Many investors, especially newer investors, have a very poor understanding of leveraged investing into stocks. Often they fall into two camps:
1) Leverage is bad, bad, bad, stay far away and don't touch; or
2) Leverage is how you get rich quick!
Both of these views are naive. Leverage is simply a tool to use other people's money for investment purposes. When used correctly, leverage can increase your returns and reduce your risk. Leverage is used by nearly everyone who has achieved significant wealth through investing.
Broadly speaking, just about everyone uses leverage all the time in one form or another: homeowners, business owners, and investors. The problem is our society has incorrectly categorized leverage into acceptable and unacceptable forms without the proper research and understanding.
Using leverage to buy stocks makes you an idiot. Use leverage to buy a rental home and you are a smart investor. While both rental real estate and stocks fluctuate wildly in price, can pay regular income, and can easily crater in value, we allow our minds to believe real estate is somehow a less-risky choice.
Leverage is used by nearly every homeowner to buy their residence. Although your mortgage is not tax-deductible, your "investment" doesn't generate income, and homeownership exposes you to risks that no renter ever worries about, many Canadians don't even count their mortgage as "debt".
Leverage shouldn't be encouraged or dismissed based on the asset class it is used to purchase. Rather, leverage should be used carefully to improve returns while limiting downside risks in all appropriate assets.
Leverage can kill you quickly and leverage can make you rich overnight, but it should not do either of these when used correctly.
Example With an 80/20 Portfolio
Let's say you want to invest in a passive, buy-and-hold portfolio and you have determined by your own standards that an 80% exposure to stocks and 20% exposure to bonds is right for you.
How do you accomplish this? Well, if you have $10,000 to invest, the traditional way might be buying $8,000 worth of a U.S. stock index and $2,000 of a bond index. You would re-balance at regular intervals to maintain this allocation.
But is this the only way? Not at all. If you want an 80% exposure to stocks, you could instead buy $8,000 worth of U.S. stock fund using 2:1 leverage ($4,000 down) and put the remaining $6,000 in bonds. Or, put in other terms as a percentage of your total net equity, 80% stocks and 60% bonds.
Again you would re-balance regularly to maintain this allocation. However, in this case it's important you do not re-balance too frequently to pull away money from bonds in losing markets.
Let's see the impact of these two portfolio styles during a devastating period for U.S. markets: 1925 to 1940—a time where stocks went up just 25% over the entire 15 year period and there were multi-year drawdowns. I used 1.9x leverage to account for margin interest costs on a 2:1 leveraged stock allocation.
Here's a table example of the two portfolios using annual rebalancing:
As you can see, during this devastating period for U.S. stocks (and global stocks as a whole), both portfolios outperformed the basic index—benefiting from regular rebalancing. However, of the two, you would have been much better off with a leveraged portfolio. Over the 15 year period you would have doubled your return of a traditional balanced portfolio and tripled the return of stocks only!
It was less risky as well. The maximum loss was in 1931 where stocks dropped 52.67%. However, because the margin rules would have stopped you out—never risking more than your equity in your stock portfolio—your maximum loss would be less than the initial equity in your stocks.
The leveraged portfolio only under-performed the traditional portfolio style in two years: 1928 and 1933. Both of those years were big gain years, not loss years. This type of return pattern is seen repeatedly throughout data history on U.S. stocks and bonds with various allocation targets.
It is important to recognize the steps taken to limit risk. If you would have allocated 80% of your portfolio to stocks and leveraged that 2:1 (160% stocks and 20% bonds as a percentage of your net equity), your portfolio would have been nearly destroyed! If you use leverage, make sure you adjust your safe assets up to reduce risk.
Leverage in itself is not scary. It's simply a powerful tool available to investors who take the time to understand and to manage leverage correctly. However, it's not for everyone!
10 Rules for Managing Leverage Correctly
- Do Not put more money into your account to make a margin call
If your position declines to where you face a margin call event, sell your stock position and wait until your regular re-balancing interval to enter a new stock position.
- Do Not use your increased account equity to maximize your margin
Use margin on new purchases or annual re-balancing only to your maximum target (1.5:1 or 2:1, etc.). Margin as a percentage of equity should slowly decline as the value of your portfolio grows while your margin debt stays the same.
- Do Not start with high levels of margin
Begin with a small amount of leverage like 1.2:1 and slowly build up from there. Allow time to see how margin impacts your account and adjust your bond allocation upward as your leverage increases.
- Do Not risk your whole account
Use bonds to limit your portfolio exposure to the risk you can handle and don't overexpose. Nearly everyone starts to get nervous at a 20% drawdown and it only gets worse from there. Invest for long term success, not for emotional entertainment.
- Do Not add risk on risk
It can be tempting to use investment loans to buy leveraged ETFs to get even more exposure. This is a good way to quickly go broke when markets fall. Limit risk by taking your whole financial picture into account.
- Do Not use margin in registered accounts
Keep the loan interest tax deductible by investing in your non-registered account only. Leveraged ETFs can be used in registered accounts instead. This also helps you become familiar with disciplined investing before taking on leverage as you should always fill your TFSA first.
- Do Not ignore downside impacts of leverage
Leveraged investing pairs well with stop-losses, trend investing, long puts, and large bond allocations. It always takes more work to make up losses—financially and psychologically.
- Do Not allow your interest costs to get out of control
Shop around for low margin or investment loan rates. HELOCs can be a good option for a stable, low-cost investment loan. Make sure your regular monthly savings exceeds your interest costs.
- Do Not use leverage to invest in a highly volatile investment
Use leverage to invest in a diversified portfolio. Index funds and ETFs, a basket of large cap stocks, broad international exposure, and low-beta stocks are the best choices. Every investment can be subject to periodic high volatility, so don't invite unnecessary risk by investing in small, or riskier individual stocks.
- Do Not use leverage if you can't stick to a strategy
You should have experience investing in a simple, carefully back-tested strategy before you introduce leverage. If you are unable to follow a strategy without leverage, you will be even worse with leverage. Leverage amplifies everything!
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