Warren Buffett famously said that investors should “be fearful when others are greedy and greedy when others are fearful.” Yet one look at statistics on leveraged investing suggests that we do the exact opposite: Investors have borrowed more money than ever to buy into this post-financial crisis bull market.
Leverage can be a powerful tool in the right hands – an investor with a long time horizon and the fortitude to stick with the strategy through rocky times. It’s human nature to assume our risk tolerance is higher than it is, but ask yourself how you’d feel watching your leveraged investment drop 50 percent during the market crash of 2008-09?
There’s also an air of mystery surrounding leverage that we don’t like to talk about. In his first book, Stop Working, Here’s How You Can!, Canada’s self-professed youngest retiree Derek Foster offered common sense advice on building a portfolio of dividend paying stocks – a strategy that inspired many investors to emulate in hopes to achieve early retirement.
But Foster omitted a crucial detail in his story: his aggressive use of leverage, including a huge bet on then troubled cigarette maker Philip Morris using $140,000 of borrowed money to amplify his gains.
It’s that type of thinking that leads to questions like this one that I received from a reader:
“With Canadian Oil Sands (COS) paying a juicy 8% dividend, does it make sense to borrow money at 4% to invest in this stock? The dividend is more than enough to pay the interest on the loan, and there is potential for capital gains.”
I reached out to 15 leading experts on personal finance and investing to get their thoughts on borrowing to invest. This two-part series will explore the pros and cons of using leverage, the risks you need to understand before you consider this approach, and the best ways to use a leveraged investment strategy.
Borrowing to invest
First, some thoughts from our experts on borrowing to invest:
Frugal Trader, from the Million Dollar Journey blog
Leverage can be a very powerful wealth building tool, but it can also be a wealth destroying weapon. It works for those who have a long investment horizon AND have the risk tolerance to watch the amplified ups and downs of their account balance.
Robert Brown, author of Wealthing Like Rabbits
I’m not a fan of borrowing to invest. As in most things, there are exceptions to the rule but too often that exception becomes the rule.
Is this person 62 years of age and considering leveraging as a way to “swing for the fence” to fund their retirement? Bad, bad idea. Is this person 31 with enough cash that they could fund this investment themselves, but is considering leveraging to protect that liquidity? Big, big difference.
Bruce Sellery, author of Moolala
I don’t think most people are equipped to borrow to invest. They get stars in their eyes about the upside potential, but don’t fully comprehend the consequences of the downside.
True, the math can work in your favour, provided you factor in fees associated with investing, but the risks can be significant – Stock market declines, economic weakness, changes in government policy such as the Conservatives change on income trusts. I have seen too many horror stories to endorse this approach.
John Heinzl, Globe and Mail columnist
I am not a fan of borrowing to invest. While leverage can increase your returns when the market rises, it magnifies your losses when the market falls. Many investors think only of the upside and are not prepared for the fear and regret that takes over when they lose capital that they borrowed and still have to pay back.
I have seen experienced investors use leverage successfully after a correction, but I would not do it myself. I much prefer to save money to invest rather than borrow it. If someone is unable to save enough money to invest then they should address their spending and saving patterns before taking out a loan.
Dan Bortolotti, the Canadian Couch Potato blog
I would ask an investor who bought a leveraged investment after the “correction” of September 2008. How would they have felt when the 10% dip turned into an almost-50% plunge within a few more months. In theory, borrowing to buy stocks during a downturn might make sense, but it takes exceptional discipline to execute, and precious few investors have that.
Larry Elford, investor advocate at Breach of Trust
Any investment that can go up at a rate above the cost of borrowing might be considered a win if an investor can handle the near exponential level of risk caused by leveraging. But while you have no guarantee whatsoever on the investment performance, there is an iron-clad guarantee that the debt clock will tick against you.
When adding in the perverse investment dealer incentives (commissions, fees) that motivate investment sellers (aka “advisors) to push larger and larger sales, leverage is often an indicator that one had a very poor and/or desperate investment “advisor”.
This strategy is for very well-off experts and possibly no one else.
Sandi Martin, fee only planner at Spring Personal Finance
If your cash flow can support it, if you’ve thought through the very worst case scenario and it won’t bankrupt you or give you ulcers, if your time horizon is long enough to make the timing of your purchase largely irrelevant, why not?
Talbot Stevens author of Smart Debt Coach
Being a “dividend landlord,” where you finance dividend-income property instead of real estate, can be an effective wealth strategy for those who, like me, don’t like fixing toilets. The math is even more compelling than first appears, because interest is 100% deductible, while dividend income is taxed less.
This is where being a “dividend landlord” has a big advantage over a traditional landlord. An investor can’t buy even one property in most cities with $250K, but could easily own 5 or 10 properties that pay tax-preferred dividends.
Rob Carrick, Globe and Mail columnist
Borrowing to invest – a.k.a. leveraging – is the definitive case of an idea looking good on paper and too often turning out to be disastrous in real life. Only the steadiest of investors can handle the idea of going into debt to buy into the ever-unpredictable stock market.
Most people are wired to panic and sell when the stocks they bought with borrowed money tank, thereby guaranteeing a bad outcome.
Jason Heath, fee only planner at Objective Financial Partners
A tight spread, historically, between prime rate and market returns, coupled with the risk of an investor bailing when the going gets bad, are two key reasons I’m leery to endorse leveraging.
I prefer generally to see leverage used to invest in rental real estate. It’s a less liquid asset that helps protect against the knee jerk reaction of selling stocks during a downturn.
Ellen Roseman, Toronto Star columnist
I’m not in favour of leveraged investing for 90 per cent of investors. Most people find it hard enough to stay invested when stock prices are depressed. When they also pay interest on a loan, they are doubly impatient to see results.
I don’t really have much to say on the subject of borrowing to invest other than to say that it is generally a bad idea. I’m rather fond of Buffett’s quip, “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money. You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.”
Those who impatiently strive to make a great fortune in the markets by borrowing tend to walk away penniless.
Adam Mayers, Investment and Personal Finance editor at the Toronto Star
Borrowing to invest is fine as long as you understand the risks and you have a long-term horizon. Leverage is great when things are going up, not so good when it goes the other way. In the short run markets are unpredictable as the last month or so shows.
But if you’re just trying to time the market I’d say not. That’s a mugs game and isn’t really investing. It’s placing a bet, which is gambling.
Betting on a single stock
Preet Banerjee, author of Stop Over-Thinking Your Money!
The pros seem enticing: the interest is deductible; the dividend income is taxed preferentially, as is any potential capital gain. The problem is the extreme risk. Investing in a single stock is speculative. Borrowing to invest in a single stock is gambling.
A dividend cut could eliminate the positive cash flow of the strategy, and in turn would likely lead to a drop in stock price. Unwinding the strategy could leave the investor with a huge loss.
Leveraging to invest makes sense if you can predict the future. If not, then it just magnifies the risk and potential return.
Nelson Smith from the Financial Uproar blog:
Whenever you’re borrowing to buy an asset — whether it be a house, stock, or anything else, there’s an added risk compared to just buying it outright. This can either lead to the investment doing really well or quite poorly. It all comes down to the amount of risk an investor can stomach. Real estate investors have done this for years, and it tends to work out for them.
If it works, it can really accelerate building wealth. And if it doesn’t, you could be in some serious trouble.
Bortolotti: Unless you plan on buying a GIC, the yield on your leveraged investment is meaningless. A stock might pay a dividend that’s higher than the interest rate on the loan, but there is always the potential for a stock to lose 30% or 40%, or perhaps a lot more, leaving you with a loan principal that exceeds the value of the asset.
“My concern was the original question framed leverage like a free lunch. That scares me.”
Martin: The pro is just what it seems – the potential to make more money from the investment than you pay to borrow it. The con is a great big flashing neon sign that says “Are you sure your interest rate and sustainable dividend assumptions are correct? What exactly will happen if you’re wrong and you lose money?” (It’s quite a large sign).
Heinzl: Regarding Canadian Oil Sands, the first question the investor should ask is: Is this a sound investment on its own merits? COS’s dividend may look attractive now, but its dividend has been quite volatile over the years. The fact that it is currently yielding 8 per cent — more than the interest rate on the loan — provides no guarantee whatsoever that an investor will come out ahead by borrowing to buy the stock.
Stevens: The risk with a very high dividend stock is that it might not be sustainable, and/or the stock will fall. To reduce this risk: 1) Choose stocks with stable and increasing dividends instead of highest yields. 2) Diversify as much as practical, not borrowing for only one dividend stock.
Heath: It’s tough for a stock to pay a high distribution indefinitely. It may mean they’re leveraging or foregoing future growth to keep a payout ratio high or that the stock is falling and the dividend rate, based on historical dividends, is therefore magnified.
Lehman Brothers was paying a great dividend rate on paper as they went to zero. Because any dividend on a low value is enticing, it doesn’t mean it’s a good investment to buy on leverage, let alone, at all.
Brown: The investment would have to return more than the cost of servicing the debt and there are just no guarantees any equity stock will.
Frugal Trader: I use leverage for dividend paying stocks in non-registered accounts – similar to what your reader is describing. This allows me to claim the tax deduction on the interest paid on the investment loan while, at the same time, taking advantage of the dividend tax credit.
I buy individual dividend stocks with borrowed money, and add to my positions when valuations are attractive. For example, with the recent energy correction, I added to some of my energy positions.
Roseman: There are three things that can go wrong when you buy high-yield stocks with a low-interest loan.
One, the company (or the industry) is in financial trouble. That can explain why the yield is higher than average.
Two, the company can’t sustain the dividend and reduces it or eliminates it altogether.
Three, the interest rate on your loan goes up. Most borrowers have short-term floating rates. With more expensive financing and a reduced dividend, the benefits of a leverage strategy can fly out the window.
Mayers: If you buy good quality stocks, or mutual funds that hold them, that are leaders in their industry, with established businesses that pay dividends you’ll come out ahead in the long run.
When corrections occur these stocks fall last and recover first and they’ll pay you a dividend in good times or bad. If they’re Canadian you get the added incentive of the dividend tax credit.
Avoid conflicts of interest
Carrick: Leveraged investing is a big money maker for the financial industry because of the interest income it generates, and because it allows people to invest more money than they would otherwise be able to muster and thus generate bigger fees and commissions.
Elford: Get advice from a fee-only planner, coach, or a fiduciary level licensed and registered adviser. Most of these people are not motivated and “incentivized”, (nor legally allowed) to sell investments that will likely harm the customer.
The net result is that, for many ordinary investors, it’s the “blind leading the blind” into debt and one of those blind people is simply a fee-or-commission-hungry salesperson in disguise. The odds of success for the investor is tiny, while the odds of success for the investment dealer and his or her salesperson are tremendous.
Banerjee: Ask your advisor how much will be generated in commissions for their recommendation. There is a huge incentive to recommend leverage because it magnifies commissions. But remember, it also magnifies risk.
Not surprisingly, one of the leading sources of investor complaints against advisors is unsuitable leverage. Tread carefully.
Heinzl: Many advisers love borrowing to invest because it is the quickest way to build their clients’ assets and therefore make more money from fees and commissions. In addition to the emotional consequences mentioned above, the interest rate on the loan creates a hurdle that the investor has to beat just to break even.
Stevens: Deal with a trusted advisor to help you understand all of the pros and cons, implement a plan that makes sense for you, and stick to it.
Part one of this two-part series looked at the risks involved when borrowing to invest. You get the impression that leveraged investing isn’t suitable for the majority of investors.
That said, for those who understand the risks (or choose to ignore them), part-two examines how best to use a leveraged investing strategy. We’ll look at the type of investor who is best suited for this approach and the mechanics behind successful implementation.