1. What is Bad Leverage?

Almost everyone advises you to invest in stocks with your own capital and avoid leverage. Even Warren Buffett has said, "Leverage is the enemy of smart people."

Yet, in reality, few people become wealthy from scratch without leverage. The key difference lies in whether you use "good leverage" or "bad leverage."

In general, an endeavor is worth pursuing only if its expected value is positive. For instance, risking a loss of $50 for a chance to gain $100 is sensible.

Leverage magnifies both risk and reward, turning a risk of losing $5,000 into a chance to gain $10,000.

This simultaneous amplification of risk and reward is "bad leverage."

Consider a coin toss bet where you wager $100 and stand to win $500. With odds of 5:1, it's a good bet. But if the minimum bet is $1 million and all you have is $1 million, it's no longer a good bet. The odds remain, but it involves "bad leverage."

"Good leverage" increases returns disproportionately to risks, offering opportunities that far outweigh the risks.

Is there such a thing as a good deal?

In modern society, good leverage is everywhere. Wealthy people aren't just those who make the right moves (I've seen many who did but aren't rich). Successful and wealthy individuals always use "good leverage" to make the right moves.

2. Good Leverage + Positive Cash Flow = Wealth

A classic example of good leverage is the limited liability company.

When Pony Ma founded Tencent, he invested $500,000. By the end of 2024, his personal wealth was HKD 315 billion (Hurun List), and Tencent's market value was HKD 3 trillion. The former is his wealth; the latter is the wealth he "controls," thanks to layers of "good leverage."

Wealthy individuals aren't necessarily those who "own" a lot of money but those who "control" a lot of wealth through forms like limited liability companies.

"Limited liability" means that if the company encounters problems, shareholders only lose their investment without affecting personal assets (unless a court rules otherwise). But if the company thrives, your initial investment can yield vast wealth, allowing you to "control" even more assets. This is good leverage.

Statistics show that the success rate of first-time entrepreneurs is only 12%. Entrepreneurship is a typical "irrational behavior," a low-probability event. But entrepreneurship is one of the most crucial engines of a nation's economy. It can't rely solely on passion, which is why modern capitalism invented the "limited liability company" as a form of "good leverage." It allows entrepreneurs to bear only the risk of their investment, encouraging more people to take risks and driving societal progress.

With "limited liability," even if the first venture fails, you gain experience and connections. The success rate for the second venture rises to 20%, and the third to 30%. It may not seem high, but succeeding once is enough. Many entrepreneurs are "serial entrepreneurs." The first piece of advice is:

Prepare for multiple ventures from day one. The first venture is like a beautiful first love, but it's just for gaining experience. Don't waste your passion, resources, and time on the first venture.

Entrepreneurship is a game where winners take a long time to emerge, but losers are quickly apparent. Most entrepreneurs realize their defeat within six months but stay due to pride and the ingrained belief that "perseverance leads to victory," waiting until they've lost everything before leaving the table, wasting precious life.

So, the essence of entrepreneurship is to leverage the high odds created by "good leverage," invest within your means, try multiple times, iterate quickly, succeed once, and never personally guarantee.

This is the first layer of leverage—amplifying personal wealth while protecting yourself.

Of course, this layer alone won't make you wealthy.

Every company has a "balance sheet." The assets a company "owns" aren't all earned; some come from liabilities, like bank loans for equipment, credit from suppliers, or prepaid consumer funds...

For instance, commercial banks can have an asset-liability ratio of up to 92%, meaning they operate mainly on borrowed money. To mask this, banks must operate in the most expensive office buildings.

This is the second layer of "leverage," often referred to as corporate debt. Entrepreneurs use "limited liability" and "corporate debt" to amplify the assets they "control," channeling part of the cash flow from these assets into personal wealth legally.

These are the two necessary conditions to become wealthy:

Good Leverage + Positive Cash Flow = Accelerated Wealth Accumulation

Conversely, most people using leverage face three outcomes:

• Bad Leverage + Negative Cash Flow = Mortgage Slave
• Bad Leverage + Positive Cash Flow = Debt Cycle
• Good Leverage + Negative Cash Flow = Entrepreneurial Failure

Leverage isn't inherently dangerous; it's about using "good leverage" and ensuring a continuous positive cash flow to keep leverage safe and manageable.

Buffett, who advises against retail investors using leverage, actually employs strong "good leverage" himself—what you might call "ultimate good leverage."

3. Ultimate Good Leverage

Buffett has repeatedly warned investors against leverage, yet his investments through Berkshire Hathaway involve leverage. However, it's "ultimate good leverage."

Berkshire is an insurance company that collects premiums annually, with future claims. This isn't ordinary debt; it doesn't require timely repayment or trigger margin calls, allowing for long-term equity investments before claims are due.

Buffett's wealth leaps during crises aren't just due to insight and courage but the nature of his funds. Mutual funds face redemption pressure during economic crises, preventing managers from investing even if they see opportunities. In contrast, Buffett can freely seek undervalued, excellent companies.

Most of Buffett's investments are in unlisted company equity, which is cheaper and more stable, offering high returns. These equities have no price fluctuations, keeping Berkshire's finances attractive and its valuation higher than typical insurance or investment companies. This illiquidity suits Berkshire's fund nature.

As he mentioned in his shareholder letter, "We have obtained financing (insurance float) at almost zero cost for decades," along with high dividend demands from invested companies, creating a "good leverage + positive cash flow" model.

So, Buffett's opposition to investor leverage actually refers to the high-risk, high-cost, unstable "bad leverage," such as:

• High-ratio margin stock trading, heavy options, or derivatives positions
• Debt without stable cash flow, relying solely on asset appreciation (excessive mortgages)
• Short-term debt and unstable funds subject to margin calls (short debt long investment)

Buffett's view is correct, especially for professional investors primarily using personal funds, one of the world's most dangerous professions. Let's compare:

Compared to mutual fund managers, who primarily rely on management fees and profit sharing without bearing losses, they effectively use a layer of "good leverage," focusing on expanding managed assets for a more secure business model.

Amateur investors with stable job income have a continuous "positive cash flow," allowing them to pursue rapid asset growth or endure years of negative returns to buy bottoms and capitalize on reversals.

However, even amateur investors with stable income should not leverage if they can't find "good leverage." High leverage not only reduces retail investors' returns but also erodes patience, distorts operations, and impedes reasonable bottom-fishing. As mentioned earlier, bad leverage + positive cash flow = debt cycle, often leading to using job income to offset leveraged investment losses or volatility.

Thus, professional investors should avoid leverage. Stock investing relies heavily on market conditions and can't provide stable positive cash flow for families. "Bad leverage" worsens this issue by increasing volatility.

Another requirement for professional investing is risk identification, recognizing actionable and non-actionable opportunities while guarding against common major losses and rare black swan risks. This stems from lacking other cash flow sources. Adding "bad leverage" reduces error tolerance.

Are There "Good Leverages" in Investing?

Yes, but they often involve complex financial product combinations and derivatives trading.

4. Two Classic Good Leverages

The first example is leveraged bonds in risk parity portfolios.

The core idea of the "Risk Parity" strategy is to allocate assets in a portfolio proportionally to their volatility. If an asset is more volatile (riskier), allocate less; if less volatile (less risky), allocate more. Otherwise, equal fund distribution results in returns and volatility too close to the riskiest asset, losing the portfolio's purpose.

According to risk parity theory, a simple stock-bond balanced portfolio with stock volatility four times that of bonds should have an 80:20 stock-bond ratio. But this results in low returns. To enhance returns without violating risk parity principles, leverage can be applied to bond positions.

For instance, allocate 60% to stocks, then leverage the remaining 40% five to six times for bonds, equalizing stock and bond volatility while achieving higher returns than a non-leveraged "80:20 portfolio."

In this scheme, the risk (volatility) amplified by leverage is less than the return gained, exemplifying "good leverage." Bond interest provides a continuous cash flow, and bond capital gains' volatility offsets stock volatility, creating a "risk parity return" from unrelated asset combinations—a classic "good leverage + positive cash flow" example.

Leveraged bonds are thus standard in various risk parity portfolios, including Bridgewater's All Weather Portfolio.

The second example is using "selling put options" instead of directly buying stocks.

When optimistic about a company or market but expecting one last dip, most investors hold cash, while some buy immediately, risking volatility. The smartest investors use the leveraged strategy of "selling put options" instead of buying.

Options are often seen as high-risk, high-leverage speculative tools. However, whether this tool is "good leverage" or "bad leverage" depends on the user's intent. Buffett frequently uses it instead of buying stocks, emphasizing in many shareholder meetings that options aren't speculative tools, especially "selling put options" and "covered call strategies."

Chinese investor Duan Yongping used this strategy to bottom-fish Pinduoduo. In late 2021, after rounds of declines in Chinese stocks, many entered the market. Duan Yongping also acted, targeting Pinduoduo. Instead of buying at $60 or waiting for $50, he sold $50 strike put options for a $5 premium.

Selling put options involves three potential outcomes:

1. If Pinduoduo exceeds $50, the option isn't exercised, and Duan Yongping profits from the option premium, over $3 million.

2. If the stock is between $45 and $50, it's exercised, effectively bottom-fishing Pinduoduo. Adding the premium, he reduces his buy-in cost.

3. Only if the stock falls below $45 does the premium fail to cover the cost, resulting in a loss. But this scenario is less likely, and the cost is only $5 more per share than directly bottom-fishing.

Selling put options is a "risk unlimited, reward limited" strategy. However, compared to direct buying, it uses less capital (leveraged) to either achieve bottom-fishing or earn a high annualized option fee.

The difference lies in believing in a company's potential but expecting no short-term surge and possible dips. Using less capital to achieve most investment goals exemplifies "good leverage."

It retains the core of value investing: buying only at reasonable prices while adding "option premium" income, creating cash flow and investment returns, effectively achieving "good leverage + positive cash flow."

5. In Conclusion, Seven Key Points on Leverage:

1. Good leverage amplifies returns with controllable risks, while bad leverage symmetrically amplifies risk and reward, often fatally.

2. Entrepreneurship leverages "good leverage," trying multiple times, iterating quickly, and succeeding once to reach the shore.

3. Never personally guarantee company debt; even good leverage can become bad.

4. Good Leverage + Positive Cash Flow = Accelerated Wealth Accumulation.

5. Professional investing is one of the most dangerous professions, especially with bad leverage.

6. Leveraged bonds in risk parity portfolios are good leverage.

7. "Selling put options" to replace stock buying is also good leverage.