Myths about Leveraging into Equities – Part 1
May 29, 2007//
Ed Rempel, a CFP and CMA, has been a regular guest poster on Million Dollar Journey. He has graciously written another great article for you to enjoy while I’m away on business. This Part 1 of 2.
For this post, I am borrowing heavily from Talbot Stevens, whose writing about leverage was inspirational to me since the early 1990’s. I’ve always been fascinated by commonly held beliefs that just aren’t true. When you start talking about leveraging into equities, there are many. Here are the most common myths:
1. Leveraging is only for the wealthy
- One of my last articles asked the question: “Is leveraging into equities the ONLY source of wealth” and showed that all super-rich made it there by leveraging into equities (businesses). What is more is that almost all moderately wealthy also made it there the same way.
- The vast majority of wealthy people did not start out that way. They made it themselves by borrowing to start their own business or borrowing to invest in a portfolio of equities.
- If you want to become wealthier (and who doesn’t?), why would you not use the wealth-building strategies used by the wealthy and the moderately wealthy? Even if all you want is to pay off your mortgage, save for your kids’ education and save for retirement, you can still get there much quicker using the strategies of the wealthy.
2. All debts are bad and should be avoided
- A huge part of our Canadian psyche is this part of our “sacred cow” beliefs. This is mostly true, since with most debt, you would be better off if you did not have it. With leverage debt (an investment loan), however, you are usually better off having it than not having it. Why?
- If you borrow money to invest where the interest on the loan is fully deductible every year, and you invest in equities that make a higher rate of return and you pay little or no tax on the equities as they grow, why would this debt be bad? You can of course pay it off any time by selling your investments, but you are better off keeping the loan and the investments.
3. Leverage is too risky for me
- I always find it strange when homeowners are uncomfortable with borrowing to invest in equities. This is because they have already leveraged in a far worse way. When they bought their home, they were leveraging into an asset with no diversification, poor liquidity and low future growth prospects – and the interest is not even tax deductible.
- Leveraging into equities with far higher long term growth, good liquidity and diversification – and where the interest is tax deductible – is obviously a far better strategy.
- We also find that most Canadians vastly over-estimate the risks of the stock market and vastly underestimate the risks of real estate. The facts, however, show that real estate has 2/3 the downside risk of the stock market. The worst decline in the stock market from top to bottom in the last 50 years was 43% (2000-2002) and the worst decline in real estate (Toronto) was 28% (1989-1996) – which is 2/3 the downside!
To be continued… Stay tuned!
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Hi CC,
Almost everyone that starts a business needs to borrow money and owning a business is an equity. My point is that is similar to leverage into equities (except no diversification).
For example, Bill Gates borrowed money when he was young to start a small business that eventually grew into a huge business. That is leveraging into an equity.
Note that most of the super-rich leveraged into only 1 or a small number of companies – which is quite risky.
I agree that perception of risk varies (and usually at the wrong times), but my point is that, in general, most people have an exaggerated view of how risky the stock market really is. That is what often part of what stops people from accumulating the nest egg they need for retirement.
For example, let’s say you would need $1 million in any equity-focused portfolio averaging 8%/year long term to have the retirement income that you want. It would take $1,500,000 to have the same income with a bond/GIC-focused portfolio averaging 5%/year long term.
For many people, they would be scared to ever have $1 million in equities, but they also would never be able to accumulate $1.5 million. So, what options do they have?
Besides working longer, retiring on less or investing more now, one other viable option is to understand the real risk level of equities and how to manage the risks.
The risk of equities does reduce a lot if you stay invested for a long period of time. This would be at least 15-20 years.
We do agree that leverage does increase both risks and returns. So, it is not for everyone. That is how virtually all rich people made their money though.
Ed
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I’ve already disagreed with #1. Most wealthy people got that way by starting a business, not leveraged investments in common stocks. And wealthy people apparently want their own children to become lawyers, doctors, accountants and engineers; not small business owners because they realize the risks in such enterprises (Source: Millionaire Next Door). To follow the strategies of the wealthy would imply starting a business, not investing in equities.
A house is not an investment, the primary purpose is to provide shelter for the family. An investment portfolio aims to earn a return. Therefore, it is not surprising that the leverage is not equivalent in people’s minds. You can also see the difference between a house and a stock in behaviour toward profits (or losses). Based on whether they are greedy or fearful they will be quick to realize their profits (or losses) in their portfolios. How many times have you heard someone selling their home because it went up 30% and couldn’t possibly go any higher?
It is meaningless to say that people overestimate risk. The perception of risk is not static. To confuse matters even further, actual risk isn’t static either. It varies over time and typically investors believe risk to be low when a bull market is topping out (and actual risk is very high). In other words, investors underestimate stock market risk when a bull market is topping out and overestimate it when the bear market is ending.
I guess the key point I am trying to make is that while leveraged investing boosts returns, it also increases risk. Leveraged investing is no free lunch – any extra return is earned by assuming more risk. While you are seduced by the extra return, don’t forget the downside.
Great post, you make some good points with respect to misconceptions due to what joe public perceives as the meaning of the word ‘stock’.