Myths about Leveraging into Equities – Part 2

Ed Rempel, a CFP and CMA, has been a regular guest poster on Million Dollar Journey. This article is continues from part 1 of the series “Myths about Leveraging into Equities“.

4. Leverage always increases risks

  • What are the risks of borrowing to invest? Let’s assume the total risk is a combination of the 3 main financial risks – the risk of losing money, the risk of emotional stress, and the shortfall risk of not having enough money to meet your long term goals (e.g. retirement). The first 2 are generally higher with leverage.
  • What about the 3rd risk? It’s been said that you can be young and broke, but you can’t be old and broke. Specifically, what is the risk that our money will run out while you are retired?
  • Most of what we actually do as financial advisors is help people set and achieve their long term goals, especially retirement. The first experience with a retirement plan is usually quite shocking! Most of our clients are average Canadians, and are surprised to find that they will need $1-1.5 million to maintain their existing lifestyle when they retire. They underestimate how much they actually spend now and then underestimate how much inflation will affect us over the next 40 or 50 years.
  • The truth here is that for most of us, the risk of running out of money is far higher if we don’t use wealth building strategies like leverage.
  • If you have never had your own retirement plan calculated accurately, you will probably doubt this. You may also be one of those frugal people that spend almost nothing. But if you consider risk as a combination of the 3 main risks, some leverage will actually reduce your overall risk.

5. To make money with leverage, your returns need to be higher than the loan interest rate

  • It may seem logical that if you borrow at prime (6%), you need to make at least 6% on your investments to break even. This is wrong for 2 main reasons – the different tax treatment and the fact that the loan interest is the same amount each year (if the loan amount stays the same) while the investment growth compounds on itself.
  • Your investment loan interest is 100% deductible each year, while the equity investments give you tax-preferred capital gains. Plus, you can defer them almost forever if you have very tax-efficient investments.
  • The break even point for a typical example is an investment return of only 4.5% after year 1, 4% after 7 years, and 3.3% after 20 years. (This assumes a 40% tax bracket and 10% of the investment growth taxed each year – 90% tax efficiency).
  • In short, after 7 years, you only need 2/3 of the loan interest rate to break even and after 20 years, you only need just over ½ the loan interest rate.

There are real risks with leverage into equities. They can be minimized, however, with an effective investment strategy, understanding the risk level of your investments, by not taking any distributions out of the investments, and making sure it is a long term strategy.

Implemented properly, once you give up the myths, leveraging into equities combined, with your RRSP’s, can be the best way to achieve your long term goals.

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Ed Rempel

d Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.  If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com
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KK
12 years ago

Looks this market is definitely over heated… the cycle of market correction of being 10 yrs is always true..

Sitting on cash and taunting the Bear
13 years ago

ED,

Are you for real? Look at your foolish comments about the market not being overheated. I am a novice investor and I have been in cash since October. When all the suckers panic, I buy.

Ed Rempel
14 years ago

Hi Sam,

I’ve just returned from the CFP conference in Calgary. Quite interesting.

Regarding your question: “Do you believe in leveraging at this point..with the markets overheated……”

Which market is overheated? Most Canadian investors and even most advisors have this wierd drive to invest primarily in Canada. This phenomenon is common in most of the world. Even in Iceland, 70 of all equity investments are into Iceland stocks. (Can you name one?)

I agree, there are some risks investing in Canada now, where we are 75% in rocks, trees and banks – all of which are quite high. This is true of other resource-based economies.China is also very high and probably will have a major crash.

The global and US markets, however, have just recently made it up to their last high from 2000. This is over 7 years, which is the longest time they have had without growth since the 1930’s. If you invest globablly or in the US, they are definitely not over-heated.

Leverage is a very effective strategy if done right and invested effectively, so it is smart to minimize your exposure to over-heated markets. At the moment, I would suggest keeping your Canadian equities to a max of 25%.

Ed

Causalien
14 years ago

Hi, I’ve actually did a spreadsheet analysis of the smith maneuver a.k.a leveraging your equities. Can everyone take a look and see if any of the numbers are off, or if my calculations are wrong somewhere?

http://www.ultracrepidate.com/?p=1080

sam
14 years ago

hi ed,

do you believe in leveraging at this point..with the markets overheated……

thanks

Ed Rempel
14 years ago

Hi CC & Mike,

Proper investment theory states that the best way to increase returns is to stick with sound investments and then leverage them. This is an important concept and a big part of why I am such a believer in leverage as a strategy.

Your quote is exactly why leverage is a good strategy: “You hope to make a greater return by assuming a higher risk. You can do the same thing without leverage by investing your entire portfolio in small-cap value stocks. Or you can assume even more risks by buying lottery tickets or looking for penny stocks on the Venture exchange. Yeah, you are taking risks, but the rewards…

Investing in more risky investments is much less likely to work than leveraging into sound investments. In fact, it is a common myth thatt more risky markets have higher returns. I’ll explain this in my next 2 articles posted this Thursday and next.

The broad markets and top fund managers tend to have reasonalby predictable returns in the long run, and leveraging into them provides higher returns with a reasonable risk generally. This is unlike buying high risk sectors, penny stocks or lottery tickets that are far less predictable, even in the long run.

Ed

dj
14 years ago

I get the concept, and it interests me, especially since our mortgage will be gone soon and we don’t need/want the money for life-style.
Was thinking we would just start putting that monthly amount into our investment account.
What are the specifics of, or where could I find more, about actually incorporating leverage into our plan.

The Financial Blogger
14 years ago

Hi FP,
the post is now ready:
http://www.thefinancialblogger.com/?p=62
Comments are welcome.
Cheers,
FB.

The Financial Blogger » Compound Interest VS Interest Risk
14 years ago

[…] I read a post on milliondollarjourney.com about Myths about leveraging into Equities. I decided to add more details regarding the interest risk. […]

Causalien
14 years ago

Canadian Capitalist: I remember previous discussions about using home equity line to invest in a higher return fund. So my question is this: Is borrowing to payoff your mortgage considered, and I quote from the revenue agency “for the purpose of earning income from a business or property”.

That’d just be too easy.