Leveraging to Increase Investment Returns- walk before you run
After the pay down the mortgage vs. contribute to retirement debate, one of the more contentious issues in the financial blogging world is whether to use leverage in order increase investment returns. To be clear, I am using the term “leveraged investing” to describe borrowing against assets and using the proceeds of the loan to invest in stocks and bonds. I am going to lump into this discussion all the various permutations of leveraged investing, whether it be the Smith Manoeuvre or trading on margin; the concept remains the same- you are using collateral (your house or your equities) to gain access to funds to invest . I am not going to tackle real estate investing in this discussion since successful real estate investing requires, at its very core, the use of leveraging for financing and tax reasons.
I do believe that, technically speaking, the strategy is sound. However, my issue with the leveraged investing is the same as the mortgage vs. contribute to retirement debate- many of the supporters tend to advocate it in the absence of context. Leveraging requires knowledge of financing, taxes, cash flow management and investing. Depending on the terms of the loan, leveraged investing may also require more time and effort than purchasing real estate as an investment (assuming that you have a tenant and barring no major emergencies, your job as a landlord is to collect the cheque and carry out some minor repairs).
As has been frequently quoted by other bloggers, most “average” investors tend to (and excuse the generalization): (i) spend relatively little time thinking about their money; (ii) ignore or pay little attention to educating themselves about personal finances; and (iii) perform worse than the market indexes. If these assumptions are true, the last thing an “average” investor needs to do is add an extra layer of complexity to their personal finances by engaging in leveraged investing. If, indeed, an average investor is performing below market, the more contextually correct advice should be to advise them to fix their portfolios first rather than use leveraged investing as a solution to their problems.
As I have mentioned in the past, I use to provide advice to businesses and I make the analogy that leveraged investing for under-performing investors is equivalent to a business that has received a lot of start-up capital and struggles to turn a profit. Rather than attempting to fix the structural issues with the business, which may not be linked to the amount of start-up capital, the business borrows more money, does nothing different in how the business is run, and wonders why they can’t turn around the business (if this story sounds familiar, this was the issue with the dot com boom- tech companies thought the solution to their problems was more money and not fixing bad product/management). You are throwing good money after bad and your risk exposure has just increased because you are using other people’s money.
Am I anti-leveraged investing? As I stated before, I believe its a technically correct approach to take- depending on how your portfolio is performing. I have no issues with savvy investors executing leveraged investing (for example, I look forward to the Million Dollar Journey’s posts on leveraged investing). However, I do have issue with more aggressive proponents of leverage investing who believe it is for everyone or you are wrong for not supporting it. Again, my approach begins with looking at context before supporting any investing strategy.
Thus, before anyone thinks about leveraged investing, ask yourself the following: (i) is my portfolio under-performing? (ii) do I have the time and attention to engage in such a strategy?If your answer is yes and no respectively, it may make more sense to fix (i) since it needs more attention than seeking more access to capital. I have no intention of engaging in leveraged investing- I am still adjusting my portfolio and I am going to focus on that goal rather than divide my time and attention on other matters.
Two final notes- does anyone remember the hay day of day trading on margin? The on-line brokerage lent you money using the stocks you purchased as collateral and a lot of people began to do it. How many people do you know that still day trades? Only a select few ever made money trading on margin. Just because they have re-named trading/investing on margin to leveraged investing does not mean that the risks haven’t changed (just as corporate raiders being re-branded as private equity does not change the nature of their business). My second observation is that leveraged investing has become quite popular due to unrealistic expectations of investment returns- something I will blog about tomorrow.