The good, the bad, and the ugly of leverage

Over the weekend, two significant things happened: the power outages in the West Virginia area caused one of Amazon’s regional data center to suffer an outage and a leap second was distributed to all computers and phones running NTP.

The cloud is good for us…

Companies have been discovering that by off loading major, critical operations to services like Amazon’s S3 and EC2 cloud support, they can leverage their development teams and more productively and efficiently. They are also able to enjoy better uptimes and longer mean-time-to-failures.

This means better profits, better products, and eventually lower prices for all of us. It is an economy of scale situation. Instead of every company paying for fully staffed sysadmins and devops team, they can delegate that to the cloud providers. This is leverage; one of the most powerful tools ever invented.

Remember your grade school science classes when they mentioned things like the pulley, the wheel, the wedge, and the lever? Archimedes is the one who said, “give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”The lever works by trading force for distance. By requiring you to move a lever twice as far, you only need supply half the force.

…even if the news stories don’t support it

When 1% of the internet goes down due to Amazon’s cloud outage followed by a leap second bug 48 hours later, it makes big news headlines. Services like Netflix depend on the cloud, and people began to doubt whether the cloud really is the right solution to pursue. What makes this hard to judge is a form of journalistic bias. I’m not talking about left wing/right wing political bias, but instead what is/isn’t reported. When a single system goes down and impacts dozens of popular, online services, it’s easy for the reporters to flock to the central location and write their negative stories.

But when lots of small companies, running their own systems, suffer the same power outage, the problem isn’t as centralized. Reporters may still write about the power outage, but it doesn’t have the same amount of leverage and it’s not as noticeable to the consuming public. Moving further along the spectrum, the companies that were prepared for both of these situations by having backup generators, backup clouds, and prepped for the leap second, typically don’t show up in the news at all. When things work perfectly and no outage is involved, it doesn’t make for an exciting headline.

Good debt vs. bad debt

Leverage carries similar power in financial circles. When you borrow money from a bank to buy real estate, you need only supply a fraction of the capital, but you can gain extra “distance”, i.e. earnings when you either pour the rent money into paying it off or letting appreciate in value (or a combination of both).

But every investment includes risk. Your property may not have tentants, resulting in negative cash flow. Or it might fall in value, reducing your equity position. The thing to remember with leverage, is that it amplifies the outcome. If you suffer losses, leverage can cause you to lose big time.

That is the reason many people abhor debt. Consumer debt (credit cards/auto loans) should be viewed as bad, because it eat ups more capital for assets that produce no revenue. But debt used to purchase cash flowing assets (stocks and real estate) requires a different evaluation. It could be good for you, or bad.

As my buddy Jeff Brown says, buying swamp land is still real estate but would be stupid to buy. If you invest in good quality real estate (including good location AND quality property), you will attract good tenants and end up making money. No spreadsheet will provide the complete answer to this.

Leverage amplifies results

The key principle of leverage is that is AMPLIFIES the results. If you invest in a good cloud provider, or buy a good piece of real estate, the leverage will help you in the long run, BIG TIME, despite the occasional bump in the road or vacant tenant. You are also unlikely to make any news headlines. But if you invest in some cheap provider or buy the cheapest property you can find, and the leverage bankrupts you, then you stand a greater chance of ending up in the news and giving politicians something else to regulate to death.

I am not a licensed financial advisor nor an insurance agent, and cannot give out financial advice. This is strictly wealth building opinion and should be treated as such.

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