Tuesday, November 26, 2013

Crazy Arguments in Support of Leverage

I always hesitate to point to work that I think my readers should avoid, but I’ll make an exception here. I was reading an article called Why borrowing to invest (leveraging) is a good idea. I’ve read many reasonable articles that point out the positive side of leverage and expected more of the same here. However, I didn’t get more of the same. (Thanks to Ken Kivenko for pointing me to this article.)

The interesting part of the article begins when the authors take aim at critics of leveraging:
“Critics argue that leveraging increases investment risk and that a rate of return higher than the loan’s interest rate is needed to generate a profit. But neither claim is accurate.”
Okay, this is going to be good. Apparently, leverage doesn’t increase risk and you can profit even if you pay more to borrow than you make on your investments! Let’s start with risk:
“Risk, as far as it pertains to investing, is the odds that you will lose money. By this definition, we have to question how borrowing money can impact risk. After all, whether you invest your own money or that of the bank’s [sic], it’s the performance of your investment that determines profit or loss. Leveraging will impact how much you could potentially lose, but the odds are still based on your investment choices.”
We don’t all agree on a single definition of financial risk, but no sane person ignores the magnitude of potential losses. If an investment goes badly for me, I care a great deal whether I lose $10,000 or $100,000.

Leverage magnifies both gains and losses. This increases financial risk by every reasonable definition I’ve seen.

Let’s move on to how to profit even if your investment returns are less than you pay in interest:
“If investing for a single year, then a return higher than the loan’s interest rate is needed to turn a profit. But most leveraging strategies are designed to be in effect for years, in which case the break-even rate of return drops below the loan’s interest rate.

“The reason is simple. Investment returns compound over time — in other words, gains from one year generate gains in of themselves in the following year. Meanwhile interest on investment loans is fully paid every year and does not accumulate (simple interest). As a result, investment growth outstrips the interest paid over time.”
This reasoning may be hard to follow without an example. Suppose you borrow $100,000 at 4% interest. You pay just the interest of $4000 per year for 25 years. So, you pay a total of $100,000 in interest.

You invest the money and earn a return of 3% per year for those 25 years. After paying off the initial loan, you’re left with $109,378. But you only paid $100,000 in interest. So, you’re ahead $9378. Or at least this is the reasoning of the writers of the article.

I wonder if the authors have heard of inflation or opportunity cost. From your point of view as the investor, you paid $4000 per year for 25 years and ended up with $109,378. This works out to a yearly return of 0.74%. Because this is very likely to be lower than inflation, you actually ended up with less purchasing power than you gave up with the interest payments.

Looking at this from a different angle, suppose you hadn’t used any leverage and had just invested $4000 per year for 25 years earning 3% per year. In the end you’d have $145,837. This is $36,459 more than leveraging produced. It’s hard to see any reasonable way to look at this and conclude that the leverage was beneficial.

Any time someone makes an argument that uses the term “simple interest,” you should be wary. Simple interest does not exist in the real world. All interest compounds. Paying off the interest every year creates the illusion of simple interest if we make the mistake of ignoring the time value of money.

Borrowing money to invest is an advanced investing strategy that should only be done by knowledgeable investors with a high capacity for volatility. Because it makes no sense to borrow to invest in fixed income investments, leverage is for those who can handle more volatility than an all-stock portfolio. If you’re like many Canadians with a balanced portfolio (roughly half stocks and half bonds), you should consider bumping up your percentage of stocks before thinking about leverage.

Investors who work with financial advisors need to be concerned about pitches touting the benefits of leverage. Good advisors would only recommend leverage for the small minority of their clients where it makes sense. The not-so-good advisors will see leverage as a way to collect more fees on a larger amount of money you have invested.

If you’re thinking about using leverage and are dreaming of huge riches, you should ask yourself a sobering question: if stock prices tumble to half their current value and then you lose your job, will you be okay?

5 comments:

  1. I have troubles with acceptance of both calculations - yours and those of the leverage proponents.
    First - "leverage" calculation: should I invest 100K borrowed at 4% into a portfolio generating 3% I would have 99K invested in the 2nd year. With time I will have a compound loss instead of compound growth and will never end up with $9378 of profit after 25 years.

    Now - your calculation: comparison of leverage investment with investment of interest amount is hardly fair. In case of leveraged investment one supposedly pays interest from the investment returns, which s/he would have had otherwise. So, this $4,000 of interest are not even available for investment. It's a completely different story that a $100K loan is unlikely to come with no collateral. Here your argument about opportunity cost comes into play.
    IMHO, if success of investment were to be a result of deep pocket and guts, then banks would be investing all the way, instead of providing loans.

    On the same note, buying a house "for investment" seems to be a form of leveraged investment, doesn't it? Therefore, provided that rented dwelling is available in sufficient quality and quantity, "rent your dwelling and invest interest savings" is a better investment strategy then "invest into house you live in." What's your take on this?

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    1. @AnatoliN: I think it's fair for the authors to choose their own scenario. Based on my example, they imagine that the investor comes up with $4000 each year to invest. When the investor starts with leverage, this investment is used to pay leverage interest. When there is no leverage, the yearly amounts are invested at 3%. My only quarrel is the authors' assertion that the leveraged scenario works out well for the investor.

      The choice of renting or buying a house has many things tied up with it that are unrelated to investing. How do you prefer to live? Do you need a mortgage to create forced savings? If an analysis shows that buying a house is inferior to renting from an investment point of view, do you prefer owning enough to pay the extra? Answers to these questions often dominate any investment considerations.

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  2. Leverage definitely doesn't fit my personal risk profile.
    Thanks for sharing your views on this article. I would likely never had read it and it's interesting to see just what types of convoluted arguments sales people might use on diffident investors. It makes it easier to see how a cash-strapped 73 year old might end up leveraging their house to play the market.

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    1. @Bet Crooks: In my extended family, it was a 75-year old who was talked into using leverage. That one still bugs me.

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