work in reverse. If the share price falls 10 per cent, you will lose $1,000. In that case, your 10 times leverage returns minus 100 per cent. You've lost everything. Sorry.

Leverage amplifies both gains and losses, which boosts the risks. But here's a surprise: It doesn't increase average returns. I'll tell you why.

Short-run v long-run

Academic studies show even professional traders fail to make money from short-term trades. It simply can't be done.

Issuing banks, brokers and financial advisers will tell you the opposite: All you need is a 'view'. Simply decide if a counter will go up or down. Two choices. What could be easier?

Research shows such thinking is wrong. In absence of special or insider information, short-run stock price movements are random. They are as unpredictable as winning 4-D numbers.

If the short-run is out, how about the long-run? Can you make money there?

Well, it is true that a growing economy will cause share prices to rise. If you buy and hold, you will ride your shares higher with the booming economy.

That is without leverage. Do the same thing with leverage and you will lose. Here's why:

First, in the long-run, there are sure to be price dips of 10 per cent and more. Without leverage, you could ride them out.

With 10 times leverage, however, a 10 per cent price dip means your investment declines by 100per cent. You will be wiped out.

Second, the long-run can be very long. Take the Japan Nikkei stock index. It hit its all-time high of 38,915 at the end of 1989. Now, it trades under 13,000.

Stock markets in Italy and Belgium had to wait 70years to break even. Japan, France, Germany and Spain had periods where it took 50 years.

If you need one more reason, levered investments are usually structured as zero-sum. With trading costs, they become negative-sum. It means sure-lose. The only exception is if you have special or insider information. That is rare.

Doctor Money's advice

The CPF rule requiring you to keep the first $20,000 of CPF money in your ordinary account is a good one. It holds down risks until you've built your nest egg.

The problem is high leverage does the opposite. It offers a way to use a little money to make big bets on events that are unpredictable: Short-term stock price movements.

Next week: Not everyone will take today's advice. So, for the die-hard gamblers, I will evaluate four ways to invest with leverage. They range from sure-lose to sure-win.

LEVERAGE: USELESS OF YOUR OWN MONEY TO MULTIPLY RETURNS

Proportion of your money used : Times leverage

100% : 0

50% : 2

20% : 5

1% : 100  Back to Columnists