I was recently studying 2008 research study by Yale researchers Ian Ayres and Barry J. Nalebuff in which they tell to use 2 to 1 leverage ratio while buying stocks in your young age and gradually lower the leverage ratio in retirement stages in order to maximize the returns? So I wonder how is this leverage ratio calculated? Lets say I keep 10,000 dollars as collateral in my brokerage account and ask for rest 10,000 dollars from the broker itself and invest entire 20,000 dollars in stocks. Is my leverage ratio 1:1 in this case? And how does this leverage help to reduce risk instead of increasing it ? Please help.
Leverage increases the possible returns, while significantly increasing risk. It does not reduce risk. Young people often have a higher tolerance for risk, and have more years in their life to make up for poor returns, so increasing average returns for a young person might be a benefit even with the risk. However I think a blanket recommendation for investing with debt is not great, you really need to be careful you don't get in over your head.– Grade 'Eh' BaconJul 7, 2022 at 12:37
The leverage ratio is just the total amount invested divided by the invested amount that is not borrowed. So if you invest $10,000 of your money, borrow $10,000 and invest it, your leverage ratio is $20,000/$10,000 = 200%. The amount you keep in collateral is not considered.
But leverage is pointless if you keep collateral in the amount that's borrowed. If you instead just invested all of your $20,000, you'd get the exact same returns as if you invested $10,000, borrowed $10,000, and kept $10,000 as collateral.
You can also get leverage by infesting in "levered" ETFs such as 2X or 3X index fund ETFs.
And how does this leverage help to reduce risk instead of increasing it ?
It does not. Leverage multiplies risk as well as return. If you invest $100 and borrow $200 for a leverage ratio of 300/100=300%, and the value of the investment drops 33%, you now have an investment worth $200 and owe $200, so you technically are bankrupt. This is why levered account require some amount of collateral. A 3X ETF could also in theory be wiped out if the market moves more than 33% - since the only funds the ETF has left would be borrowed. In reality there may be ways to survive but it would be a massive climb back to solvency.
So I get that young investors that can take more risk (because they have longer to make up for losses) and can take advantage of leverage, but be very cautious of the risks and have a good risk management strategy in place.