Borrowing money to invest is like weaving through traffic. You'll get to your destination sooner as long as nothing bad happens. – MJ, 2020
The case for leverage (borrowing money to invest) seems compelling. You can borrow money at 3-4% interest, and invest it in stocks that will probably make 6-8%. What’s not to like?
The answer is “the unexpected.” Anything that forces you to sell your investments while they’re down can cost you a lot of money. You could be forced to sell when you lose your job due to problems with your boss, your company, or the whole economy. Or your lender could demand its money back. You can’t anticipate every possible reason why your stocks might crash at the same time as you’re forced to sell.
It’s true that such problems are likely rare. But they don’t have to happen often to make leverage look like a bad idea. Selling when your stocks are down 30% gives back a decade of expected excess stock gains above loan interest.
Using just a modest amount of leverage is like a little weaving through traffic: it probably isn’t too unsafe. But as you borrow more to magnify returns trying to make more money, the odds of blowing up increase, just as the odds of crashing increase as you weave faster through traffic.
I’m not 100% against leverage, but investors should enter into it with their eyes open. Most analyses touting the benefits of leverage don’t include the possibility of something going wrong. But things going wrong is normal in life. Stock markets crash. People lose jobs. With too much leverage you can end up without money to invest during future good times. To thrive you have to first survive.
Many make the analogy that the stock market is a bit like a casino, except that if you play it right, the odds are in our favor. One can calculate your risk. However, there are problems in stock markets that don't happen in casinos, and in which risk calculation is difficult and perhaps impossible. Some might call those uncertainties, as opposed to risk. An example would be covid 19. People talk about black swans, and tail risk protection strategies. But for the average retail investor, I haven't seen good data to support such strategies. However, two ways to protect against uncertainty are to not concentrate but diversify and avoid leverage. In both cases, that might decrease return.
ReplyDeleteAnonymous: For the most part, I agree. On concentration, for random stock picks, diversification actually increases returns. So, concentration can only increase returns for skilled stock-pickers, which is an extremely rare skill in recent years.
DeleteOn leverage, if all goes well it increases returns, but it increases the odds of blowing up if things don't go well for a time.
With both concentration and leverage, there is asymmetrical risk. Perhaps the only two ways for a portfolio to go to zero are concentration and leverage. Perhaps the only way for a portfolio to go to less than zero is leverage.
ReplyDeleteAnonymous: "less than zero" is a sobering thought. While I was working, I was always very comfortable with my portfolio 100% in stocks, but I never used any leverage.
DeleteVolatility is a commonly used surrogate for risk in investing. It's not without controversy. The case is made that until you get near the time that you have to sell a asset, volatility is irrelevant. Indeed, one hears of volatility harvesting to obtain the rebalancing bonus.
ReplyDeleteHowever, volatility becomes a risk, with commonly used forms of leverage.
I can't resist adding the following :-). I haven't seen any data on it, but there likely is a correlation between overconfidence and the use of leverage and concentration. That correlation will tend to increase the asymmetrical risk of leverage and concentration.
ReplyDeleteAnonymous: I guess that would mean that investors who own just one Canadian bank tend to use leverage, but those who diversify across 3 or 4 Canadian banks don't tend to leverage. :-)
DeleteGreat article. However, I take exception to the statement "When you’re forced to sell at huge losses". This only applies if an investor has used all of his available margin. If a retiree needs to sell their whole nest egg to pay living expenses they are already in deep doo-doo. More than likely they will have to sell a small portion of their nest egg at a loss. Painful? Sure. But not the end of the world.
ReplyDeleteRegarding leverage. If done sensibly is not a problem either in good markets or bad. I make liberal use of margin. My margin rules limit the amount to no more than one year's dividend income.
I take it that you approve of "Dripping". I call my strategy "Dripping in advance". The advantages of doing this is that the dividends of the shares bought on margin contribute to the repayment of the loan. Also, I have no idle cash sitting around.
I would like to know your thoughts on that strategy.
Cheers, John
Hi John,
DeleteAs I explained in the article, the danger of using leverage doesn't come from normal circumstances. What if the stock market crashes and something causes a huge spike in your spending, such as medical bills or helping a child who lost a job? You say this doesn't matter because "they are already in deep doo-doo," but but there is a big difference between being leveraged and not leveraged before all this happens. The unleveraged retiree would take an unpleasant financial hit. The leveraged retiree takes a devastating financial hit. The more leverage you use, the more exposed you are to unexpected problems. The only thing that can make leverage sensible is to limit the borrowing percentage. What I think of your dripping in advance strategy comes down to how much leverage you're using.