Leveraging: Should you borrow money to invest?
Borrowing money to buy stocks in your 20s and 30s can give you nearly twice as much money by the time you retire as a conventional investor. Rather than load up on stocks in your 40s and 50s, you could start investing heavily in equities starting in your 20s. Following that strategy will, on average, leave you with 90% more money when you turn 65 than conventional investment strategies and give you enough to comfortably finance your retirement until you’re 112.
Most people wind up making their biggest stock market bets when they have the most money on hand, not when it’s necessarily the right time to invest. If you’re unlucky, you could plop your life savings into the market just before it slides. In contrast, borrowing money lets you spread the risk of investing over many more years. This is where a long-term leverage strategy can really be beneficial.
What is leverage with an example?
One of the drawbacks of investing only with cash is that your gains are limited by your financial resources. Many professional traders borrow money to invest or employ strategies that allow them to invest more cash than they have on hand. This is called investing with leverage, or leverage trading. Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. At the same time, leverage will also multiply the potential downside risk in case the investment does not pan out.
Here’s an example of how leverage can result in outsized returns. Let’s say you have $100 of your own money, and you can borrow $1500 from the bank at an interest rate of 6%. Let’s say you invest the entire $1600 amount in an investment, which you are confident will grow 15% in a year, and return the borrowed money plus interest at the end of a year. The value of the investment will be $1840 at the end of the year and you will pay the bank back $1500 + $90 = $1590, leaving you with a total of $250 and a net gain of $150 once you subtract the initial $100 you invested. That’s a 150% return!
However, you need to be very careful. The more leverage, the greater returns can be, but the losses can be larger as well. What if the investment declines by 3%? After paying the bank back for the loan, you will be left with a total of -$38 and a net loss of $138. That’s a 138% loss spun out from what could have been only a 3% loss if you didn’t use any leverage.
The risks of leveraging in investments
The vast majority of investors think that a leveraged asset is always riskier than an unleveraged asset. Yet in reality, the key issue may not be the use of leverage, but the risk of the underlying asset. Leverage can be risky but it’s just one risk among many. You need to understand all the risks of investing in an asset (bond, equity, commodity or currency) and work out whether the potential reward for taking that risk is worth it.
The decision on whether to use leveraging for investment purposes depends on the confidence that you have in the long-term quality of your investments, their income yield and their future growth in value. If you look at the long-term historical trend of the stock market, you will see that it has risen with lots of temporary declines along the way. If you do not sell your securities when the market temporarily drops, you have a very good chance of making money from leveraging. However, you need to understand that looking at a stock market trend is looking at an average. The average is made up of winners and losers, long-term holders and short-term buyers/sellers, educated investors and uneducated investors, companies that perform well and those that fail, etc. When someone buys a stock, someone else must think it is time to sell, and vice versa. Who is correct? That means you need to understand what you are doing. If you are working with a financial advisor, you need to understand what they are recommending and why.
How do you spread the risk out in your investments?
One of the most effective ways to manage investment risk is to spread your money across a range of assets that, historically, have tended to perform differently in the same circumstances. While it cannot guarantee against losses, diversifying your portfolio effectively – holding a blend of assets to help you navigate the volatility of markets – is vital to achieving your long-term financial goals whilst minimizing risk. The primary goal of diversification isn't to maximize returns. Its primary goal is to limit the impact of volatility on a portfolio.
Having a lot of investments does not make you diversified. To be diversified, you need to have lots of different kinds of investments. That means you should have some of all of the following: stocks, bonds, real estate funds, international securities, and cash. Investments in each of these different asset categories do different things for you. Stocks help your portfolio grow. Bonds bring in income. Real estate provides both a hedge against inflation and low "correlation" to stocks—in other words, it may rise when stocks fall. International investments provide growth and help maintain buying power in an increasing globalized world. Cash gives you and your portfolio security and stability.
Investors can spread risk not simply by diversifying across assets, but by diversifying across time too. It’s in this sense that stock markets are safer investments for workers (and especially younger ones) than for retired people, especially older ones. Ian Ayres, an economist and Yale Law School professor, proposes that retirement savers should invest more in the stock market when young and less when old, even if young people need to borrow money to invest. Although for young people this means increasing their short-term risk, the early leverage strategy can achieve better diversification across time. Over time, they should decrease their leverage and ultimately become unleveraged as they come closer to retirement.
The problem for most investors is that they have too much invested late in their lives and not enough early on. One of the most basic principles of investing is to gradually reduce your risk as you get older since retirees don’t have the luxury of waiting for the market to bounce back after a dip. Borrowing to invest requires a long-term investment horizon to be able to hold through a full market cycle and avoid the need to sell at the low point. So it may not be appropriate for investors age 60 or over, or for those nearing or in retirement.
Should you be borrowing money to “leverage” your investments?
The only time it makes sense to borrow money for an investment—known in financial lingo as "invest a loan"—is when the return on investment of the loan is high and the risk level of the investment is low. If not, you're taking on a lot of risk for a low or negative return. You need to be really sure when you use leverage on something. Whenever we use leverage in real life - we only use it on investments that we are really sure of and have really high probability.
We all want the perfect investment – the one that offsets equity market losses but still makes money in the long run. Some investors may choose a leveraged approach to improve their cash flow management. The key to success with this strategy is for the investments affected with borrowed funds to generate a higher return than the loan’s interest rate and result in a more diversified portfolio. For example, if your share portfolio is overweight in a certain sector and you do not want to sell the shares, you could use the equity in your current portfolio to borrow and invest in companies in other sectors. For the long-term, we can usefully diversify, but when the market is down, “diversifiers” won’t always help.
There are multiple effective ways in which you can hedge yourself against downside market risk. You could buy a put option, you could sell a call, or you could purchase an inverse ETF. All these hedging strategies have risk/reward trade-offs that will help hedge your portfolio against further downside risk.
Suppose you own shares of Cory's Tequila Corporation (ticker: CTC). Although you believe in the company for the long run, you are worried about some short-term losses in the tequila industry. To protect yourself from a fall in CTC, you can buy a put option on the company, which gives you the right to sell CTC at a specific price (also called the strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option.
In reality, mitigating risk while protecting returns can be extremely difficult. When an investor buys two assets that are negatively correlated, one of the two assets is destined to depreciate in value no matter which direction the market goes. Many financial writers preach the value of index investing - just buy the whole market and be happy with being average. That's fine if you're aiming for average returns and don't want to bother trying to beat the market. It's unlikely, though, that you will be able to accumulate serious wealth by utilizing that strategy.
One strategy is to buy a select few stocks in uncorrelated sectors. For instance, you can buy a technology stock and balance that with some consumer staples companies to counterbalance a higher-risk sector with a more defensive one. Stocks with lower betas tend to fall less than the overall market during a downturn.
Most buy-and-hold investors ignore short-term fluctuations altogether. For these investors, there is little point in engaging in hedging because they let their investments grow with the overall market.
Conclusion
In short, while it’s definitely important to understand the fundamental nature and potential pitfalls of the use of leverage, it can be an extremely powerful tool to reduce one of your biggest financial risks, “Last Decade Risk”. Of course, you only borrow what you’re comfortable with and what you can qualify for in the early years.
Borrowing to invest should always be a long-term strategy to increase your odds of success. If you cannot stomach the ups and downs of the market or if you chase performance, then borrowing to invest is probably not the right strategy for you. In any leveraged portfolio, a strong stomach will likely be required during periods of market turmoil. Remember to regularly rebalance any leveraged portfolio if your allocations stray significantly from their intended targets.
There is no correct answer to this question. The right strategy for you might be large, small or no leverage. Whether it makes sense for you to use leverage to invest comes down to your particular circumstances and your appetite for risk.
