Making good investment returns is a skill that everyone of us can learn. Like playing a sport or a musical instrument we need to train, practice and then perform. Like anything worth doing well, this requires dedication, patience and perseverance. As many in the Invstr community are demonstrating, the results can be impressive.
There are ways of increasing our performance or investment returns, once we have mastered the basics of investing. Risk and reward are never far apart in investing. It is rare to find high return opportunities that don’t involve taking more risk.
When we buy an investment or open a ‘long’ position we know what the maximum risk is. Since prices theoretically cannot go below zero, ‘long’ positions can never be worth less than zero. You can only lose what you paid for an investment.
When you sell an instrument to go ‘short’, the loss is potentially unlimited – the price of a security has no absolute limit. So going short involves more risk than going long.
Powering up your position is another way of potentially increasing your returns by taking more risk. In the real world, this is referred to as ‘leverage.’ Leverage involves borrowing money to buy an asset. Leverage costs money and entails taking more risk.
Let’s use a real world example like buying a home. Most people take out mortgages to buy a home. The mortgage costs money – an interest rate that we have to pay to the lender. It also involves risk. Let’s say we put up $10,000 cash to buy a $100,000 home and then borrow the remaining $90,000. If the value of the home goes up by 10% we have a gain of $10,000. This represents a 100% return on our cash. However, if the value of the home goes down by $10,000, the value of our $10,000 cash is wiped out: we would lose all of our initial investment if we had to sell the home.
So, leverage is a double-edged sword. It can massively increase our returns or it can magnify our losses. The greater the leverage, the greater the risk.
In the financial world, the experts of leverage are hedge funds, who use leverage to try to increase their returns and out-perform traditional ‘long-only’ fund managers.
Power Ups in Fantasy Finance are similar to leverage in the real world. We pay a price for the chance of multiplying our returns. This comes at the risk of magnifying our losses.
Use 2X Power Ups when you are confident in your investment decisions. Use 4X Power Ups when you are very confident. Knowing when to use Power Ups and when not to use them – understanding your own appetite for risk and your real confidence level – will help you to use leverage wisely. Happy investing!