Psychology of Leverage

The psychology of leverage (assuming debt/loans) to buy assets has changed tremendously over the past several generations. Why is it that for some things we don’t think twice about borrowing and others we won’t?

Throughout history, the residence is about the only asset people have taken for granted that they will borrow money to obtain. And that makes sense because of the price and the payment structure is an alternative to rent.

However, car loans, credit card use for personal spending and college debts have become more of the norm for the recent generations. Many of those who lived through the great depression abhor debts. That was not always the case, but rather a hard lesson learned long ago.

Back in the “roaring” 1920’s, people started buying stocks and the prices kept going up and up (“a sure fire way to make money”). For as little as 10% down (borrowed 90%), you could buy stock back then and all was fine until prices started to fall. With a market that was overleveraged, people could not sell fast enough to cover their obligations and prices crashed as sell orders came in to cover the debts. Not all that dissimilar to the highly leveraged real estate market we just experienced.

The lesson learned eighty years ago really resonated with that generation. They recognized that leverage worked wonderfully in one direction and horrifically in the other. Buying anything on “credit” was frowned upon for a long time. If you did not have money in your pocket, you did not make a purchase. When shopping for a car, it was largely paid in cash or it was not driven off the lot.

Leverage always equates to risks. So why are people so willing to accept those risks on some items and not on others? From experience and history, it seems that people become comfortable when risk perceptions change. The risks are there…they just don’t see them as being as severe as they “once were.” Some good examples are stocks in the 1920’s, leveraged buy-outs throughout history, junk bonds of the 80’s coinciding with the real estate downturn and most recently real estate again. The next very expensive leveraged lesson…highly priced education???

Times have changed. The world is a financial web of debts and obligations not only from individuals but from governments and corporations as well. We wonder what the world may look like going forward…have we learned the lesson of having too much debt? The evidence is there that people are paying down their obligations and saving more. But will it continue?

Will it continue because people make the choice or will it be forced upon us because lending opportunities will not be there? The banks are flooded with cash but stingy in loans. A cause or an effect?

If you want to buy stock on margin today, you can do it, but you can’t borrow as you could in the 1920’s. Real estate will always be purchased on debt but we suspect the down payment will have to be higher. This is already the case for commercial and investment real estate.

For home purchases, the government is still helping to support prices with some of the same high loan ratios as before the crash…but at least this time around, people are tested to make sure they can make the payments.

If you go back in history, the great economic booms and busts are associated with leverage. It is usually coupled with increasing asset prices and the increasing availability of debt. Even risk adverse people can get caught into it…things seem “safer” when the illusion of security is there.

Think about another one of these “boom” examples, the “dot com” era of the late 1990’s. Maybe the lesson to learn is…when traditionally risky things are absent of apparent risk…maybe the risks are even higher and leverage should be avoided?

If you have a question you want addressed, please submit them to asksb@missionwealth.com

Author’s Note:  Brad Stark, MS, CFP, AAMS, CMFC and Seth Streeter, MS, CFP, Co-Founders of Mission Wealth Management, LLC, a Registered Investment Advisor. The information contained in this article is general in nature and should not be construed as comprehensive financial, tax, or legal advice. As with any financial or legal matter, consult your qualified securities, tax, or legal representative before taking action. Securities offered through National Planning Corporation, Member FINRA/SIPC.  NPC and MWM are separate and unrelated entities. Certain statements contained within may be forward-looking statements, including but not limited to, statements that are predictions of or indicate future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties; all statements are subject to change without notice. Also, historical performance cannot predict future results.