Warren Buffett has been investing in the stock market for more than 70 years. At only 11 years old, he made his first equity purchase — three shares of Cities Service Preferred. He sold early and made a small profit, but ultimately learned a lesson about patience as shares soared higher. Over the decades, Buffett has passed on a vast amount of wisdom to investors. One lesson investors should heed from the Oracle of Omaha involves leverage.
“When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious,” explained Buffett in his 2010 shareholder letter. “But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”
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Buffett was primarily discussing leverage in relation to personal debt, but the same principles apply to leveraged exchange-traded funds — a relatively new financial product. Leveraged ETFs are like regular ETFs laced with greed and impatience. They attempt to deliver multiples of the performance of an underlying index or benchmark they track. Some track broad indices, while others track specific sectors or commodities. Leveraged ETFs seek to magnify returns by using some of Wall Street’s favorite financial drugs: derivatives, futures contracts, and swaps.