How to Play
Leverage – The game of Diversification using Leverage
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Leverage involves borrowing money from the bank to invest. By having more money invested the returns can be much higher when the asset appreciates in value, however losses are also magnified when the asset value falls in value.
Leverage has been a great tool available to investors to accelerate their wealth, although many investors have lost their entire wealth through the use of leverage.
If you elect to borrow funds to invest within the game of Diversification you can only borrow up to a maximum of the same amount as your Total Net Worth.
Example – If you have $10,000 in Total Net Worth, you can borrow up to $10,000 in additional funds. If you borrow the maximum amount the player has a total of $20,000 to invest for the year.
When an investor borrows money for investment purposes the banks charge an interest expense. The interest expense is based on a percentage of the borrowed amount.
The borrowing costs or what is called the interest expense is fixed at 7% per annum within the game of Diversification.
Example – If you borrow $10,000 as in the example above, your interest expense for one year will be $700.
For the game of Diversification this interest expense is paid yearly in arrears and is subtracted from the gains (if any) or added to the losses.
Example
A players Total Net Worth is $5,000 and the player has Savings of $5,000 for the year. This gives the player $10,000 in Total Funds Available for Investing.
The player wishes to borrow from the bank the maximum amount. The player can therefore borrow another $10,000 giving them a Total Investment Amount of $20,000.
Let's assume the player invests 100% of this amount into Property.
If the return is 10% for Property that year, the player makes a Return ($) of $2,000 (10% of $20,000).
The Interest Expense is $700 (7% of the borrowed amount being $10,000).
The total net return is $1,300.
As the player only outlaid $10,000, the net return is actually 13% ($1,300 of $10,000) rather than 10% being what the underlying asset increased in value.
If the property fell in value by 10%, the player would lose $2,000 (10% of $20,000) plus the interest expense being $700 (7% of the borrowed amount). The total loss would therefore be $2,700 ($2,000 + $700) or 27% of the players Net Worth.
As can be seen by the above example, leverage is often described as a double edged sword. It can magnify both returns and losses significantly.
To mitigate the high risks associated with leverage, players can reduce the leverage amount or not borrow to invest at all.