Do you want to know how to make 50 percent a year by putting your money into things that return only 15 percent? Welcome to the wonderful world of leverage, which is Wall Street speak for "using borrowed money." Leverage is the secret sauce that lets buyout firms (which now call themselves "private-equity houses") and hedge funds and smart traders make huge returns on their investments -- when they get it right, of course.
Leverage works great when the assets you're buying (or betting against) generate more cash than it takes to pay the interest bill on the money you've borrowed to boost your investment returns. But if the market moves against you, leverage magnifies your losses on the way down the same way it magnified your profits on the way up.
If we do some simple arithmetic, you'll see what I'm talking about. And you'll see how people who borrowed a lot of money in the good times -- such as 2006 -- could look like geniuses, but looked considerably less smart at other times. As part of our exercise, you'll also see why you'd better have enough in financial reserves to hold on during sharp, nasty downturns -- like the first three trading days of this year.
Now, to the numbers. To show you how simple this can be, let's assume that you'd decided in 2006 to put a dollar of your own money into the boring old Standard & Poor's 500-stock index, then put in another four dollars of borrowed cash. How much do you think you made on your personal investment? Would you believe 55 percent? You don't believe it? Okay, watch.
In 2006, the S&P earned 15.79 percent in capital gains and reinvested dividends, according to my handy-dandy Bloomberg machine. Say you'd put $10,000 of your own cash into the S&P for the year, and put in another $40,000 that you'd borrowed at a 6 percent annual interest rate. You had $50,000 working for you, producing, before expenses, a gross return of $7,895. (That's 15.79 percent of $50,000.) Your interest cost was $2,400: 6 percent of $40,000. Subtract the interest from the gross return, and your net return was $5,495 -- or 54.95 percent on the $10,000 of your own money that you'd put into the deal.
The purists among us will notice that I haven't counted taxes or investment expenses, I haven't allowed for the fact that dividends trickle in throughout the year rather than coming in all at once, and that my arithmetic differs from the calculations that professional investors use to compile their investment returns. But you get the basic point: Borrowing heavily can amplify the return on even the most mundane investment if things go your way.
Now, let's say that earning more than 50 percent in 2006 inspired you to roll the dice again last year. Once again, you used $10,000 of your own cash and borrowed $40,000 at 6 percent. The year 2007, however, was mediocre, with the S&P producing only 5.49 percent of gains and dividends.
To the calculator once more. Last year, your S&P play produced $2,745 (5.49 percent on $50,000) of gross returns, less the same $2,400 of interest. This left a return of only $345, a crummy 3.45 percent on your 10 grand. For that, you could have put the dough in a money market mutual fund at considerably less risk.
But what the hey. The third time's the charm, so you play the same 10/40 game one more time. But in the first four trading days of this year, the S&P dropped 3.55 percent. It's like having the football team you're rooting for give up a touchdown on the opening kickoff -- before you can blink, you're in the hole. In our case, you're looking at a three-day loss of $1,775, a hefty 17.75 percent of your investment. (To make life simple, I'm ignoring the three days of interest expense and dividend income. If I included them, the loss would be somewhat larger.)
You can see how this can get nasty quickly. If the S&P ends this year with a 10 percent loss after reinvested dividends, you'd lose almost three-quarters of your $10,000 investment. (The math: $5,000 of losses plus $2,400 of interest costs divided by $10,000 equals a 74 percent loss.) If the S&P loses 15.2 percent, you're wiped out. By the time the market recovers, which it always does sooner or later, you're out of the game.
The moral of our math lesson: When you hear that the private-equity houses or hedge funds or someone on some trading desk has put up eye-popping numbers, make sure to find out how much of the return comes from using leverage.
It's easy to look like a genius when things are good. But if you want to keep your money, make sure you know how to avoid total wipeout when things are bad.
Allan Sloan is Fortune magazine's senior editor at large. His e-mail address isasloan@ fortunemail.com.