Its hard not to comment on a post titled “Leveraging into Equities: The ONLY Source of Wealth?” The post’s argument is nicely summed up in the following passages:

Of the 400 richest [on the Forbes list], 37 made it there as mutual fund or hedge fund managers, and 22 are investors – all investing in equities. 28 made it in real estate, but really it was by building a real estate company. Even Oprah Winfrey built a media and entertainment business.

Businesses are equities. Whether they borrowed to invest in one business or many, the ONLY real way to major wealth is by leveraging into equities.

This leads to the obvious question – if leveraging into equities is the ONLY “yellow brick road” to wealth, why don’t more people do it?

Let’s charitably accept the argument that starting a business is the same thing as investing in publicly-traded companies (it actually isn’t, but it is a favourite argument of the Smith Manoeuvre cult-members). Let’s also charitably accept that successful businesses engage in leverage, though many good businesses have gone bankrupt by taking on too much debt and Warren Buffett, third on the richest list, has this opinion on the subject:

The most dramatic way we protect ourselves is we don’t use leverage. We believe almost anything can happen in financial markets… [so] even smart people can get clobbered with leverage. It’s the one thing that can prevent you from playing out your hand.

Even after accepting the above fallacious conclusions, we are left with a case of survivorship bias. Yes, most of the individuals on the Forbes 400 list got there by starting a business but it doesn’t follow that all individuals who start a business will end up on that list. In fact, most startups, even those run by very smart people, fail in the first few years. Someone starting a business today faces very long odds of just becoming successful, let alone landing on the Forbes 400 list.

But forget all these arguments for a moment and think about what you want. If you are like me, you want to pay off your home, save for retirement, send your kids to University and eventually, not having to depend on a paycheck. You are not aiming for a spot on the Forbes 400 and couldn’t care less about the list. Do you need leveraged investments to achieve your goals? Not really. A far simpler and less-risky path is to spend less than you earn and invest the difference in a low-cost, diversified portfolio. Why take more risks than you need to?

This article has 20 comments

  1. Yes, let’s borrow money to invest in “home run” shots and we’ll all get rich! I remember my Dad telling me that, NOT!

    Debt is the one thing you can pay down and get real value from NOT having.

    –C8j

  2. Great post! I whole-heartedly agree.

    Thankfully, I have no problem being average and I’ve never actually looked at the Forbes 400 list but I also don’t have a problem with buying a lottery once every 6 months or so. 😉

  3. Good post – I think the vast majority of investors shouldn’t even think about using leverage.

    It’s funny, I normally have a mental picture of CC being calm, cool & collected while he writes his inciteful prose. Reading this one however I had a mental picture of CC furiously pounding away at the keyboard, foaming at the mouth, yelling out Remple obscenities…

    Either way it was a good one!

  4. Canadian Capitalist

    Mike: You’re right about the first two, but I did not yell out obscenities! 🙂

  5. Only because you’re at work right?

  6. I had a feeling that article would stir up the pot a little. 🙂

    FT

  7. I read both MDJ’s and CC’s blogs. While I can see an aversion to unnecessary risk, there is a good point made that leverage done properly with quality investments beats throwing darts at speculative stocks. The point of the article was about getting wealthy, not just secure, and in either case why not learn from the successful? I do see your point that this may lead some down the garden path, but I sort of felt that Ed covered that with the power tool analogy. Some people can ruin themselves with credit cards on consumer items, ruining yourself with a leveraged investment seems more noble to me (if you must fail). So you can pay for stock pickers, or you can buy the index. They both seem valid to me.

  8. Canadian Capitalist

    florch: I am sorry but the logic of Ed’s post is flawed. Even with leveraged investing, average folks are never going to end up super wealthy. Its simple logic: you are borrowing money at 4% to earn maybe 6% after taxes. Your net, if you are lucky and don’t shoot yourself in the foot is 2%. For me, its just not worth the risk.

    Mike: Yes, I was at work. But I didn’t even mutter obscenities :))

  9. Leveraged investing isn’t risky if you do it right, for example if it’s only used for sort-term investments. For example, if you bought a call option on a stock that goes up 25%, then you borrow the money necessary to exercise the option and then sell off just enough of the stocks to pay back the principle and hold onto the rest of the stocks… That’s smart leveraged investing.

  10. MDJ, I’m kind of curious as to why you post Remple’s stuff on your blog? Do you believe in his methods or are you trying to provide a forum for different opinions?

  11. My opinion is, that leverage used correctly is a great way to build wealth. Risk can not be taught by others it has to be personally experienced to find once on comfort/risk level.
    I personally can’t hold a mortgage of +300k, but I have little hesitation to borrow this amount of money to invest in to quality investments. I prefer the stock market over real estate with it’s extremly high commissons and inherent illequidity. But….there are good times and bad times for leverage. In May 2003 it was a no brainer (in my opinion) to pick up RY and XIU with borrowed money, the dividend almost coverd my PLC interest payments at that time. I just waited.
    I work with people that recently bought houses with little down and a huge (400k) mortgages…that is risky to me.
    I lost sleep for three nights when I bought my house 10 yrs ago because I had to borrow 75% of the purchase price.
    How would I ever pay back all that money? 🙂
    Just my 2 cents.
    N64

  12. Mike – I have to admit I could see CC hitting the keyboard with a bit more satisfaction that normal with this post. *grin*

    As for the entire idea that equities are the only path to wealth. Depends how you define wealth. I don’t want a $1,000,000 to my name. I rather roll around on the floor with my family in a mad game of tickle each other and be completely happy for even just a few minutes each day.

    CD

  13. Mike: I find it refreshing to see various opinions about financial issues, especially from those who work in the field of finance. So, as you said, I like providing different opinions and discussing them.

    FT

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  15. CC…with Canadian banks providing a 2% dividend plus 13% average capital gains growth over the last decade, it’s more than possible, diversify from there. My job pays enough that I can pony up the 2% shortfall and wait it out for the long run. I greatly respect your opinions on this blog but guess we’ll agree to disagree on this one. Plus I know Ed is selling something – doesn’t mean he’s wrong, even though my portfolio looks more like yours – no high MER mutuals thank you.

    My parents retired on real estate rentals, and they’re the first to say that if you could see the score (in terms of capital gains growth) there were many years they didn’t win, but they won in the end. I see the stock market as real estate without the PITA factor and the bonus of liquidity – you just don’t need to leverage as high to get a decent ROI. As smart as you are and as hard working as you are, your portfolio would kick butt leveraged over 20 years.

    Risk+Work+Time=Reward

  16. Canadian Dream: re: family. Me too, they’re my greatest motivation and money is secondary. I feel I’m doing this for all of us. My job is the golden handcuffs. Sometimes I’m gone too much, so a chance to walk away a bit early by investing well is very important to me.

  17. Canadian Capitalist

    florch: IMHO, leverage works much better with rental properties because (a) it is a pain to sell (b) finding a deal is much easier because so few people are looking (c) real estate, by its very nature, is more risky (and more rewarding) than bonds and less risky (and less rewarding) than stocks.

    You seem to know what you are doing: moderate leverage with an awareness and willingness to take on the risk. How many people are like you? In my opinion, the vast majority are rather poor investors and would be better off not taking any more risk.

  18. I can agree with that. I wouldn’t advise it to someone who didn’t have at least a solid layman’s grasp of personal finance, and moderation is the key. It would be crazy to be so far leveraged that a market downturn or a job layoff could wipe you out.

    cheers, have a great weekend

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