The effects of financial leverage cannot be observed and appreciated without understanding compounding. Particularly the off skew character of larger and larger compounders. In this article we explore the concept of leverage and why it works.
Compounding on it’s own won’t make you money quickly, but without it, and applying it’s principles, building wealth is very difficult. Compounding money is pure math, it is scientific and certain. If you do X you will get Y. To appreciate the value of compounding you need to play with a compounding calculator to see the effects of different compounding rates. For example, a 10% compounder will give you a certain final balance over a given number of multiplications, but 20% which is double, reasonably, one would expect that your result would be double with the same number of multiplications….but it doesn’t…it gives more! This skew effect can be obseved exponentially bigger as you raise the compounder higher and higher. Applying 40% or 100% one would expect over the same number of multiplications, one would get 4 times as much money or 10 times as much, but this exponential escalation of return happens because of the math. So to understand compounding in an effort to make wealth, you begin to realize that of vital importance is getting the boggest possible compounder.
What is financial leverage?
Financial leverage is simply another way of saying “borrowed money” Plain and simple, that is all that is meant by financial leverage. But to leave it at that would be a gross injustice of the value, utility and purpose of financial leverage. It is the fountain head of wealth. As stated above, a larger compounder makes thing’s happen exponentially faster and faster, so even a small increase in the compounder, makes a huge difference. By using other peoples money OPM, we maximise the returns quite effectively using leverage.
A simple example will illustrate the concept, then I will outline the problem of using leverage to manufacture wealth. If we have a unit of value (an investment) that will yield 10% per multiplication and that multiplication takes 1 month to complete, and we have $100 and that is all the available money we can possibly find for the investment, we would in 1 month be left with $10 dollars more or, $110 dollars, but if we borrow another hundred dollars, for a total of $200 to apply to the investment, we repay the $100 and we are left with $120 or a return of 20% That is double the compounder. So with a simple lever we have increased the small compounder of 10% into a much bigger compounder of 20%
If your goal is to create wealth, there comes several problems you need to resolve before you can have that wealth. Namely, most banks and institutional investment vehicles, will offer typically around 10% per YEAR not per month. Often it is in the single digits depending on what part of the boom/bust cycle we are currently in. 5% 6% 8% are not compounders that can really create wealth. Of course, the multiplication is annual so these are quite futile if your goal is wealth creation.
The other problem is that with these small compounders, your borrowed money will chew up the capital gains because borrowed money has a price attached to it. Clearly, you need to find investment vehicles that offer much bigger and frequent compounding events.
A unit of value
Ultimately, if you want a more use-able compounder, you will need to get into business. You will need to manufacture your returns manually, not passively as in the case of bank interest. The goal is like McDonalds, or any other successful business, that you create a unit of value that gives a certain monthly return, then you must use financial leverage to multiply that return once you are satisfied with the reliability of the unit of value to give you that monthly return.
It is simpler than you think. Returns of 50% per month are not uncommon and using financial leverage, once you are certain of the investment, you can borrow to maximise that return.
The way to find a unit of value that you can re-produce is simple. If we look at the problem logically there are 2 things a business needs to be a truly successful unit of value. They are automation and a product or service. To find automation, you need look no further than the internet. The internet is one big vending machine and users (people who use the internet) buy stuff and serve themselves with no major human input. The second thing is having a product or service.
Ideally, you do not want to spend millions on research and development, creating a product from scratch, so ultimately the answer lies in having access to other people’s product’s. The above outlines the simple robust system that all wealth creation stems from. Financial leverage is the final piece to the wealth puzzle.
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