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moneysense.ca, 14/06/09
The Problem with Leverage
Leverage is typically advertised as a profitable strategy over the long term. But market history suggests that investors may sometimes have to wait a long time before the strategy turns profitable.
moneysense.ca, 14/06/09
Isn’t there a lack of data? There are a lot more than 10 ten-year periods between 1900 and 2000 (ninety by my count). With fluctuation between 12.9% and -0.5% it’d be worth having a few more numbers to work with.
Also, how can one calculate the excess returns for leveraging? Do the authors make any assumptions about the leverage ratio? If you leveraged ten-to-one, for example, your excess returns (and losses) would be astronomically greater than an equivalent non-leveraged portfolio or even a two-to-one ratio… so many questions. I should find that book and read it I guess
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Which stocks were used as measurement? For myself, I usually only leverage to buy stocks that can “carry themselves” for leveraging like REITs, Limited Partnerships and the now-near defunct Income Trusts. In those cases, you can find many stocks yielding over 10% these days, so in my case at Prime +1 (3.25%), the pre-tax spread is 6.75%! And you’re making that 6.75% spread every month.
In my case, I only worried about the credit quality of the stock to pay cash to cover the interest. One of my stocks doubled in price so I sold it off and paid back all of the leverage and now the OTHER stocks I bought with leverage are essentially “free” to me now even though many of those ones are under water. Despite being under water, they’re still distributing and that’s all I care about – the free cash every month.
Cash Canuck: I’m assuming the entire portfolio is leveraged, perhaps with home equity as collateral. That is why, only the difference between stock returns and T-bill returns matters. I also agree that the data is fairly sparse — there are only 10 non-overlapping 10-year periods between 1900 to 2000. Still, there are some surprising results here. For instance, in the 20-year period ending in 2000, leverage would have been unprofitable.
Phil: My point isn’t that leverage never works. In the return sequence above there are periods when leverage would have provided out-sized returns. Perhaps, this is one of those periods. What surprised me is that leverage doesn’t always result in a profit, even over periods as long as 20 years.
Interesting study, would like to read it….I would also like to see a comparison to see how leveraging in real estate has paid off in the last 100 years….everyone says borrow to buy a house…I would like to know how profitable this really is (taking out the mental benefits of owning a home and sticking to just the numbers)…and how it would compare to leveraging stocks….
Did you account for taxation? Ignoring the tax deductions from the investment loan and preferentially treated Canadian dividend stocks when comparing to interest-bearing investments would introduce error in your analysis.
@Guy Davis: The results are gross before taxes. Tax effects are not taken into consideration. It is true that interest on the investment loan results in a tax deduction and dividends and capital gains are taxes preferentially. However, it is very hard to do an after-tax analysis because tax rates have been all over the map. Tax on only half the capital gains is (if I recall correctly), a post-2000 phenomenon. And I’ve lost count of the number of times dividend taxes have been tinkered with in just the past few years.
In any case, the capital gains taxation is a tax on nominal gains, not real returns. If I make an $100K investment and inflation runs at 2% and I have $120K at the end of 10 years, I haven’t made any real gains. But if I sell, I’ll be on hook for capital gains tax on $20K of my “profits”. What I’m trying to get at is analyzing after-tax returns isn’t very simple.
1) I’m not sure why this is a surprise. Leverage magnifies returns and obviously not all 10 year equity returns are positive – especially after paying interest. I would think 20 years at a minimum is the “long run” – 30 years would be better.
2) Saying that using leverage isn’t always profitable is like saying that owning stocks isn’t always better than bonds. However true that may be – it’s the overall return for the duration of the investment that matters – not whether some periods were profitable/unprofitable.
@Mike: In two out of nine 20-year periods, leverage would have resulted in a loss is certainly a surprise for me. It is especially surprising that the 1980-2000 period turned out to be negative. It is true that only the return for the total holding period counts but investors are likely to be very discouraged if their returns were negative over 20 years. It would be interesting to see the results when the post-2000 horrible period for stocks is included in the analysis.
I have to agree with Cash Canuck. When you are backtesting, and I have done my share of it, it is preferred to use sliding windows. If you want to be extraordinarily thorough, you would run tests starting on January 02 and extending for ten years. Then you would run tests starting on January 03 and extending for ten years. In other words, test for sliding windows of ten year periods.
Of course this analysis is based on buying-and-holding which is a strategy that I don’t employ.
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