Leveraging to Increase Investment Returns- walk before you run

Posted by on June 18, 2007 in Investment Strategy

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.

7 Comments on Leveraging to Increase Investment Returns- walk before you run

By FourPillars on June 18, 2007 at 8:54 am

Great post. I definitely agree that leveraging isn’t for everyone and that all investors should make sure that their all aspects of their finances are in good order before worrying about “extra” things like leveraging.

I’ve seen some leveraging strategies which advocate leveraged investing over rrsps which I believe is a huge mistake for someone in a high tax bracket. If you can contribute at a 40%+ deferral rate and withdraw that same money later on at a much lower average tax rate and don’t pay any tax in the interim, that’s a gift from the gov’t in my opinion and shouldn’t be missed.

Mike

By Canadian Capitalist on June 18, 2007 at 10:13 am

I can’t agree more with your opinion. While leveraging will most probably work, that is not the issue. The issue is whether most average investors should take the added risks of leverage.

On a personal note, I do leverage myself. But it is more of a liquidity tool when I think there is an irresistible bargain in the market and I don’t have enough cash. It rarely happens (maybe once a year) but then I try and pay down the loan within the next year. I also restrict leverage to 10% or less of our total portfolio.

As an aside, I have a post scheduled that deals with this same topic.

By admin on June 18, 2007 at 1:11 pm

FB- any strategy which involves taking money out of registered accounts is fundamentally misguided. If you are in a high tax bracket, there are more than enough government sanctioned tax shelters/loss vehicles to use.

CC-Looking forward to the post. I’ll link to it. Your strategy of capping leveraging to portfolio size is quite prudent to limit down-side risk. Hope you share this with your readers.

By Should You Leverage? on June 18, 2007 at 8:54 pm

[...] 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 [...]

By Financial Jungle - » Jungle Bulletin: You Give A Little Love And It All Comes Back To You on June 19, 2007 at 4:05 am

[...] Thicken My Wallet writes a very fulfilling piece on the merit of leverage investing. My favourite part is when he uses a struggling business as an analogy to an under-performing investor. You’ll have to visit his link as I won’t give it all away. Not to be outdone, Canadian Capitalist reinforces Thicken My Wallet’s post by reminding borrowers how swiftly the avalanche of dot-com money vanished in 2002, and investors should thread carefully when considering leveraging. [...]

By The Financial Blogger » You Might Not Be Aware of This: You Are Leveraging on June 20, 2007 at 7:30 am

[...] are two other posts regarding the risk related to leverage strategy. Thickenmywallet started with “Leveraging to Increase Investment Returns – walk before you run” and then, Canadian Capitalist with “Should you Leverage?”. All those posts made me [...]

By How Exposed is the Smith Manoeuvre to the Lipson Case? | Million Dollar Journey on March 19, 2008 at 5:34 am

[...] For those who are on the fence about SM, I have posted on taking a more contextual approach to this issue before. [...]

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