The Law of the Lever states that if the distance a from the fulcrum to where the input force is applied (point A) is greater than the distance b from fulcrum to where the output force is applied (point B), then the lever amplifies the input force.
Archimedes proved this law and famously said that,
“Give me a lever long enough, and a fulcrum on which to place it, and I shall move the world!”
The Law basically says that there is theoretically an infinite amplification possible. For the same given effort, it is theoretically possible to amplify its output by increasing the leverage!
Voila…and we have a formula to drive home big advantages!
While this law was discovered around 250 BC, actually we have been using leverage right since the wheel was invented! The wheel was a kind of lever, which gave us the ability to carry far heavier stuff with far lesser effort!
Physics teaches us that there are three types of lever based on the relative position of Effort, Fulcrum and Load. We have seen so many examples of levers in our daily lives like pulleys, seesaws, nut crackers, wheelbarrows, nail cutters, bottle openers, scissors, tongs, brooms & mops, shovels etc.
Let us zoom out of the Physics textbooks and take the discussion to a higher level of generality. Right from using the wheel (or even before that, using our jaws to eat!) to the mobile phones, we have used the amplification of a leverage to make our lives more comfortable or more efficient. I can spend the whole day giving examples of the application of leverage in some form or the other. I am choosing to spend only a few minutes though…
Cars – We can walk. It is probably the safest mode of travel. When we use car, we add more
- Comfort – Oh, it so easy, just sit and manage a few levers and one wheel
- Efficiency – We save time by travelling faster. More people can travel for the effort of one..extend the concept from car to a bus!
Books – We can learn by doing and spend our whole life in the process. Or, we can read books. There are people who have spent their whole lives researching a particular subject. All you need to do is spend a few days reading it and that’s it! In some ways Isaac Newton pulled Europe, mired in superstition and dogma, out of the dark ages. He laid the foundation of Physics as we know today. Subsequently, various other people took the baton forward – Einstein, Heisenberg, Bohr, Hawking, Feynman etc. They built on his foundation, one after the other. Now, when we read a book by Steven Hawking, you are effectively dealing with a leverage of all the cumulative knowledge accumulated over the years.
Internet – The Internet provides a tremendous leverage of reach and networking. Look at the number of followers some have over social media. Theoretically, my blog can be read by anyone sitting in any part of the world.
“We live in an age of infinite leverage. Technology, Capital, Media make it so easy to multiply work.”
– Naval Ravikant
Business – Anyone having slightest acquaintance with accounting is aware of operating and financial leverage. These are the amplification factors by which the increase in topline can bring a disproportionate increase in the bottomline of a business.
Personal Finance – I”ll take this one in slight detail. Let’s first dip into the resources from the domain of Accounting. There are broadly two sources of funds:
- Own money (own, father’s, father-in-law’s!)
- Debt/Loans (Home, Consumer Durable, Auto, SME, Personal, Credit Card)
Obviously, all loans come at a cost. The Loan Rates (in India) in ascending order are approximately, as under:
| Type of Loan | Approximate Rate (%) (in India) |
|---|---|
| Home Loan | 8 |
| Auto Loan | 9 |
| Loan against Securities | 11 |
| Personal Loan | 11 |
| SME Loan | 12 |
| Consumer Durable Loan | 16 |
| Credit Card Loan | 40 |
The own money on the face of it looks free; but it isn’t (even father in law’s)! Your money has an opportunity cost. Instead of deploying your money in the thing under consideration, you could have invested it somewhere which could have fetched you some gains. This opportunity cost is the effective cost of your funds; it isn’t free. Compare this to the “Capital” in the balance sheet of a company. Cost of capital is not zero. Businesses are set up with the objective of making profits. The Loans on a balance sheet carry some sort of assurity for the lender in the sense that in case of a claim for company assets the lenders have a right before the business owners. The owner of the business risks losing all the capital without any security. Obviously, the businessman would demand a higher rate of return than the cost of loan – thus, the cost of capital has to be higher than the cost of loan.
It is of utmost importance to understand that out of all these sources of funds, none of them is free – the “own money”, in some sense, is costlier than the borrowed money! If this is correct, it makes sense, at a basic level, to do business on borrowed funds rather than own capital, isn’t it?
So, where is the problem?
Next question, If leverage has been such an integral part of human progress + it is cheaper than own money + it gives you more bang for the buck, then where is the problem? Why does it carry a bad reputation, especially in the Investing Circle?
Well because, leverage is a double edged sword – it cuts both ways!
“Any virtue carried to an extreme is a vice.”
– Aristotle
And this is precisely what we do with leverage. We take the double edged sword to its illogical extreme to the extent that the inside edge starts cutting us. Every time, we have created a technology which makes our lives more comfortable or efficient, we have used it to such an extent that its second order ill effects kicked in. Excess leverage makes a system fragile against shocks.
A car is useful, but if you overspeed, your reaction time reduces and that makes you susceptible to accidents. A very common form of extreme leverage is Equated Monthly Installments (EMIs). EMI transforms the way you look at the price of a thing.
- You cannot afford to pay the price of that top end SUV, but break the price down into EMIs….
- You would rather buy a mid range mobile, but break down the price of the fancier version in EMIs….
- You don’t even need that fancy smart watch, but you look at the EMI…
…& Viola!
You look at the EMI and ask yourself, Why Not! Why wait! Why not now! You can easily afford that! And so you buy all of this and a lot more. And you spend the rest of your life servicing those EMIs! God forbid, if your source of income takes a hit, for instance, job loss, pay cut, business loss, business discontinuity, then you undergo great stress. Even if that doesn’t happen, the mere thought of the possibility keeps you under persistent stress.
The same phenomenon applies to financial leverage. A lot of over leveraged companies fail to sustain during economic downturns. History has shown that most businesses failures are triggered not by competition, or poor product or poor marketing, but by poor financial management. That is why financial investors prefer to stay out of leveraged companies. They keep it simple by simply investing in debt free companies with free cash flow generation.
In other words, while Archimedes was right in his claims of moving the Earth, he had to get everything right, including luck, to get that done. Even an iota of error in the application, and he would have been thrown into a parallel universe! The “double edged sword” nature of the leverage means that while it gives you great amplification, it equally amplifies the chance of you getting blown away, literally & figuratively. More the leverage, more is your sensitivity to errors or things not going your way!
Can you have the cake & eat it too!
However, if leverage has played such a key role in the development of human life, there must be an optimum solution. As Lena Horne said,
It’s not the load that breaks you down, it’s the way you carry it.
In case of technological leverages, we have a sense of what is an optimum level of leverage – driving a car at an optimal speed, for instance. Paraphrasing Peter Bernstein…
You should try to maximise returns if and only to the extent that losses would not threaten your survival.
It is slightly trickier in financial matters…
- Should you simply stay out of debt, or should you explore it in some ways?
- What kind of debt is good, what kind of debt is bad?
Is there a way to have the cake & eat it too! In other words, is there a way to get some efficiency, while keeping the risk of being blown away under check. Because, if there is an optimal solution, it may make sense to take the calculated shot in the arm! Let’s find out…
Rules of Effective Leverage
There are three basic rules that can help you manage debt effectively & get the best out of it:
Rule1
If you take a loan and deploy money on an avenue,
(Return on Avenue) > (Cost of Loan)
From a financial perspective, a loan is a liability, and the money raised from it should be deployed in an asset.
Here, it is important to look at assets & liabilities not in the traditional accounting way. Rather, let’s look at them in the Robert Kiyosaki way…
Assets: generate income or appreciate in value
Liabilities: incur expenses or depreciates in value
Some implications of this rule:
- You should not buy liabilities on loan. It is not very smart to buy a car, fridge, fancy mobile, or a luxurious holiday on borrowed funds. Home is a different matter, because home has a potential to appreciate in value and the home loan is the cheapest loan out there. It is outrightly stupid to buy a car on loans; not only is a car loan costly, but also the fact that the car loses 40% of its value the next day!
- Even if you deploy the money raised on assets, you should ensure that the return on assets is greater than the cost of the liability. No point taking a personal loan @ 11% and parking it in a bank FD @ 7%. This looks highly obvious and you may think that nobody does it, but if you have a Bank Deposit and a car loan, you fall in this category (Oops, you didn’t realise that!). Rephrasing the rule in this context…
(Return on Assets) > (Cost of Liabilities)
- As a thumb rule, all consumer loans (including car loans) are not smart…period!
Rule 2
Assets should generate funds before the loan (liability) outflow is due. While, the Rule 1 is understood, even if not applied, Rule 2, is not even understood very intuitively. If you have a home loan @ 8% maturing in 6 months. You can prepay it today itself, but instead, you lend the money to a friend @ 12%. Smart move, as you make neat 2% (4% annualised, for 6 months) of the outstanding loan amount out of thin air! The only problem is that 6 months down the line, when your home loan matures, your friend says he needs 3 more months to pay the money back!
A lot of corporations violate Rule 2. When short term rates are lower than long term rates, corporates try to fund their long term capital requirements with low rate short term funding. They hope to keep rolling over the short term liabilities. A sudden squeeze on the short term funding gets them in financial trouble.
Rule 3
If either of the two conditions,
- (Return on Asset) > (Cost of Liability)
- Assets generate funds before liabilities demand them
falter, then you should be able to unwind the leverage easily. Going back to the car example, if you see a straight empty highway, you can press the pedal harder, provided you are able to slow down as you approach a turn or dense traffic. If Archimedes realises that in his attempt to move the earth, he should immediately get off the lever, lest he should learn a lesson in escape velocity in the most unpleasant way!
Here is a Twitter Thread I wrote regarding how Warren Buffett used these principles in his investing.
To sum up
if you have a proposition going for you, it makes sense to use the amplification of leverage to drive home the advantage.
- Planning to go from Mumbai to Pune, how about driving in a car, instead of walking all the way
- carrying heavy luggage, how about using luggage with wheels
- remembering a friend, how about doing a video call, instead of writing a letter
- want to learn value investing, how about reading some books
- want to express your opinions, how about opening a Twitter account and reaching out to millions
- want to sell your products to the whole world, how about using an online platform like Amazon
- enjoy the convenience of your credit card & get upto 45 days of free credit, plus earn reward points..just ensure you don’t miss the payment deadline!
Specifically, in the case of financial leverage, if you have a financially lucrative proposition going, do not shy away from using borrowed money, as long as the three Rules are followed. If you see empirical evidence of consistent growth in top-line, use the knowledge of the Rules of Effective Leverage to grow your bottom-line disproportionately!
If you have a bad business idea, why run it with your own money; if you have a great business idea, and you know the rules of effective leverage management, why run it with your own money anyways!