While most people are comfortable with the idea of using leverage to buy a home, surprisingly few of us would consider borrowing to invest in stocks. Indeed, leveraged investing comes with a lot of negative connotations. But the fact is, if an investor has any debt at all – including a mortgage – he or she is already effectively borrowing to invest.
Canadians may be wondering if borrowing to invest is a good idea after the coronavirus market crash. In this article, I explain why borrowing to invest – especially after a market crash – can be a sensible and profitable strategy for investors. By using smart debt, conservative leverage, and appropriate timing, investors can amplify their returns and avoid the many pitfalls that come with leveraged investing.
How Borrowing Money to Invest Can be an Effective Strategy
Leverage magnifies returns, making good returns better and bad returns worse. Since markets historically have had two positive days for every one negative day, using leverage can be a great way to increase your expected long-term investment outcome.
For example, let’s assume you have a portfolio worth $100,000 and in one year you earn 10%. You now have $110,000. Not bad!
Now, let’s say you can borrow an additional $100,000 to invest. Your portfolio is now worth $200,000 – and if it earns a 10% return, you’ll have a total of $220,000. This is actually a 20% return on your original investment.
Apply this approach over 10 years and – assuming an annual return of 10% – your portfolio will be worth $518,748. Pay back the $100,000 loan and you’re left with $418,748. That’s a 15.4% annual return on your original investment.
Conversely, without leverage, your $100,000 portfolio would grow to $259,374 after 10 years – leaving you with nearly $160,000 less than you’d have with the leveraged investing approach.
Note: this example ignores the cost of borrowing, which we’ll get into later in the article.
When is Leveraged Investing Appropriate?
Let’s look at two scenarios when borrowing to invest in stocks can make good sense:
- Young investors with a long time-horizon
- When markets are down 20% or more
Leveraged Investing for Young Investors
In the 2010 book Life-Cycle Investing and Leverage, Yale professors Ian Ayres and Barry Nalebuff say, “It is sensible, even responsible, for young investors to use leverage.”
Their argument is based on the fact that young investors tend to have much less cash to invest, but still need to maintain a lot of exposure to stocks. Even a young, 100% equity investor with only a few thousand dollars to invest is allocating a lot less money to stocks than they optimally should at that stage of their life.
The solution is called time diversification. It means borrowing to invest in stocks when you’re young – then gradually decreasing the use of leverage over time. This results in more consistent exposure to stocks over your lifetime, and a much better than expected outcome.
Leveraged Investing When Markets Are Down
The second scenario where it makes sense for investors to use leverage is when markets are down.
Talbot Stevens, the author of Smart Debt Coach, believes that all moderate-risk investors should consider borrowing to invest after a market decline. He says it’s one of the best examples of how the rich think and act to build wealth. They see opportunity in the “negative” of a down market and turn it into a positive.
Mr. Stevens’ favourite strategy is what he calls, “Buy More, Low”. This is where you strategically wait for a meaningful drop in the market before using investment debt. Historically, after the market has had a negative 1-year return, the following 1-year return has averaged 19%, almost double the long-term average of 10%.
Using perfect hindsight, I’m sure many investors wished they could go back in time to February 2009 – the depths of the financial crisis – and use a leveraged investment strategy. After a decade-long bull market run, those same investors probably felt like they missed a golden opportunity to “back up the truck” and invest at an incredible discount.
Now might be that opportunity. Markets are fresh off of a 30% loss thanks to economic fears as a result of the COVID-19 global pandemic. This could be another “once in a lifetime” chance to buy more, low.
If you’re motivated to jump on this opportunity, the best way to start investing is to open a self-directed account with an online broker. We’ve done extensive research on all the top online brokers in Canada and ranked Questrade as the best discount broker for self-directed investors. The trading fees are low ($4.95 to $9.95), ETF purchases are free, and Young and Thrifty readers who start investing with Questrade get $50 in free trades.
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Leveraged Investing Strategies
Some investors might be intimidated by the idea of borrowing to invest – thinking it’s a strategy only for the wealthy or sophisticated investor. The truth is, there are several ways an everyday investor can use leverage as part of their investing strategy.
- An RRSP Loan: Probably the most common and accessible form of leveraged investing, an RRSP loan is when investors borrow from a bank to make an RRSP contribution prior to the RRSP deadline. An investor makes his or her contribution with the borrowed amount, then uses their tax refund to pay off a portion of the loan (with the remainder of the loan paid off over the course of the year). The idea is to borrow ahead to make your RRSP contribution and maximize your tax refund for the prior year.
- Catch-Up Loan: Another leveraged investment strategy involves borrowing an amount over a short period of time – say 1-3 years – to catch up on unused RRSP or TFSA contribution room. So, instead of contributing small regular amounts over many years, the investor would borrow and front-load those contributions all at once. The investor would then pay back the loan each with the cash flow they had planned to contribute all along.
Using Home-Equity Line of Credit to Invest
How does one borrow to invest responsibly? That involves using smart debt to borrow at the lowest possible rate. In Canada, that means using a home equity line of credit (HELOC) to invest.
A home equity line of credit is a secured line of credit against your home. That means your lender can offer you a much lower rate because they’re using your home as collateral.
The typical interest rate on a HELOC is less than 4%. Interest rates are tied to the bank’s prime lending rate, which has come down recently as the Bank of Canada cut its key lending rate to deal with the COVID-19 crisis.
Lower borrowing costs + a significant market decline = an opportunity for smart investors
Borrowers using a HELOC to invest typically only pay the interest on the loan each month. This interest is tax-deductible when used solely for investment purposes in a taxable investment account. HELOCs are also flexible in that borrowers can choose to withdraw from them at their leisure, up to the maximum amount.
On the downside, HELOCs are callable loans – meaning the bank can ask for payment in full at any time. The interest rate can also fluctuate since HELOCs have variable rates tied to the bank’s prime lending rate. Finally, the interest-only feature of a HELOC keeps payments low but means the principal may never get paid off.
Some investors may not have access to a secured line of credit. Know that it’s still possible to get a personal loan in Canada at very low-interest rates. Two excellent, reputable options to source these personal loans are Loans Canada and LoanConnect. Both are search platforms that will help you find the best personal loans to suit your needs.
Checklist For Whether You Should Borrow to Invest
While there are plenty of smart reasons to consider a leveraged investing strategy, there are several pitfalls that investors need to avoid. Here are some rules to put in place before borrowing to invest:
- You have appropriate cash flow: Borrowing to invest takes on considerable risk in the form of additional monthly interest payments and the risk that your lender calls the loan. Have a solid emergency fund in place so that you can cover loan payments even if your income stopped. You don’t want to have to sell investments at a loss to cover your loan payments.
- Use a home equity line of credit: It’s possible to borrow to invest with a margin loan from your online brokerage account. But this opens up the possibility of a “margin call” if your investments drop in value. Use a home equity line of credit to eliminate the risk of a margin call.
- Borrow responsibly: Short-term interest rates are unpredictable. To reduce the risk of increasing loan costs, you should only use a maximum of 50% of your available loan for investing.
- Take a long-term approach: Market risk is the possibility that the entire market does not produce the expected returns. Your leveraged investment strategy should have at least a 10-year time horizon to produce the results you’re looking for.
- Diversify: It can be tempting to select individual stocks for your leveraged investing strategy, particularly dividend stocks whose payments can theoretically cover the cost of borrowing. But individual securities come with significant risk, which is why a responsible investment approach is to diversify by investing in low-cost, globally diversified index ETFs.
Remember a basic principle 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 a 100% allocation to equities.
Leveraged investing isn’t for the faint of heart – but investors largely misunderstand the risks involved with borrowing to invest. Yes, leverage magnifies returns both up and down. But smart investors can use leverage to their advantage by amplifying their long-term returns.
Indeed, young investors probably should use leverage to create time diversification and higher expected future returns. Furthermore, borrowing to invest when the market is down can also dramatically improve future expected returns.
Investors can use modest leverage at low-interest rates to invest in a diversified portfolio of index ETFs and give their portfolio a boost in long-term returns. If you’re not ready to “DIY invest” with an online brokerage like Questrade or Wealthsimple Trade, consider opening an account with a top robo advisor like Wealthsimple. It not only makes investing easy, but you’ll save a lot of money on fees. Plus, you can take advantage of our exclusive promo offer: open and fund your first Wealthsimple Invest account (min. $500 initial deposit), and get a $25 cash bonus deposited into your account.