Leveraging Your Investments
Posted by Gail | Filed under Credit Wise
I get a lot of questions about using credit to invest. Sometimes people want to know about The Smith Maneuver. Some people want to know if it makes sense to use their home equity to invest. And others want to know all about margin investing.
Whenever you use someone else’s money to invest, you are “leveraging” your investments. And whenever you leverage, you increase your potential for return. You also increase your exposure to risk. I don’t care who tells you that leveraged investing is a good idea, if you don’t understand the upsides and downsides, you’re a sucker.
Buying on margin is one of the easiest ways to lose your shirt. When you buy on margin, you borrow cash from the investment broker to buy more than you could afford on your own. Your investment brokerage house gives you a limit and you can borrow as much or as little as you need. So here is how you might use your margin account, and the implications.
Let’s say you had an account at ABC Brokerage, and you had an existing investment portfolio of $100,000. (Hey, round numbers make this easier to understand.) They offer you the option of opening a margin account. You’ll have to invest 50% of your own money for anything you decide to buy but they’ll lend you the other 50%, no questions asked.
You get a tip that The Best Supermarket Ever is bringing out an earnings report to beat the band. The stock price is sure to jump 5% from $30 to $31.50. So if you used your $12,000 you could buy 400 shares and make a profit of $600. However, if you used your leverage account, you could buy 800 shares and make a profit of $1,200. Hey, you’d double your money and your cost would be just the interest on the $12,000 until you sold… pretty cool.
Problem is, the shares don’t go up in value, they go into the tank. Seems that there’s a major lawsuit that’s just been filed against The Best Supermarket Ever and the stock price drops by 20%. Now you’re out $6 a share on 800 shares, which means you’ve lost, at least on paper, $4,800. Ouch! Sure you can hold on to the shares and hope they go back up, or you can hold on to the shares and ride them all the way down, but that’s not really the point. The point is that by leveraging your investment, you increase your potential upside, but you also increased your exposure to risk. Now you not only owe interest on the $12,000 you’ve borrowed to leverage, but you’ll have to cover your margin because the value of your investment has fallen from $24,000 to $19,200. If that forces you to sell, you’ll “crystallize” or “make real” your loss.
Tip: When you buy on margin, the brokerage house holds the investments you purchased as collateral for the loan. If the value of your investment falls below a pre-determined level, you will be asked to make an additional deposit to the account or sell all or part of the investment to make up the shortfall. This is a margin call.
Leveraging is usually sold on the fact that the interest on investment loans is tax deductible. That’s one reason why things like the Smith Maneuver and home equity lines of credit for investment purposes became such hot topics of conversation. They were presented as a way to grow your money faster because investing a larger amount means compounding has more to work. They were also presented as a way to make your mortgage interest tax deductable, which always has been a carrot for donkeys who will do anything to beat the tax man.
The big question you have to ask yourself is this: Am I prepared to lose more than I have to invest?
If you use your own cash to purchase an investment, any gain or loss will equal the gain or loss of the investment itself. However, if you use borrowed money to purchase an investment, the gain or loss you experience will be greater.
One of the most deceptive techniques used to demonstrate the benefits of leveraged investing is to use the historical performance of the market as a whole to compare a non-leveraged and a leveraged investment portfolio. Brochures show graphically how much better you would have done if you’d been “smart” enough to leverage, as opposed to using the tried-and-true “investing what you can afford to lose.” Problem is no one ever “buys the market”… even indexed investing isn’t the whole market… so the example is a red herring.
Hey, I have nothing against leveraged investing for people who understand the implications and how the markets work. But often this strategy is sold to people who don’t have Clue One about the risks they are taking. (If you’re writing me to ask if it’s a good idea, you’re exactly the person I’m talking to.) And even people who know what’s what need to be careful that they don’t over-extend themselves. The last thing you want is to be forced to cash out early because of an unforeseen change in your ability to make interest payments or cover your losses. Make sure you borrow less than you can afford so that you can comfortably absorb whatever bumps the investment world may throw your way.
March 3, 2010 at 8:15 am
Thanks for this, Gail!
As I’ve paid off my debt and been slowly moving more into the world of investing, I’ve had a lot of questions. I hope you tackle mor einvestment issues in the future!
March 3, 2010 at 8:57 am
My broker has suggested I consider leveraging my home equity to invest. I said, no way! I’m too conservative to even think about it as I hate seeing debt. I’d end up paying it off quickly and making the interest deductions barely worth it. Best just earn it first for me.
March 3, 2010 at 10:13 am
I have seen this go horribly, horribly wrong in more than one case…eek, I would hyperventilate if that were me.
March 3, 2010 at 10:16 am
This is one area where I wasn’t so smart, but I thought I was being smart. I took out a loan to boost my investments, my goal was to save faster for a home, as I had no other debt and this was described as good debt, I did it. Trouble was I don’t think my advisor and I saw eye to eye on what the time horizon for my house purchase was, and he had somewhat of a bias I think when it comes to young single women buying houses on their own. I got caught and my investment was soon not worth the value of my loan so I had to carry it until it gained back it’s value and I could divest, luckily I was in a position to do this but it wasn’t easy. I had to use other investments to purchase my home, so as a strategy it didn’t work and I would never do it again. If I had stuck with my monthly savings plan, I would have been much better off.
March 3, 2010 at 10:24 am
“good debt”
That phrase NEEDS to be changed to:
“BETTER DEBT”
Student loan, investement loans, mortgages are ‘better debt’ only relative to consumer debt which is BAD debt.
So bad and better, not bad and good!
March 3, 2010 at 10:30 am
My brother is a market whiz…. and is very informed. During the economic meltdown, we both had a similar amount invested. Except, he also had invested some in margin.
Long story short, we both ended up recovering to the same point, except he had many, MANY sleepless nights, and I slept like a baby…. and this is someone I would classify just shy of an expert.
Margin is a huge risk, don’t risk it, unless you’re prepared to lose it all and then some.
March 3, 2010 at 10:32 am
Abbey makes a good point about how advisors might make us feel like this is some kind of strategy that “the smart people” use, or worse, that if we don’t use it , we’re stupid. I once had an advisor that tried to sell us on the tax breaks involved, but in the end, I couldn’t get over the idea that we were adding debt. I wanted to get rid of it.
March 3, 2010 at 10:45 am
Kat your comment about your brother makes me laugh — I work in the derivatives market and half the people I know use leverage to invest their own money and half wouldn’t even think about it. The people that are true market whizzes know that anything they invest or borrow to invest has to be losable, if they can’t afford to lose it they don’t invest it.
I am definitely in the minimal leverage category. I do have one margin account with a low limit that I use more for my own entertainment/education then real investing. The irony is that because I am willing the lose everything in that account I haven’t lost anything and have done well (of course I closed my position at that point though).
March 3, 2010 at 11:15 am
I have been using the Smith Maneuver for almost a year. I invested it in income bearing REIT’s. I use the income I earn to pay the interest on my PLC and paydown my mortgage. Right now my investment is up by 20%. I borrowed less than what I was qualified for and have determined the borrowing rate at which the income I earn will no longer cover my interest. I am not a market whiz but so far this has not caused me any sleepless nights. I continue to cross my fingers.
March 3, 2010 at 12:07 pm
@JMC Ahh, it’s easy to sleep when you’re up 20% — as long as you’re prepared to lose it all and then some. Happy trading!
@Lilly Sounds like you have a great set-up — and isn’t it funny how when you don’t care about an investment, it’s probably the one that performs the best.
I’m sure you’ll get a laugh out of this as well:
My father is a day-trader. He refuses to hold a stock overnight.
My oldest brother likes to play the penny stocks. He loves the idea of earning 1000% – loves the mining stocks (very knowledgeable about them too, but still, find a hole and throw your money down it really)
My 2nd oldest brother is the whiz/expert, and he believes in diversification, shorts, options you name it, he dabbles. His money is spread out across so many areas in the stocks as well.
My older sister invests in GIC’s, while in her part time she and her husband are becoming passionate poker players.
Me? I like dividend investing… and generally won’t buy a stock unless it has dividends.
Within one family, the whole gambit of traders… LOL!
March 3, 2010 at 12:49 pm
True enough Kat! 20% today – who knows tomorrow! It could all disappear easily. We’ve already seen that movie.
If you read Garth Turner’s blog greaterfool.com there is sh*t storm in the form of real estate bubble bursting higher interest rates coming our way. That causes me sleepless nights! Definitely time to review bond holdings and pay down your mortgage if you can. I renewed my mortgage this year at a really good rate. When it comes due in 5 yrs there is a good possibility I will be renewing at close to DOUBLE the interest rate. I shudder to think about my mortgage payment.
Have a great day everyone. The weather is beautiful here.
March 3, 2010 at 12:57 pm
My apologies – it’s greaterfool.ca
March 3, 2010 at 1:06 pm
I’m with Kate…I’d love to see more articles about investing…especially for beginners who are just recently saving and starting down that road. Thanks again for another great blog!
March 3, 2010 at 1:35 pm
I also would love to hear more about investing. Gail, you do have a gift for making it understandable.
March 3, 2010 at 2:21 pm
Gail, you appear to have a dilemma – you have trained many people so well on the basics of paying off their debt and saving that they are ready to learn about more complicated investment strategies. On the other hand, you probably still have alot of new people coming in to the site (especially since they just started airing your show in the States) and these people still need the basics. That’s an interesting position to be in.
March 3, 2010 at 2:32 pm
No wonder I don’t have any investmenets or haven’t any of what Gail says because I don’t understand it. I am very well educated but no matter how many times it has been explained I still don’t understand. I seem to have an investment/economical mental block. It has never been explained simple enough for me. Everyone expects me to have a basic knowledge which I don’t. What is “leverage”, “margin”, or “smith maneuver”? Because I don’t fully understand investing, or simple financial terms, I keep as far away from anyone trying to get me into any of this. That way I can’t get into trouble. I know this might not be best but until I really understand it I will stick with my savings accounts. I wonder if there is an Investment for Dummies book – I could sure use it or maybe not…..
March 3, 2010 at 3:20 pm
Debt is risk – why on earth would I want to put my house at risk for an investment gamble? Totally insane. I would never consider it.
March 3, 2010 at 3:54 pm
I got burned on a leveraged investment. In the end we were OK, but after doing that I don’t think I would take the risk again, myself. I am just not a big fan of the gamble.
The thing that irked me the most about the whole thing was that the investment adviser who suggested the leveraging scheme still got paid. She collected her $5000 fee even when losing us tens of thousands of dollars, and she didn’t even apologize. I get it, I went in with eyes wide open and I paid the price. But the whole thing reminded me that I can’t trust someone else to have my best interests at heart. She doesn’t lose out on her fee if her advice proves faulty, or the market tanks, or the loan I took out for the investment gets recalled.
March 3, 2010 at 4:30 pm
I never want to risk more than I am willing to lose. Which means I don’t take many risks! Which means of course the gains I set up for are safe and small too.
I just hope slow and steady wins the race for us!!!
March 3, 2010 at 7:16 pm
We leveraged last year because we thought we were coming into cash that ended up not happening (long story). We took out a $20,000 loan in invested in Apple in our RRSP. We bought at $96 a share and sold at $204, putting that money into a more reliable investment. With what we got back from our taxes we paid out most of the loan, and have nearly paid off the rest over the year.
Our investment is now worth over $44,000, we have $3,000 owing on it, and we have paid appx $900 in interest. So we’re way ahead – but how often are you right about stuff like that? I don’t think I’d risk it again – too scary.
March 3, 2010 at 8:16 pm
Hi Gail,
Tks for this article…I do have friends that have contracted those type of investment debts, so far not many have much to brag about.
HOWEVER, what if we do it for real estate investment. Compared to the stock market its easier to understand and you have more control on real estate investment. Do you think its a good idea if we were to leverage on our home equity to buy another house or apartment building?
March 4, 2010 at 7:49 am
Lveraging investments and margin calls were what was responsible for the roaring 20s and the great depression of the 30s. everyone got into leveraging and look where it got them.
I won’t use leveraging simply because it opens us to more risk and I think in the end the Tortise won the race. I can continue to have my money trickle into my retirement accounts a bit at a time just to make it all work.
March 4, 2010 at 9:19 pm
@ Stephanie – using leverage to buy anything has both risks and rewards. I’ve personally used my property to purchase real estate and we’ve done really well. The key for us has always been buying really good properties at a discount where we can demand the rent that we need to cover all overhead expenses. Just understand that the numbers will only work for you if you have consistant rental income, some tenants are not that great.
March 18, 2010 at 11:42 pm
[...] Vaz-Oxlade wonders if many investors who are leveraging to invest have Clue One about the risks they are taking. Post a [...]
March 19, 2010 at 10:31 am
[...] Vaz-Oxlade wonders if many investors who are leveraging to invest have Clue One about the risks they are taking. Post a [...]
March 19, 2010 at 1:08 pm
[...] Gail Vaz-Oxlade wonders if many investors who are leveraging to invest have Clue One about the risks they are taking. [...]
October 13, 2011 at 10:14 pm
What a lot of you are not understanding about leveraging, and the Smith Maneuver is that you will not be GROWING your debt, you will be maintaining debt, but the debt will move from being a complete and total expense paid using after-tax dollars, to slowly becoming a debt with tax deductible interest. Regardless of how your investment performs, we have seen historically the market perform with decent returns on any 10 year rolling period, so the thought of complete and total loss of capital is unrealistic. The investments you should be investing in will be dividend paying investments, and should be of a “safer” calibre. You don’t need to be invested in long shot equities. There are certainly investments available with less risk that will allow you to build a portfolio without so much fear. And all the while, you’ll be generating tax refunds for the investment interest.
I just read the whole Smith Maneuver text, and many of the comments that have been made in this regard online, because I was totally skeptical about the prospect. I will continue to do research, but the above comments represent my opinion at this point. I think the strategy is right for those people that have the discipline, and risk aversion necessary to deal with a strategy like this. For those of you that do not, stick to your GIC’s and Money Market instruments that earn you 0.5-3% interest. They may be safe, but I’d prefer to have more money available for my retirement.
December 16, 2011 at 12:49 pm
[...] Making Money Make Sense. Leveraging your investments. “I get a lot of questions about using credit to invest. Sometimes people want to know about The Smith Maneuver. Some people want to know if it makes sense to use their home equity to invest. And others want to know all about margin investing.” [...]