The Leverage Equation Read online

  Network and Relationship leverage – Expands your reach to include other people’s connections so you’re not limited to your own.

  Experience and Knowledge leverage – Employs the expertise of others so you don’t have to learn everything yourself.

  BOOST YOUR LEVERAGE WITH OVERLAPPING STRATEGIES!

  While it’s helpful to organize the various leverage tools into a framework built on six categories, the fact is that, in practice, the different types of leverage typically overlap.

  For example, my information product business on the Internet uses technology to manage and deliver the product, but it’s really a form of knowledge leverage where I package my experience into a scalable business model which then requires marketing and communications leverage to develop the sales funnels.

  Notice how a single business model can apply multiple types of leverage, and how each leverage tool performs a specific function for the business model; yet they are seamlessly interconnected.

  The mistake you want to avoid is drawing hard lines in the sand with each category definition. The categories are a useful framework for mentally organizing what would otherwise be an unwieldy collection of tools. They help you understand how to connect the function of each tool to your strategy; however, as you get more accustomed to working with the tools, you’ll see how these lines of distinction get blurred.

  Always remember that the core principle driving all types of leverage is to help you do more with less of your own resources by expanding the resources at your disposal. They are all tools that accelerate your wealth so you can produce faster, greater results.

  IN SUMMARY

  Think of building your wealth like building a house. Although you may be comfortable wielding a hammer, a hammer isn’t appropriate for every situation. You’ll need to employ many tools and strategies to accomplish your goals effectively. With leverage, using all six types will help you build the best financial house.

  The next few chapters will give you a deep-dive into each type of leverage so you have the tools and strategies necessary to overcome the obstacles that separate you from the financial success you desire.

  EXERCISE: 10X YOUR RESULTS

  The purpose of this exercise is to break open your thinking from the structured, limited box that all of us tend to get stuck inside.

  The idea is for you to create seemingly outlandish goals that you could never achieve when limited to your own resources. Then try and figure out how to actually achieve those crazy goals using leverage.

  The cliché slogan (that’s actually true) is “when you shoot for the stars, even if you fail, you’ll end up on the moon” (which is a pretty amazing achievement).

  Your homework is simple. Take whatever goals you have, multiply them 10 times, and then create serious plans using leverage to actually achieve those new goals.

  Try to figure out a realistic way to 10X the results you produce, the income you earn, and your net worth. It will force your mind to incorporate leverage to open up new possibilities.

  There’s simply no other way to achieve a 10X goal. It will shake up your thinking patterns and force new strategies. It will challenge your assumptions and expectations.

  So go ahead… how will you 10X your results? Figure out a serious plan to make it happen and see what changes occur in your limiting beliefs.

  And then, for extra credit, 10X your 10X goals and repeat the exercise. Push the boundaries. What can you learn?

  1 – FINANCIAL LEVERAGE

  The rich rule over the poor, and the borrower is servant to the lender.

  – Proverbs 22:7

  Sean Quinn was the richest man in Ireland, estimated to be worth $6 billion in 2008. By the end of the financial crisis that began that year, he was $3 billion in debt and he declared bankruptcy.

  Allen Stanford, founder of the Stanford Financial Group, was worth $2.2 billion before being convicted of operating a Ponzi scheme and losing everything.

  Bjorgolfur Gudmundsson built an Icelandic bank to a personal fortune of $1.1 billion in 2008 before filing for bankruptcy in 2009 after the Icelandic banking collapse.

  I’m fascinated by stories about people who build vast fortunes, only to quickly lose them. Each story provides a kernel of wisdom regarding what works to build wealth and what can destroy that success. On close inspection, the pattern that emerges is that leverage is nearly always the driver behind the rise, and that inadequate risk management is the cause of the fall.

  The unique characteristic of financial leverage is that it cuts both ways. It makes the good times great, and the bad times unbearable. It amplifies your return on investment, so when things go south you can get into trouble fast.

  Financial leverage places a premium on risk management skills, because without them you’re just an accident waiting to happen. You must know how to control losses during periods of adversity so you can produce consistently profitable results.

  FINANCIAL LEVERAGE VERSUS INVESTING

  People often confuse financial leverage with normal investing. Financial leverage is the use of other people’s investment capital or debt financing to increase profits. It’s putting other people’s money to work for you.

  This is very different from putting your own money to work for you. For example, investing your money in dividend stocks or bonds is not financial leverage because you’re not incurring debt and you have no financing costs to carry.

  Yes, it allows you to live off the passive income produced by your capital because it is your money that is producing the income, not your time, but there is no leverage involved. You’re merely putting your investment capital to work so you can make money without regard to how you spend your time.

  When you invest your own money, the only cost of capital is the time you took to earn and save it. You have no interest cost and you don’t have to repay the money, which is a key distinction. It’s very different from borrowed money, which is what we mean by financial leverage.

  When you leverage other people’s money, you’re putting more money to work than you actually own. This creates debt, resulting in a debt-to-equity ratio. The higher the ratio, the greater your financial leverage (and risk!).

  Let’s say you buy an investment property worth $100,000 by putting 10% down and leveraging the other 90% with mortgage financing. To keep things simple, in this example we’ll ignore cash flow and tax considerations so we can isolate the leveraged impact on changes in equity.

  If the property increases in value by just 10%, you’ll have a 100% return on investment because you only invested $10,000 to control $100,000 in property value. The rest was borrowed. That means a mere 1% increase in property value equals a 10% return on investment. Conversely, if the property drops in value by 10%, you’ve lost all of your investment. That’s the power of financial leverage. When you’re leveraged 10:1 it means all changes in equity value are multiplied by 10.

  RETURN MUST EXCEED BORROWING COST

  The key to profiting from financial leverage is that your return on investment must exceed the cost of borrowing. In the example above, where you leverage real estate equity with mortgage financing, you’ll increase your profits as long as the real estate returns more than the financing costs net of expenses. The difference between the asset return and the financing costs is your profit.

  The obvious implication is that borrowed money should only be used to fund an income producing asset, and never for consumption. If the money borrowed is used for consumption, that’s just extending your spending capability. It’s like hiring an employee who gives you massages all day. It might feel good in the moment, but it’s not going to grow the business. Financial leverage should only be used to purchase assets that produce more revenue than they cost.

  For example, let’s assume you invest on margin with a 50% maintenance requirement. That means for every $2 invested in equities you only need $1 in cash, so your investment is leveraged 2 to 1. If your equities rise by 100%, your account value will rise
by 200% minus financing costs. Conversely, if your equities decline by 50%, your account will decline by 100%, meaning you’re wiped out, plus you’ll also lose the financing costs.

  Notice how financial leverage creates asymmetric returns because you must subtract financing costs from the gains, but you also have to add financing costs to the losses. The cost of leverage reduces the good times and magnifies the bad times. That’s because the carrying cost, or interest on the financing, must get paid regardless of the return on investment. So when you get a negative return on investment coupled with interest costs, it’s very easy to get in trouble fast.

  A great example of this problem is the large number of real estate investors who lost everything during the 2008-2009 economic downturn. The common practice back then was to purchase investment property with a 10% to 20% down-payment and to re-leverage as properties increased in value. In other words, if you bought a house for $100,000 with $10,000 down and it increased 20%, then that $20,000 gain would get reinvested to buy two more $100,000 houses with $10,000 down on each, so you never had more than 10% to 20% in equity. Leverage inflated the bubble by creating more and more demand for investment property as prices rose; but it also led to the destruction of the bubble because a mere 10% to 20% loss in asset value caused a 100% loss of invested capital – resulting in massive foreclosures and forced selling.

  Similarly, financial leverage was the cause of both the rise and fall of Long-Term Capital Management in 1998. The firm used highly leveraged strategies in the credit markets, which worked fine… until it didn’t. The carrying costs plus leveraged losses buried the fund so fast that it took government intervention to unwind the mess and stabilize the financial markets. They couldn’t even sell their losing positions in the market because the entire house of cards collapsed so abruptly.

  THE 3 MUST-FOLLOW RULES FOR FINANCIAL LEVERAGE

  This section introduces three rules for employing financial leverage in your wealth plan.

  Rule 1: Avoid over-leverage

  Commodity trading is one of the most leveraged investment strategies. Not surprisingly, more than 90% of all commodity traders end up losing money.

  That’s not a coincidence.

  The contractual leverage built into commodity trading makes it easy to control massive amounts of price change with very little money. If you get on the wrong side of the market just once and your account is undercapitalized (or overleveraged), you’re quickly out of the game.

  For example, assume you trade sugar futures on the Chicago Mercantile Exchange (CME). Each contract is for 112,000 pounds of sugar. Every 1-point price change in sugar represents $1,120.00 of gain or loss, and the initial margin requirement to control the same contract is roughly the same amount of money. Controlling the price change on 112,000 pounds of sugar with little more than $1,000 (exact margin requirements vary) represents extraordinary leverage. It takes very little price change to wipe out the initial investment.

  The rule is simple – the greater your financial leverage, the greater your risk. There’s no rule of thumb for what’s safe versus not safe. It’s simply a sliding scale where less financial leverage is safer and more financial leverage is riskier. The greater your financial leverage, the less room for error you have. You must be sufficiently capitalized to execute your plans through normal, expected setbacks. Never leverage yourself to the point that it puts your survivability in jeopardy.

  Rule 2: Manage risk

  Financial leverage multiplies your results, which is why it’s appealing. It’s the kind of leverage that allows you to invest $1,000 today and get $10,000 a few years from now. But because of its enormous multiplication power, your allowable margin for error is much thinner than without it. To manage this risk, you want to put a cap on the downside risks as much as possible just in case a worst-case scenario should strike.

  For example, my real estate portfolio was made up of different properties in different states, each held in a separate legal entity, and each building was financed with non-recourse mortgages. That way, if a lawsuit, environmental disaster, or job market change struck one property, the damage would be contained so it didn’t impact the other properties, or my personal equity.

  Every business and investment strategy must always have a contingency plan for worst case scenarios, and you need to build it into your plan before you ever put money at risk. Financial leverage only makes risk management more important because of the much thinner margin for error resulting from multiplying all losses.

  Rule 3: Minimize financial leverage during deflation

  The normal economic reality for investors is inflation. It has been so persistent for most of your lifetime that you might mistakenly assume it’s a given, but it’s not. Deflation occurs frequently enough that you must be prepared.

  Financial leverage is a great strategy when your payment amount is fixed in nominal dollars, but you repay those debts with future, inflated dollars. It’s even better when the assets you purchase with leveraged money rise with inflation. In fact, that’s exactly how most real estate fortunes have been made.

  However, deflation turns that analysis upside down. Asset values decline and you’re forced to repay debt in more valuable, deflated dollars. An excellent example is the 2008-2009 real estate market decline that wiped out many investors.

  Few people can conceive of deflation’s far-reaching impact because of its virtual absence from economic history. The truth is the government wants inflation and generally controls the economy to produce inflation. That’s why the dollar has lost 90% of its purchasing power twice since the creation of the Federal Reserve in 1914. Yes, the value of the dollar has declined 90% twice in roughly 100 years, demonstrating the pervasive, powerful force of government-induced inflation.

  That’s good news for financial leverage because inflation is the economic condition that gives this strategy the greatest probability of success. But it also means you want to be very careful when you see any indications of deflationary risk.

  The most common precursor to deflation is an advanced credit bubble. In 2006, anyone in the United States who could fog a mirror could get a 30-year fixed mortgage on almost any size home without even proving income. They were called “liar loans,” and through excessive financial leverage they artificially created more demand for housing than people could actually afford. As an avid real estate investor at the time, I chose to do the opposite by selling my investment real estate to reduce my financial leverage, thus controlling my risk exposure to the subsequent deflationary decline.

  If you’re in the late stages of a credit bubble where deflation is a genuine risk, consider designing your plan to use one of the other five types of leverage described in this book. Be strategic. If the economic environment is unfavorable for financial leverage, risk management tells you to use the other leverage tools that don’t cut both ways.

  For example, once I had sold all my real estate leading up to the 2007 top, I switched my focus to building FinancialMentor.com using the five other types of leverage that don’t carry the same downside risk. It was a conscious decision to manage deflationary economic risk by eliminating financial leverage in real estate. This illustrates a key principle: never get married to any one asset class or strategy. Instead, always allocate your capital where the risk/reward is most favorable by avoiding high risk situations. This one strategy has been worth millions to me in my investment career, and it can dramatically improve your investment performance consistency.

  IT TAKES MONEY TO MAKE MONEY

  Just because I’m cautioning you against financial leverage doesn’t mean I don’t like financial leverage. When used wisely, it can be an important weapon in your wealth building arsenal – because it’s how you overcome the limiting belief that it takes money to make money. The beauty of financial leverage is: if you have a valuable investment opportunity, you can find the capital needed to fund it; you don’t need to have your own money.

  This is very important because the
belief that it takes money to make money is a dangerous deception that limits people’s wealth plans by closing possibilities.

  For example, in an earlier chapter I shared how I acquired 10.2 apartments units using absolutely none of my own money or credit. I worked hard to find a great deal by analyzing investment areas and sorting through more than a hundred properties over a period of months before I could negotiate something that would work. It took skill, discipline, and effort…but zero money.

  I know lots of people who’ve built very profitable internet-based businesses – both in ecommerce and digital publishing – for almost no money out of pocket. Yes, it took a lot of work and they had to develop many skills to succeed, but money was not a factor. What you need is a great idea and the sweat equity to make it happen.

  Max Gunther wrote the book “The Very, Very Rich and How They Got That Way,” which pulled data from Fortune Magazine’s lists of the wealthy that preceded Forbes’ now infamous list of the 400 richest people. In 1968, half of the people in Fortune’s list inherited their money, but a recent study of the Forbes 400 showed that 69% of the list created their own fortune.

  This demonstrates the declining role of inherited wealth over time, as new wealth created by industrious, hard-working entrepreneurs is supplanting old wealth.

  Similarly, Amar Bhide wrote, in his book The Origin and Evolution of New Businesses, that most of the founders of Inc. 500 companies bootstrapped their business, with a quarter of them starting with less than $5,000, and nearly half with less than $50,000. Think about it. If half of the Inc. 500 was launched with less than $50,000 in starting capital, then clearly money is not the obstacle to building wealth.

  FINANCIAL LEVERAGE WITHOUT MONEY

  Another myth is that the only type of financial leverage is borrowed money, but in fact financial leverage comes in many forms.

  For example, derivative financial instruments such as futures contracts and options are highly leveraged investments because they control a much larger amount of underlying assets with a small amount of money than is possible to control through outright ownership.