What works for you can also work against you.
- Leveraging allows you to borrow money to make investments, which can multiply gains or losses.
- Ramit Sethi says this is dangerous and he doesn’t think it’s a good idea for the average investor.
- It’s much safer to invest on a regular basis without using leverage.
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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