Leveraging is a great way of creating accelerated wealth but it comes with a warning: if leveraging is applied incorrectly it can destroy your wealth equally fast.
The higher the leverage, the greater is the risk to your investment and business. At the same time, there is greater potential for profits. Leverage works both ways; it is a double edged sword.
Before applying leverage, you have to understand some basic truths about leveraging or things could go dramatically wrong and you can get yourself hurt and go bankrupt.
State of Knowledge
The financial crisis of 2008 was caused when excessive greed led people to use leverage without proper understanding of risks involved. The most important factor for using leverage correctly is your state of knowledge.
For instance, if you lack knowledge about finances or the business/investment you wish to start, there is no point in rushing to get a 100% finance in order to try making a no-money-down deal. Similarly, if you lack the knowledge of systems and how to set them up, there is no point in rushing to fully automate your operations. Same is true for any form of leveraging.
You should make a correct assessment of your financial, emotional and spiritual intelligence in any given situation before applying leverage as an instrument for accelerated wealth creation. Greed is the product of a lacking emotional and spiritual intelligence. Leverage driven by greed is the worst enemy of wealth creation.
Leverage is like a power tool that can make your job of wealth creation very easy but its improper use, without adequate knowledge or precautions, can cause you tremendous hurt.
There is a saying that, ‘It is never the investment that is wrong. It is always the investor who is wrong’. So, take the time and trouble to learn about the business or investment before jumping onto the bandwagon of leveraging for quick gains.
In uncertain market conditions, when the outcome is not known or when the market is moving downwards, the amount of leverage should be reduced.
You could increase the leverage as you gain confidence, and when the market forces are moving in a positive direction.
For example, in property investment, it is extremely easy to do ‘no money down deals’ if you have the right knowledge and the market is moving up. This is because even if you make a mistake, the rise in price of the property will cover your error. On the other hand, doing a low equity deal when the property cycle is moving southward then even a small error in your judgment will wipe out your equity.
If you are using leverage for accelerated financial returns, then you have to be very alert towards changing market conditions. If the market conditions deteriorate, then you have to take measures to reduce your leverage in time. People go bankrupt when they hesitate to act or foresee a developing situation. Reducing your leverage by selling some of your assets is no shame. You can always buy assets and increase your leverage when favorable market conditions return.
The amount of leverage to apply is also dependent your age. When you are young, you can risk applying high levels of leverage. This is because even if things go wrong, you have the time to recover and start all over again.
As you grow older, it is wise to reduce leverage even if you have become more proficient at applying leverage with experience. The last remark will, no doubt, be debated because there are many elderly people who are still young at heart and ready to take all kinds of risks in life. I, unfortunately, speak for the majority.
Before applying leverage, you have to access your risk appetite. This is because if things go wrong, then people with less risk appetite will start to panic and make incorrect decisions that can set them back by years in their financial growth and planning.
Greed is the biggest enemy of leverage. It is greed which makes us blind to applying leverage without appropriate knowledge, skills and timing. Before applying leverage, one has to develop checks and balances provided by spiritual, financial and emotional intelligence.