Reality Check: How Did That Leveraged Investment Work Out?
Last year I invited 15 financial experts to share their thoughts on borrowing to invest. At the heart of the debate was a question I received from a reader about using leverage to invest in a single stock:
“With Canadian Oil Sands (COS) paying a juicy 8 percent dividend, does it make sense to borrow money at 4 percent 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 can see why an investor might be tempted to double-down on a stock after a big sell-off. But was it a good idea?
At the time of this question, Canadian Oil Sands stock had just dipped from $21 to around $17 – an approximate 20 percent correction – but still paid a generous quarterly dividend of 35 cents per share.
Since then, the price of oil continued its sharp decline from $80 per barrel down to $44 today. Canadian Oil Sands stock plunged right along with it, falling from $17 down to $6.46 today. The once juicy dividend has all but been eliminated. Today COS pays a quarterly dividend of 5 cents per share – a yield of 3.1 percent.
Related: Why living off dividends no longer appeals to me
So how did that leveraged investment work out? Let’s say our investor borrowed $20,000 on his line of credit at 4 percent interest. He executed the trade in October 2014, when Canadian Oil Sands was trading at $17. He purchased 1,175 shares.
The current market value of his investment is $7,590.50 – representing a 62 percent loss. He would have received dividends of $411.25 in November 2014, and then payouts of $58.75 in February, May, and August of this year.
The market value of his investment, combined with $587.50 worth of dividends, brings his total value up to $8,178 – still a 59 percent loss.
Remember that our investor borrowed the $20,000 at 4 percent, and so he made interest-only payments of $66.67 each month for a total of $800 for the year.
It looks like the dividend wasn’t nearly enough to pay for the interest on the loan after all.
In summary, our investor still owes the bank $20,000 on a line of credit, and his investment is worth just $8,178 (including dividends). He pays $66.67 every month to service the loan, but his investment only brings in $58.75 per quarter in dividends.
Related: Leveraged investing – A guide for those who can’t help themselves
The obvious lesson here is that you’re taking a huge gamble when you invest in a single stock, and you’d have to be certifiably insane (or Derek Foster) to amplify that risk with leverage.
I can’t imagine placing all your hope into one stock – and thats without any leverage. With leverage is just asking for a disaster to happen, and with the volatility of oil it becomes even worse. I can see leveraging in some cases like how Frugal Trader did it – investing in solid, stable companies over a variety of industries. It works for some people but not others and is hugely dependent on risk tolerance.
Hi Dan, leveraged investing can work if it’s part of a well thought out long term strategy and you diversify your investments across many sectors (and countries). In that case you’re betting on the overall value of the markets to continue to deliver 8% returns over the long term.
In that respect, it’s much like taking out a mortgage and knowing that the value of your home may fall in the short term, but as you pay it off over the next two decades your home should be worth more than you paid for it, and in the meantime you’ve amplified your returns due to the leveraged loan.
This COS example is an odd one. It mixes speculation with a desire for steady income.
I would get it if he had mad money that he could afford to lose on some company he thought might go through the roof. Some people do this. However I find it hard to imagine “mad money” being a loan.
However placing a bet when the optimistic return is under 4% per year just leaves me scratching my head.
Hi Robert, the amazing part is that this was an actual reader question. I’m assuming (hopefully) that this reader had other stocks in his portfolio and just wanted to double-down on COS due to the 20 percent correction.
A head-scratcher indeed.
OUCH!!!! Yes, putting all your eggs in one basket can pay off, but here is one of the countless examples where that might not have been quite so good. What if he had bought CDZ or some dividend paying ETF ? In this case he would have lost on the purchase as well, but CDZ will continue to pay dividends, I guess.
Talbot Stevens (aka, the Smart Debt Coach) suggests that it’s okay to buy a broad-based ETF when the markets are down 20 percent or more (called buy more, lower). It would certainly be more palatable to be only down 4-10% instead of 60%.
I have read many articles in the last couple of years advocating heavy weighting in dividend stocks as a solution for those leery (and weary) of market risk and minuscule interest options. Many of the articles suggested any drop in stock price wouldn’t matter as it would eventually recover and in the meantime the dividend cash flow would continue. Did it not dawn on those writers that if the stock tanks, cash flow is likely next and then the dividends will tank? I suppose a 50% drop in the stock and a 50% drop in the dividend is supposed to make the investor happy that based on the current value, their dividend yield hasn’t changed or that it doubled (for now) if it’s just at the stock tank stage? Where are the loan payments coming from now? Spin it until your client feels good about it.
Hi Laurie, excellent points. And one of the worst examples of cognitive bias is looking at past history to predict future success. Many dividend investors act as if companies like Wal-Mart, Coca-cola, and McDonald’s will continue to dominate their respective industries for the next 20-30 years, as they have over the past few decades. But as we’ve seen from books like, Good to Great, the best companies of tomorrow will surely look different than the best companies of today.
How is this different from buying a lottery ticket? Maybe this makes sense if you’re bored and have money to lose. No such thing as a sure thing, death and taxes and all that…
Hi Kurt, it’s not much different than gambling. Leveraged investing would be risky enough if you bought a broad-based ETF. Placing a bet on one individual stock is financial suicide.
Nice to see this revisited. Good example with COS.
I linked back to what I wrote and I still feel this way:
“I’m not a fan of borrowing money for investment purposes myself. I prefer to save first then invest. Borrowing money for investing implies you don’t have the money to invest in the first place, somewhat like taking out a massive mortgage to buy a fancy house. Besides, there are no guarantees when it comes to investment returns and there are too many investment factors you cannot control with leverage (such as your investment returns).”
Leveraged investing is only good if you can cover your expenses when a loss occurs. Otherwise, for 95% of the population (maybe more) I wouldn’t do it.
Mark
I think the principal mistake of this story is “you’re taking a huge gamble when you invest in a single stock”. Leveraging is not bad when used properly. Otherwise, many investors, myself included, would probably never start investing in the beginning! When it comes to dividends, diversity and growth are the clue to me!
Cheers,
Mike
Hi have followed this blog for over a year and have found a lot of the stories and examples interesting and helpful. Normally I don’t comment on any boards I read but on this topic because of personal experience I feel more compelled. In 1996 I got interested in investing in the stock market. At first I had every intention of looking at the fundamentals of each company that I felt had superior future prospects. Balance sheets, financial ratios, P/E, P/S, P/B ratios cash flow and so forth as well as industry projections- I looked at all that. Back then computerized stock screening was primitive if available at all so this was a tedious process. the Internet bubble was just getting started and you would see on CNBC in the morning almost daily companies like amazon, eBay, yahoo -many internet hi flyers gap open 8-10points. Watching that was very intoxicating. Didn’t take much brains to figure out that if you had good credit you could take out a credit card cash advance for 20k at zero percent for a year ( in my case) open a online discount brokerage margin account and parlay that in to 40k buying power all on borrowed money! Margin interst at that time was around 6% and was negligabe if you were holding positions for two days to at most two weeks waiting for the stock to pop and then liquidate your position. At first I had modest success. seemed like everything was going up- you could bet on almost anything with a .com behind it and market momentum would be good for 5-8 pts. I was trading 100-300 shares at a time so if I lucked out I could pull $2400 on the trade. At first I had discipline ( came up with trading parameters – at what percentage loss would liquidate the position etc) and was able to profit modestly. I wasn’t getting rich though. After talling up the winner and loosers I would net around $1200.US/ mo over a 8 mo period. Not bad but at the volume I was trading at and the numbers I was use to seeing I started getting greedy. I would notice that when I got into a loosing position and per my rules would liquid it to perserve my working capital- the next week – even more frustrating the next day the stock would pop back up and make up the loss I had incured and further advance to make a profit- Had I not liquidated the position. This happened a lot!! So… I widened my parameters- and where do you stop? If you rationalize one adjustment it becomes easier to rationalize others and soon your watching a position tank and saying to yourself OK – I’ll hang on for 2 more points then liquidate – then see something in the streaming realtime chart that makes you thing OK when it get down there at support level it should bounce off of it -then I’ll liquidate! Only to see it crash through that support level and keep tanking. In the following three months I transformed from Jack the Trader to Joe the Investor. Only with a portfolio full of postions very much in the red and none of which I would have invested for the long term. Because the majority of my working capital was tied up in these positions I was unable to trade my way out of this hole and finely after much fingernail biting three months later was able to liquidate my last position for a total net loss of around $2300.
It could of been much worse. I closed my brokerage account paid off my credit card loan. 5 months later I had as well as everyone else at the time a ring side seat of the 1999 internet meltdown- that I could have been right in the middle of- lesson learned