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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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About the author: Ed 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.

Ed has written numerous articles to educate the public and his clients on his unique insights into strategies that actually work, instead of the “conventional wisdom” common in the financial industry.

Ed has trained more than 200 financial advisors and is considered the Smith Manoeuvre expert in the Toronto area. He has received accolades from Frasier Smith in his book “The Smith Manoeuvre” for customizing this strategy for hundreds of clients. His extensive experience in tax and finance has placed him in high demand. Ed’s team collaborates on each of their clients to help them create financial security and freedom.

{ 19 comments… add one }
  • Mike May 30, 2007, 9:18 am

    4. Leverage always increases risks

    To say this is a myth is just not true. The whole point of leverage is to increase risk in order to increase the potential return (positive or negative). I’ll agree that most people don’t understand exactly how much risk is involved in leveraging but there is always some.

    Another thing is that you never mention interest rate risk which is one of the basic risks with long term borrowing. The risk from rising interest rates is less on investment loans than on normal debt because of the tax write-off but it still exists. Before leveraging, the investor should calculate how much their potential payments will be in the future if rates go up by 2%,4%,6% etc. This way they can determine an appropriate amount (if any) to borrow.

  • The Financial Blogger May 30, 2007, 9:52 am

    If you leverage over a long term period (as you should never leverage for short term), the only risk you have is yourself! Most individuals become very emotional regarding their own finance and investment. They do stupid things without thinking about what is going down. They see the market going up, they buy. When it’s dropping they sell… Quite tough to make money out of this strategy!

    By investing in blue chips, dividend stocks and market index, you minimize your risk and still can hope to reach 7%-8% a year. In fact, you need less than 6% yield (prime rate) to make money out of leveraging.
    FB.

  • Canadian Capitalist May 30, 2007, 12:07 pm

    Do you have any studies backing up your claim that an average Canadian needs $1-$1.5m to retire? I recently read a study that based on StatsCan data concludes that average Canadians need far less.

    Like I pointed out in my comment on the first post, leverage is not a free lunch. 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…

  • ThickenMyWallet May 30, 2007, 1:20 pm

    With respect to point 5, although the investment loan is 100% tax deductible, in the event that your investment is yeilding less than the interest, you end up in a negative cash flow position every month until you file a tax return and get a potential refund. That may be a long time to be a negative cash flow position monthly.

  • Causalien May 30, 2007, 1:33 pm

    Ed, I have a question for you.
    In point #5, you mentioned that you only need a 4.5% return to break even after one year. Can you expand on the calculation which went into finding this figure?

    For example, if I borrowed 1000 at prime rate. After a year, I have to pay $60 interest. If I deduct that for tax and say I am taxed at 40%, it means that I get $24 back? So the effective interest I paid was $36. I am sure I made a mistake somewhere since it’s not the same number as the one you arrived at.

  • FourPillars May 30, 2007, 1:54 pm

    “If you leverage over a long term period (as you should never leverage for short term), the only risk you have is yourself!”

    FB – what happens if the borrowing rate goes from 6% to 12%? What happens if you are unemployed for a long period of time? Are those not risks to consider as well?

  • Canadian Capitalist May 30, 2007, 3:09 pm

    Causalien: Let’s say you liquidate your portfolio after one year. How much return should you earn to break even? It’s $36. But you also have to pay capital gains, which is typically 50% of your marginal rate. So if you earned X% and paid 20% of it in taxes and you broke even and you solve this equation – X – 0.2 * X = 36 – you’ll get 4.5%.

  • The Financial Blogger May 30, 2007, 7:28 pm

    Hi FourPillars,

    In regards to the interest risk, I’ll write a full post for tomorrow on my site : http://www.thefinancialblogger.com
    because I think your point deserve a full explanation.

    As in regards to being unemployed for a long period of time, I pretty sure most individuals will buy a house and get a mortgage knowing that they could lose their job one day. If it ever happens, you have much higher risk to lose your house than losing with investments.

    If you ever need more cashflow, you simply cash in your funds and pay off your loans. It is not that simple with a mortage and people are still buying properties.

    There are always uncontrolable factors in life that can mix up your plan. However, you have to live on and hope they won’t happen to you at the same time!
    FB.

  • FourPillars May 30, 2007, 9:09 pm

    FB, I’m planning a similar post but not for a few weeks.

    I never said that interest rate exposure was exclusive to investments loans. Anyone is who borrowing money for any reason should think about interest rate risk.

  • Causalien May 30, 2007, 11:51 pm

    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.

  • The Financial Blogger May 31, 2007, 8:02 am

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

  • dj June 3, 2007, 8:32 pm

    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.

  • Ed Rempel June 9, 2007, 1:22 pm

    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

  • sam June 9, 2007, 4:04 pm

    hi ed,

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

    thanks

  • Causalien June 14, 2007, 12:07 am

    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

  • Ed Rempel June 14, 2007, 10:31 pm

    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

  • Sitting on cash and taunting the Bear March 8, 2008, 11:59 am

    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.

  • KK August 9, 2009, 2:05 pm

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

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