Leveraged Investing: A Guide For Those Who Can’t Help Themselves
Last week we reached out to a panel of experts to weigh in on a controversial topic: borrowing to invest. Leveraged investing isn’t for the faint of heart. That’s why most of our experts suggested avoiding leverage and instead focus on building wealth the old-fashioned way – by saving over time.
So if leveraged investing is an act of sin for 90 percent of investors, this post is for the other 10 percent who understand the risks but just can’t help themselves.
Below are some thoughts from our panel of experts on how to minimize risk when using margin, and how to build a successful leveraged investing strategy.
Tips for a successful leveraged investing approach
Rob Carrick – Globe and Mail columnist
Buying investments on margin in a brokerage account is one way of leveraging. The more comfortable plan is to use your line of credit, or arrange an investment loan from a bank or other lender.
Related: Taxes and your investment income
Unlike brokerage margin accounts, investment loans may allow you to borrow 100 percent of the amount of money you plan to invest.
Investment loans can also be had without risk of a margin call, which is where the value of the securities you bought with borrowed money falls and you’re asked to add cash to your account. In both cases, it’s possible to pay just the interest on the loan on a month-to-month basis and repay the principal when you sell your investments.
And now for a basic principal of leveraging: While diversification using bonds is the key to successful investing in general, when borrowing money to invest you’ll want to go with 100 percent stocks or equity funds.
As for borrowing costs, rates of 3 to 4 percent are typical with a home equity line of credit and an investment loan might have a rate of 4 to 4.5 percent. If you plan to hold your leveraged investments for a long period, be mindful of the fact that rates will likely rise over time.
Frugal Trader – Million Dollar Journey
I avoid ETFs for leveraged investing due to their distributions. Often times, ETFs distribute what’s called Return of Capital (ROC), which can impact the tax deductibilty of your investment loan (check with your accountant).
There are some tax rules to consider with leveraged investing that should be discussed with an accountant. I have written about some of the rules here.
I use a HELOC because my bank gives me prime rate and I don’t have a regular mortgage, so my balance available is high. I’m weary over margin accounts because of margin calls (happens often during market corrections). Otherwise, use an investment loan if it gives you a better rate than a HELOC (doubtful).
You cannot deduct interest from an investment loan, or claim the dividend tax credit, if the investment loan proceeds are used to buy investments in a registered account (RRSP, TFSA, RESP).
Talbot Stevens – Smart Debt Coach
On borrowing to invest after a market decline: I love it and think that all moderate-risk investors should consider this strategy. It’s one of the best examples of how the rich think, and act, to build wealth. They see opportunity in the “negative” of a down market and turn it into a positive.
My now favourite Smart Debt strategy is what I call Buy More Low, where you strategically wait for a meaningful drop in the market before using investment debt. Historically, after the market has had a negative 1-year return, the following 1-year return has averaged 19 percent, almost double the long-term average of 10 percent.
Related: What are you doing with this stock market pullback?
Some will sell after the market rebounds to eliminate all or most of the investment loan. Others will use the drop as a safer starting point for a longer-term hold.
Preet Banerjee – Where Does All My Money Go
I would avoid interest-only leverage, and test the waters with a short term of a year or two. I would also recommend waiting until the investor has been through a full market cycle where their portfolio’s weekly volatility is greater than the value of their monthly contributions.
Dan Bortolotti – Canadian Couch Potato
If you must use leverage, consider taking out an RRSP loan, using the tax refund to pay down part of the loan immediately, and making sure you can pay back the rest within a year.
Sandi Martin – Spring Personal Finance
Borrowing to invest after a correction, during a correction, before a correction, market top, market bottom…that shouldn’t factor in if you’re into the low-cost index investing.
If this is a value investment, then of course the price and value of the security matters, as does your opinion on the direction of the market as it impacts that one particular security.
Jason Heath – Objective Financial Partners
Ideally, if you were going to leverage to invest in stocks, I’d take one of two approaches to minimize your risks: buy when everyone else is selling or engage in dollar-cost-averaging.
Anyone who had the guts to leverage in 2009 when the sky was falling and talk of Canadian banks going bankrupt was all the rage did quite well. But it’s tough to be counterintuitive. People prefer to invest generally or even to leverage when things are going well. Buying at the top is not a good long-term approach though.
If you’re going to leverage, dollar-cost-averaging is a good way to do it. It reduces the risk of picking the wrong time to invest. Dollar-cost-averaging is a good investment strategy period, but I think in particular if you are convinced that leveraging is for you.
Related: When is the best time to invest?
Whether you borrow on a variable or fixed rate basis is another consideration. Historically, research from York University’s Moshe Milevsky has shown that Canadians have been better off about 90% of the time going with a variable rate mortgage. I’d argue we might be in that fixed rate mortgage sweet spot right now.
If you’re borrowing to invest and you’re not doing so on a low-rate, secured basis, I’d say it’s going to be tough to make money (ie. unsecured line of credit or margin).
Nelson Smith – Financial Uproar
The way I’d recommend doing this is using a loan to top up your RRSP. You can borrow the money and then use the tax refund to pay down a chunk of the loan immediately.
Also, enter into it with some sort of end game in mind. Don’t just set this up and forget it. Actively pay down the debt over time, whether you do it using the dividends or just from your own general savings.
The only person I know who does this won’t even look at a stock under a 5 percent yield, which I don’t think is such a bad strategy. He looks at it like real estate, he wants that cash flow just in case the market tanks.
Ellen Roseman – Toronto Star columnist
If you are determined to follow this strategy, you have to keep good records. When using a home equity line of credit, don’t mix up or commingle your investing and spending. It can be worthwhile, in terms of saving time and taxes, to take out a separate line of credit for your investing.
On minimizing the risks of leveraged investing
Banerjee: Overall, there are very few people who should consider borrowing to invest, but engaging a leverage strategy after a correction reduces the risk from extremely highly speculative to “less extremely highly speculative than before the market decline”.
Related: Why investors should embrace simple solutions
When you are early in the accumulation phase, a wildly volatile market will look timid as the monthly contributions represent the bulk of the increase in the value of your account. You don’t fully appreciate volatility until your portfolio is large enough.
Frugal Trader: To minimize risk, an investor needs to be invested for the long term. Over any 20-or-30-year period, the stock market has never lost money but can be highly volatile. I think the real question to ask yourself is “what would you do in a market event like the 2008/2009 financial crisis?” If you would sell your holdings, then leveraged investing is not for you.
Carrick: Setting up an investment loan today, after a long rally back from the depths of early 2009, is crazy. Any adviser who suggests it is just looking to generate commission income from selling investments and is, thus, a menace.
But the case for borrowing to invest, and there definitely is one, is considerably stronger when you do it after stocks fall in price.
Let’s look at some ways borrowing to invest can work for you:
- You commit to making a big investment, rather than adding money to your account on a piecemeal, “when-I-can-afford-it” basis.
- Academic studies have shown that a lump sum investment will outperform a gradual investing approach most of the time.
- Interest on non-registered investment loans is tax deductible.
- Your gains (and losses) are magnified through the use of borrowed money.
Martin: Make absolutely certain you can pay back the loan without substantially impacting your ability to do everything else.
Take the time to think through a few reasonable scenarios like: if my investment drops in value by 40 percent and interest rates rise by 0.50 percent, what will that look like? Feel like? If I lose my job, or have some kind of cash flow emergency while my investments are down, what exactly will I do? What if the security I’ve invested in cuts their dividend? Etc.
Smith: Borrowing to invest during a correction most likely makes more sense than doing it when markets are hitting new highs, but there’s still an element of market timing to it that I don’t like. Investors need to look at multiple other factors other than just the level of the markets. The TSX had two 10% corrections in 2007 and early 2008, which would have been a terrible time to try this.
There are a couple of steps investors can take to minimize risk. The first is to not go crazy with the borrowing. If you only have $10,000 of your own money and someone is willing to lend you $50,000, it’s best not to max that out. The most I would even consider is a 50/50 split between owned and borrowed cash.
The other way to minimize the risk is to ensure you’re getting dividends. I’d recommend a higher percentage of the portfolio to go into sectors that pay generous dividends like REITs, telecoms, and perhaps preferred shares.
If you’re getting a 3 percent yield on a portfolio worth $20,000, that leaves some wiggle room to pay the interest on the $10,000 originally borrowed.
Stevens: What can an investor do to minimize his or her risk when borrowing to invest?
- Only consider Smart Debt: responsible strategies, responsible amounts, and responsible timing.
- Only start or increase investment debt when the market is “not high”
- Eliminate the risk of a margin call, which could force you to sell when the market is down. (Ironically, if the investor wouldn’t be scared away from the strategy, a margin call would actually benefit investors by forcing them to buy more low, reducing their average cost, and increasing their profit when the market rebounds. But for most, behaviour trumps math nine times out of 10.)
- Diversify
The biggest pitfall is investors not understanding the strategies (there are many, with varying risks), and how you will react using borrowed money when the market drops. Sadly, we’re not taught about finance basics, let alone advanced strategies like investment debt.
Related: 5 lessons learned about investing
After a lack of understanding, the biggest pitfall is the behavioural reality that greed causes investors to borrow to invest at the exact time they should do the opposite. That’s why the Buy More Low concept came to be, as an improvement to the traditional long-term approach based on the lessons of the financial crisis (that ironically was caused by irresponsible and aggressive leveraging).
Heath: I’d say the best thing to keep in mind when you leverage is that it’s risky and it needs to be a long-term strategy. Stocks are likely to provide your best return when leveraging but stocks can have 10-year periods where they return zero and the S&P 500 did just that going into the global recession.
Keep your costs low. If you’re trying to make money on a spread from leveraging, high cost equity mutual funds that eat up 2.5% of your fees are likely to ensure an unsuccessful outcome.
Unfortunately, most of the leveraging I’ve seen over the years has been to invest in high-cost equity mutual funds (no doubt at the recommendation of someone selling these products).
Roseman: Here, in my view, are conditions for the 10 percent who might consider borrowing to invest:
- You are an experienced investor who has lived though a few extended bear markets.
- You are in a higher tax bracket and can benefit from the deduction on your interest payments.
- You need an interest deduction to offset the fully taxed income you withdraw from an RRSP or RRIF (and you do this RRSP/RRIF meltdown strategy with help from a skilled financial adviser).
- You plan to stick with a leveraged stock buying strategy for five years or more.
Capital gains are still within your grasp when you buy low and sell high — and capital gains have a lower tax rate than Canadian dividends if you’re in a higher tax bracket. But in my view, you don’t have to borrow to achieve those capital gains. You can just buy shares gradually and use your dividends to accumulate more shares with a DRIP or a synthetic DRIP offered by a discount broker.
Related: How risky should you get with your TFSA?
Finally, keep your eyes fixed on the long term. I’m talking five to 10 years. A correction can lead to a bounce and then to a full-fledged bear market. Borrowing to invest is something to consider only if you know you will be able to hang on and not lose your faith.
Before you take the plunge
John Heinzl – Globe and Mail columnist
If an investor has any debt at all – including a mortgage – he or she is already effectively borrowing to invest. I believe in paying down debt first because doing so provides the highest GUARANTEED return (after tax) of any investment.
Heath: Some perspective – Canada’s prime lending rate has averaged about 8 percent over the past 50 years and the TSX has returned about 9.5 percent. That doesn’t leave a big spread to justify leveraging. Especially when you consider that most investors will earn market returns less fees.
If you’re in mutual funds, average domestic equity MERs are 2.4 percent, so borrowing at prime to invest in Canadian stock funds doesn’t seem to be a good risk to take.
Beyond that, there have been seven declines on the TSX exceeding 25 percent during the past 50 years.
Final thoughts
I’ve used the RRSP top-up approach in the past with positive results. The loan was paid off within a year and I was able to turn what would have been a $12,000 RRSP contribution into a $20,000 contribution at minimal cost.
This is a strategy I’d try again if I wanted to max-out my RRSP contribution room and knew I could pay off the loan quickly.
As for longer-term leverage strategies like the Smith Manoeuvre, this is not something I’d consider until my mortgage was at least 75 percent paid-off, I had no other debt (including car payments), and I was meeting all of my other savings goals.
For now, I’m meeting my savings goals so I don’t see the need to take on more risk by using leverage.
I like using RRSP loans as well. They are a great way to learn about leverage without being exposed to any long term risks. A large deciding factor for me to decide whether or not to use leverage is the cost of borrowing. I leveraged 15:1 in a real estate investment back in 2009. The Vancouver housing market has done well since then so I’ve made over 100% on my initial investment. I also leveraged 8:1 to buy some farms. The land values have since appreciated by 50%, but I’ve made 400% on my investment, before factoring in the cost of borrowing. I also use margin to maintain a 2.5 times leverage in the stock market. By using an indexing strategy I more than doubled the return of markets last year. I’ve probably saved around $100K of my own money over my career so far, but my net worth has grown to over $300K today, mainly thanks to using other people’s money to invest. I think leverage can be useful if it’s used responsibly.
Investing can be risky enough…without leverage.
Personally, I’ve never done it. I suppose the only type of leverage I might employ or would consider, is the RRSP-top approach. There are advantages of doing this if you’re way behind in RRSP contributions AND the borrowing costs are very low AND you can pay back the loan quickly.
Otherwise, borrowing money you don’t have, especially if you already have mortgage, car or credit-card debt is not a great move IMO.
Like you Robb, the only way I’d consider the SM is when my mortgage is all but done and I have lots of assets in the bank to offset the loan risk. That’s many years away for me. Even then, it might just be nice to be debt-free!
We are both 35 years and have 2 kids 4 and 6 years old. We have multiple sources of employment income adding up to net after annual income taxes 145,000 a year combined.
We put the maximum annual RRSP contributions of $36,000, $11,000 TFSA’s and top up our non-registered accounts of about $20,000 a year.
We have 20 years left on our 25 year mortgage of $3,200 a month and we spend another $2,900 a month for food, property taxes, utilities, car and home insurance, daycare, clothing etc. other necessities and cost of living expenses.
We currently have a 30,000 reserve fund in plain old savings accounts, cashable GIC’s and we do get a $14,500 a year annual RRSP income tax refund.
For the last 2 years we were offered and took out a cheap 2.50%, Canada prime-0.50% variable line of credit from our credit union. We borrowed $60,000 and put it in various, 6 provincial residual bonds at 3.97% to 4.29%, so averaging 4.12%.
These will be worth $181,622 in December of 2039. All the interest is income tax deductible from our accrued compound interest and if our line of credit from our credit union rate goes above 4.12% then we have sufficient money coming in and in reserve that it can be paid off in 12 to 18 months.
The current annual interest on our line of credit is about $1,500 a year versus annual accrued compound interest per year of $4,500 a year.
Even if our borrowing rates were to double going to 5.00%, we would still be ahead by $1,500 a year, $4,500 versus $3,000. We would pay it off as soon as we can because we currently have $20,000 in GIC’s that mature annually and an annual $14,500 RRSP income tax refund coming in.
If we were to really get in a tight spot, we can always cash in some of our $165,000 in current TFSA’s, RRSP’s, 38%/62% which would incur some possible commission and possible market price declines in our bonds, strip bonds, residuals. We would mostly likely avoid our RRSP’s and take from our TFSA’s as we would not be taxed at 40%+.
This is a very last resort move because we have a big payment from a contract of $15,000 after income taxes coming in 3 months that is on top of our net $145,000 combined incomes.
Our advisers wanted us to borrow to invest in equity ETF’s but we are conservative GIC, government bond, residual, strip bond investors as want some floor against borrowed principal and interest.
Many investors came into big trouble borrowing against their homes putting it into equities mostly back in 2000, 2001, 2007, 2008. We wanted to avoid that.
We use mini-leverage in our non registered account. We use margin when topping up or adding new dividend paying stocks. I know our dividend flow and try to keep the margin to a 3-4 month payback. We usually add funds on a biweekly basis to pay off the loan quicker. I would feel uncomfortable using more than 10% of our margin amount.
We have a rental property that is fully paid off and is worth about $450,000 in Mississauga here.
We own our own primary residence with no mortgage either and it is worth $400,000. We have no debts of any type.
We are both in our mid 40’s and real estate has served us well but we have only $125,000 in RRSP’s because we both pension plans at work.
We will get about $7,500 a month combined pensions that are only inflation indexed capped at 2.50% annually in 20 years but we don’t have much in savings, $35,000 in GIC’s total.
So we took out a 2.75% line of credit in 2013 and bought some 7 longer term different provinces, government zeros at 4.25%, 4.22%, 4.199%, 4.136%, 4.267%, 4.225%, 4.249% in the amounts of $27,000, $29,000, $35,000, $18,000, $31,000, $16,000, $32,000.
They will all mature in 2041, 2042, 2043 and will be together worth $630,000.
We will gradually payoff some of our $188,000 line of credit over the years with the $1,250 a month net we receive every month and from our employment income.
In the meantime, all our interest is tax deductible and this will also offset some of the $5,200 a year in annual interest.
It was time to diversify away from having about 85% of our total net worth in real estate. We do currently contribute $7,000 a year to our RRSP’s left over available from our RPP contributions through our work to our pensions that allows us by CRA and pension tax law.
We will be topping our TFSA’s to the maximum $62,000 now and $11,000 annually over the next several years. We will stagger different zero coupon, strip bonds investment grade shorter term 4-7 year corporates and 20+ provincial zeros as well.
Once we pay off our line of credit to a $100,000 balance in about 6.5 years, we will borrow to our limit of $90,000 additionally to a $190,000 line of credit balance.
This $90,000 will be invested in a group of preferred shares, dividend paying ETF’s and some dividend paying common shares. We may buy some REIT’s as well.
Using leverage after a correction sounds good. But the truth is we still don’t know the future at that point. The market can drop again after a correction and rise again after a gain. Nothing is guaranteed. That’s why leverage is dangerous.