The stock market's much-anticipated next correction will briefly open the door to an investing strategy that is almost never a good idea.
Borrowing to invest – a.k.a. leveraging – is the definitive case of an idea looking good on paper and too often turning out to be disastrous in real life. Only the steadiest of investors can handle the idea of going into debt to buy into the ever-unpredictable stock market. Most people are wired to panic and sell when the stocks they bought with borrowed money tank, thereby guaranteeing a bad outcome.
But the case for borrowing to invest, and there definitely is one, is considerably stronger when you do it after stocks fall in price. "Even the most cautious, including myself, would have to agree that, done right, this is truly a wealth-building strategy," said Talbot Stevens, author of The Smart Debt Coach, who runs seminars for investment advisers on leveraging.
First, let's look at some ways borrowing to invest can work for you:
1) You commit to making a big investment, rather than adding money to your account on a piecemeal, "when-I-can-afford-it" basis.
2) Academic studies have shown that a lump sum investment will outperform a gradual investing approach most of the time.
3) Interest on non-registered investment loans is tax deductible.
4) Your gains (and losses) are magnified through the use of borrowed money.
Here's a quick example from Mr. Stevens of how gains can be magnified. We start with $100,000 borrowed to invest with, a 4-per-cent interest rate and a 40-per-cent tax rate. Our interest cost is $4,000, or $2,400 after taxes. If the stock market goes up 20 per cent (that's a highly optimistic number, but you'll see shortly why Mr. Stevens uses it), then your gain after interest costs but before taxes would be $17,600. That's a gain of about seven times the money that came out of your pocket.
The reason why so many people choke on leveraging is that losses are magnified, too. Let's say you took out a $100,000 investment loan and the stock market fell 10 per cent. Your loss would be $12,400, which consists of $10,000 from lower stock prices and $2,400 from the cost of your loan. If you sell, and you will very much want to if you're like most people, you would have lost roughly five times the amount you put up. Actual stock market losses in a correction could be quite a bit more severe than 10 per cent. From June, 2008, through March, 2009, the S&P/TSX composite lost close to half its value.
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 borrowing to invest after a correction is a different situation. Mr. Stevens calls it an "automated buy-low process."
Using data for the S&P/TSX composite index from 1956 to 2011, Mr. Stevens found the average annual total return of dividends plus share price gains was 11.1 per cent. But if you bought after a year in which the index fell 10 per cent or more, the average gain was 20.8 per cent. If the market dropped more than 20 per cent, the average gain in the next year was 28 per cent. In no way does buying after a down year ensure success in leveraging. It just helps give you a better chance of success.
Normally, a leveraged investment should be held for the long-term, say 10 years, to allow the market's good years to overwhelm the bad. But Mr. Stevens said that if borrowing to invest after a market correction, a shorter-term approach of capturing the rebound can work as well.
Leveraged investing is a big money maker for the financial industry because of the interest income it generates, and because it allows people to invest more money than they would otherwise be able to muster and thus generate bigger fees and commissions.
Interest in borrowing to invest seems to track the stock market's ups and downs. Data for the Investment Industry Regulatory Organization of Canada (IIROC) shows that margin debt – that's where people borrow money in their brokerage accounts to buy securities – has been rising along with the stock markets in recent years and late last year exceeded the pre-crash peak.
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. Unlike brokerage margin accounts, investment loans may allow you to borrow 100 per cent 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 per cent stocks or equity funds. "Bonds don't make sense on an after-tax basis," Mr. Stevens said.
As for borrowing costs, rates of 3 to 4 per cent are typical with a home equity line of credit and an investment loan might have a rate of 4 to 4.5 per cent. If you plan to hold your leveraged investments for a long period, be mindful of the fact that rates will likely rise over time.
Money borrowed to invest is sometimes glorified as "good debt," which is to say debt that builds wealth. Mr. Stevens, who spends a lot of his time helping people understand the benefits and dangers of leveraging, doesn't like that term. "Good debt implies a positive outcome," he said. "That's not always the case with borrowing to invest."