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moneysense.ca, 18/06/07
Should You Leverage?
[I was going to list all the reasons when you shouldn't leverage and conclude with a maybe, but Thicken My Wallet beat me to it with a great post on this very topic. I have slightly reworked this post to avoid being redundant.]
Many of my fellow bloggers seem to think that leverage should be a part of every financial plan. While it may be a suitable choice for their own financial situation, I think it is unwise to suggest that everyone should get an investment loan.
It is easy to understand the logic behind leverage: you borrow money from your friendly banker at say 6% and invest it in equities and earn a greater return. As an added bonus, you also get to arbitrage the difference between tax treatment of interest payments (100% deductible against income) and capital gains (or dividends). Voila! You are making money on money you don’t have! What a great deal!
The problem with this logic is that for leverage to make a significant difference to your bottom line, you’ll have to borrow huge amounts of money. Let’s say that, on average, you expect to borrow at 3% and hope to earn 7% in the equity market. Your estimated average spread is 4%. To earn an extra $1,000 per year, you need to borrow and invest $25,000. Let’s say you heard the siren song of leveraging, borrowed and invested $25,000. The markets tumble 20% over the next year. Would you have the fortitude to stick with the plan, now that you are $8,600 in the hole? Only if you have lived through a bear market, you can answer that question..
I’ll admit that leverage would have worked splendidly in the past few years. The total returns from the TSX Composite for the past four years has been 26.7%, 14.5%, 24.1% and 17.3%. By borrowing at less than 6% (most of the time it was more like 4%), you would have made a nice profit in leveraging to invest. Now, ask yourself this question: If leveraging is such a no-brainer, why wasn’t it popular in 2002? Chasing recent returns is the surest route to investment ruin.
On a personal note, I have occasionally leveraged to invest in equities in the past. But I use leverage strictly as a liquidity tool when I don’t have enough cash to invest and I think there is an irresistible bargain in the market. I also try and pay down the investment loan within the next year and I have a strict rule of never leveraging more than 10% of the portfolio value. Even if everything goes wrong (investments tank, interest rates spike and our incomes plummet), I want to be assured that we would survive to fight another day with a mere financial flesh wound.
moneysense.ca, 18/06/07
Good post.
I’ve since tempered my view on this, as I was quite enthusiastic early on. I still am, but realize that my set of circumstances lend well to it: a tin tummy and contour pillow for risk, a long time line, living below my means which presents itself as excellent cashflow.
A perfect storm of job loss with no job available paying at least 1/2 my current salary, my wife not being able to go back to work after mat, a big drop in the markets and a big drop in housing all at the same time could be devastating. Life is risk, but I feel more insulated than most. Therefore for my circumstances, this is appropriate.
I’m thinking along the same line. Moderate amount of leveraging is fine only if you can find irresistible bargains. I’m very fortunate to have avoided investment loans during the tech bubble. It’s so difficult to recover from losses. If you lose 50%, your remaining capital must double just to recover the nominal value, and that’s before inflation and loan interests.
With regards to how much to leverage, I prefer some percentage of my net worth instead of my portfolio. For example, if my net worth is $500k, and my portfolio is $20k, then it should be reasonable to leverage up to another $20k.
I’ve decided to liquidate my leveraged plan after reading this post.
Just kidding….but you’re right – leveraging is not appropriate for most investors.
Mike
Mike: Your assumptions are very conservative and your leverage is very modest compared to your portfolio. I’m sure you’ll be ok. I am a bit worried about comments like “it should be part of every plan”.
I worry about that too. It sometimes seems like devoted advocates of the SM are the Jehovah’s Witnesses of the leverage world.
Mike
I concur that leveraged investing is not for everyone. Unfortunately the purveyors of such leveraged strategies all too often prey on people’s desire for greater returns, without a proper conceptualization of the risk involved.
“leveraging is not appropriate for most investors”
Funny – everyone who has a mortgage fits this brush stroke nicely, although very few of them see it that way.
“A perfect storm of job loss with no job available paying at least 1/2 my current salary, my wife not being able to go back to work after mat, a big drop in the markets and a big drop in housing all at the same time could be devastating. Life is risk, but I feel more insulated than most. Therefore for my circumstances, this is appropriate.”
The people worst off from a market crash are those who are FORCED to liquidate at the market bottom, either due to margin calls or cashflow / mortgage / medical (US) reasons. A drop in housing should not affect you; ie, you’re only underwater on your mortgage if you owe more than your equity. Had you used a proper 25% down-payment with a 15-year amortization (as suggested by The Wealthy Barber), with a couple years of payments before the baby came along, you should be doing fine. It’s only the people who stretch when they’re already at the cliff who are in trouble. By this standard, housing should not be consideration on the “what’s the worst that can happen” list.
Remember – a recession is when some people lose their jobs, a depression is when you lose your job.
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I think that leverage strategies are not used properly (and definitely not explained properly) and this is why people think it is not for everybody. As an example, you should not use leverage to buy more “hot stocks” such as resources right now. Same thing as you should not had bought techno stocks in 1999-2000.
People that actually leveraged the good way (buying long term, based on future value of good companies) in 2001 and 2002 as the market was very low are probably laughing by now. They are now fully protected from any drop as their portfolio should worth more than 200% of their initial investment.
CC, what happen when you buy a “bargain” and it is not? I find that market timing is a much riskier game than leveraging .
As Sol Veritas said, most people already use leverage in their life for different reasons beside investment. It is just that they don’t realize it. The definition of leverage is to do more with less. That applies to several things in life. I’ll write more on that this week.
Great post!
FB.
FB: I said when I think there is a bargain. It may or may not work out. It’s not a sure thing. I disagree that this is market timing. Market timing is strategically entering and exiting the market, not adding/establishing positions when markets tumble.
As far as definitions go, it seems to me there’s a fine line between market timing and value investing.
With regards to leveraging, I was leveraging a lot before – but now that interest rates on my LoC has climbed to 6% and the downside risk looks much greater than upside potential in the markets right now, I am almost completely unleveraged as of today. I only have about $2K of leverage left floating around. I have been in this mostly unleveraged state since last fall.
In fact, inside my RSP account where I don’t have any leverage, my recent cash contributions to my RSP are remaining in cash or short term fixed income securities. I’m still waiting for an opportunity to deploy that cash, which currently mounts to about 25% of my RSP portfolio.
I’m currently bearish on the market, but I haven’t decided whether I’m bearish enough to short the index. The thought of sitting on a short position would probably give me sleepless nights. Cashable GICs are currently in favour for me and I’ve been pouring all my new cash into that asset class while I wait for opportunities to arise.
Interesting post and definitely food for thought. I’ve been “leveraging” just to buy blocks of stocks that look nice (and usually pay a big chunk of the margin debt down when I receive my next paycheck). I like to think I’d only go really big on leverage after a big market drop (and would probably wait a week or two after the drop to make sure it wasn’t still falling).
After the tech slump, I held on to my JDS Uniphase for about 3 or 4 years before selling. I thought about adding to it (on the assumption that it was now a good deal), but had just lost my job and didn’t have the funds available. Does this mean I have a strong stomach or do I still need to test myself?
You know you are at a market top when….
Usually, when these strategies come out and everybody is talking about them, is when it is best to hunker down because the big fall is right around the corner. And like Kevin O’Leary says on BNN, “There will be grown men weeping.”
CC: As for market timing, if you set a specific target price for an entry point on a stock, then to me that is market timing. If you have a regular monthly amount that gets invested at regular intervals, that is not market timing.
We’ll have to differ on what is market timing and what isn’t. It is a moot point anyway because once you have a set asset allocation and initial positions, you’ll have to invest relatively more money in the under performing asset class to bring it back on target.
Still, I think that at current prices emerging markets and REITs are over valued. I am happy to wait for a correction before initiating a position just like I did with income trusts.
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