How does leverage affect investment risks?

Leverage is a financial strategy that involves using borrowed funds to increase the potential return on an investment. The correct answer highlights that leverage amplifies both potential gains and potential losses. When investors use leverage, they are effectively increasing their exposure to an asset without fully committing their own capital.

For example, if an investor uses leverage to buy a stock, they can potentially achieve a higher return if the stock price increases, as they are investing more than their initial capital. However, if the stock price falls, their losses are also magnified, since they still owe the borrowed money regardless of the asset's performance.

This dual effect of amplifying returns and losses is a crucial concept in risk management. Investors must recognize that while leverage can enhance profitability, it also introduces a higher level of risk, potentially leading to significant financial consequences if the market moves against their position. Understanding this relationship is essential for anyone engaging in leveraged investments, as it informs strategic decisions and risk tolerance assessments.

Leverage does not reduce investment risks; rather, it increases them, and it certainly has a profound impact on the overall risk profile of an investment strategy. It is not focused solely on returns or devoid of risk implications, making a comprehensive understanding of leverage critical for successful investing