The Fastest Way to Go Into Debt When Investing

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Leverage leaves you vulnerable to a glitch in human psychology. Find out why many smart investors avoid investing with debt. [[{“value”:”

Don’t blink. A minute is how long it takes to turn an uphill ride into a downhill, off-the-rails plunge into debt. Just ask crypzsof, a Redditor who recounted the tale of how he started with $30,000, peaked at $1 million in his brokerage account, and ended up $50,000 in debt.

Leverage is the fastest way to lose it all. But the most dangerous moment — the one to watch for — may come after the initial loss.

Commenters in the Reddit thread for this story echo a theme: When things got bad, they doubled down. Some leveraged even more to reverse their falling fortunes, worsening losses. In other words, it may be whether you decide to double down, to fight fire with fire, that matters most.

Is leverage bad?

Many of the most well-known financial gurus seem to be wary of it. Warren Buffett and Charlie Munger, two of the most successful money managers of all time, avoid it. Morgan Housel, author of one of the most popular books on money, calls leverage “the devil.”

In Housel’s New York Times–bestseller The Psychology of Money, he says “Leverage — taking on debt to make your money go further — pushes routine risks into something capable of producing ruin.” In other words, leverage makes it easier than ever to go into debt. It’s why financial gurus often advise avoiding margin accounts and day trading.

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Leave room for error

Even the smartest people in the world go bankrupt to leverage.

In one of his many public talks on investing, Warren Buffet said, “Charlie and I, we saw many high-IQ people, really extraordinarily high-IQ people, destroyed by leverage.” Even though Berkshire Hathaway would have been many times richer had it leveraged, Buffett still avoids doing so.

The reason so many smart people fall prey to leverage probably has a lot to do with psychology, including a concept Morgan Housel calls “room for error.” The idea is, when you live on the wire, you’re particularly vulnerable to all the problems you won’t see coming.

Inflation, a pandemic, a housing market crash — they can all cause unexpected reversals in the stock market. Leveraged investors are hit hardest. Unlike regular investors, leveraged traders leave themselves wide open for financial ruin, which typically manifests as debt.

The psychology behind doubling down

Traders like crypzsof tend to “double down” because of sunk-cost fallacy. It’s a known psychological term for the tendency people have to justify poor-decision making with, “I’ve already gone this far — it’s too late to turn back now!”

I know the feeling. Like crypzsof, I’ve leveraged my investments when the market was easy. Then the market crashed without warning, like it often does, and my profits turned to losses. Instead of paying off my debt and going “clean slate,” I clung to my leverage for months.

The takeaway here is to expect leverage to cloud your judgment when you need it most. Even knowing about sunk-cost may not be enough. Many smart people avoid it for this reason.

An emergency fund is the opposite of leverage

Building an emergency fund makes going into debt less likely. It’s a cash cushion, the purest form of “room for error” in finance (except for, maybe, a solid insurance policy).

Let’s say someone crashed into your car, and you need to pay the insurance deductible. Pay with your emergency fund. Your dog broke her hip? Emergency fund. Roof caved in? Emergency fund. An emergency fund lets you pay unexpected bills without taking on debt.

An emergency fund isn’t the solution to leveraged investments. But having it can make daily life more stable. A high-yield savings account is one of the best places to build an emergency fund. Click here to explore accounts with returns 10-times higher than average.

Before you take out leverage

You should know the psychological risks before taking out leverage. Leverage is one of the fastest ways to go into debt. Your brain is wired to respond poorly to leveraged investments tanking. It’s not just spreadsheets you must track — it’s how you feel when your money burns. How do you react? Your financial future hinges upon it.

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The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.Cole Tretheway has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.

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