Leverage

The landscape of investment products consist of products with a large and products a small leverage. Investment products like bonds have a small leverage. Options, however, have a large leverage. Investing in bonds will generally result in a smaller profit or loss than investing in options.

Leverage is an important term for investors. When designing your investment portfolio, the term leverage should be kept in mind. But how exactly does that leverage work?

Scale

Leverage for investment products can be compared with the leverage in daily life.

People who are employed by a company, do not use a leverage for their income. Someone who receives a salary, gets paid for the number of hours that person has worked. The more the employee works, the more he or she will earn. The income of an employee will always be an upward straight line.

People who make and sell products that are easy to reproduce, do use a leverage. Example of these products are books, movies and software. Most of the work for these products has to be done only once, like writing a book. No matter how often the book is sold, the time and effort of the writing will stay the same. The costs of printing and distributing the book are only a small part of the total cost of the product. So: the more books are sold, the more the writer will earn.

The leverage is caused by the additional cost for each product that are lower than the costs of the previous products. The product is easy to scale.

Investment products with a large leverage are like the above mentioned example. A part of the costs of an investment are paid by someone else. This way, the investment product is (or seems) cheaper, but the profit stays the same.

Earnings model

Is this charity or is there a catch?

Obviously this is not charity. A person or company who lends money or takes a risk, would like a fee in return. This is usually in the form of interest or a surcharge on the price of the product. The person or company that sells the product, has the intention to make money.

To estimate the real risk of an investment product, it is important to know the earnings model of the seller. Some sellers make money if you do, but others earn money if you lose money. So always check the earning model of the sellers!