(Illustration by Serge Bloch)
It’s often said that fortunes are built with other people’s money. Like many business clichés, there’s a lot of truth to that maxim. There’s nary an empire around that didn’t get started with borrowed money. Individual investors can take the same approach. Borrowing money to invest, also known as margin or leveraged investing, is an increasingly common strategy in Canada. The appeal is that borrowing allows you to buy more securities than you’d otherwise be able to, magnifying your returns. The downside is just as obvious. If your investment goes south, not only could you lose your principal, but you’ll end up owing more money on top of that.
Canadians, however, seem more willing than ever to take the risk. At the end of March, institutional and retail investors had $19.4 billion invested on margin, according to the Investment Industry Regulatory Organization of Canada (IIROC), a high-water mark in the 15 years that IIROC has been keeping track. Indeed, the longer a bull market persists, the more debt investors seem willing to take on. This, market experts argue, is exactly the wrong approach to leveraged investing.
The reason for the steady increase in investment debt is likely twofold. Interest rates are low, of course, so debt servicing looks cheap. That’s at least rational: The return on a leveraged investment is all about the spread between the interest you’re paying and your return on your equity investment. The second factor is more psychological. Investors are becoming more complacent as the bull market continues—which could be cause for concern. “It’s not until the final stages of a bull market that we start to think that now’s a good time borrow to increase investments,” says Talbot Stevens, a financial author and adviser in London, Ont. “But that’s the time to start thinking about reducing your equity exposure.” Indeed, the IIROC data on margin accounts eerily correlates to the stock market. Previous peaks coincided with stock market crashes in 2000 and 2008.
Stevens advocates a different approach: Borrow to invest when the market is down, and pull back as it gains strength over multiple quarters. It sounds like common sense, but most investors don’t act that way. “The amount of borrowing to invest increases in the fourth, fifth or sixth year of a bull market,” Stevens says. A less risky approach is to start at the beginning of a cycle.
Rob McGavin, managing director of financial planning and advisory services at Scotiabank, says the correlation between investing on margin and the stock market isn’t cause for concern on its own. What’s more important is the type of person making leveraged bets. Generally, this strategy is appropriate for high-net-worth individuals who can afford to service debt. “You need [to] not be overly burdened with other debts to begin with,” McGavin says.
For those so inclined, there are a number of things to consider first, such as the form of borrowing. Some investors use lines of credit or take out a dedicated investment loan from a financial institution. (This kind of credit is not included in IIROC’s calculation, so the debt underpinning our stock market may be considerably larger than we know.) It’s not unheard of for people to use a home-equity line of credit to invest. The upside is the interest rate on a home-equity loan will be among the lowest available. “But you’d better be damn sure you can service the loan, or you’ll lose the investment and the roof over your head,” says Gordon Gibson, vice-president of strategy at National Bank Financial.
The other option is to use a margin account, where a broker lends money to buy securities. If the portfolio drops precipitously, the broker may require the investor to put in more cash or sell off part of the portfolio (known as a margin call).
Just how much to borrow depends on the individual, but Stevens counsels caution. After qualifying for an investment loan, for example, take only half that amount. For those who have never taken on investment debt before, he recommends assuming 10% to 30% of borrowing capacity. Risk tolerance plays a role, too: How much investment debt do you feel comfortable having? That’s difficult to assess beforehand. “There’s no risk questionnaire on the planet that will tell you how you’re going to react until you’re in the hot water,” Stevens says.
Although some people will use leverage to make a single big bet on a stock, a more conservative approach is to put together a diversified portfolio. A typical scenario these days, according to McGavin, is to buy a basket of blue-chip stocks that pay dividends. “With today’s interest rates, you might have a dividend yield that exceeds your borrowing rate,” he says. Those interest payments are tax deductible, further reducing borrowing costs. Dividends receive preferential tax treatment, too.
Since equities are volatile, advisers generally recommend investing with a seven- to 10-year horizon in mind. This is why risk tolerance is so important for leveraged investing. “The last thing you want to do with borrowed money is pull the plug at an inopportune time,” says Jonas Friel, vice-president and senior investment adviser at BMO Nesbitt Burns. “Seeing this through can actually be the most challenging aspect.”
For that reason, leveraged investing tends to be more appropriate for younger people as opposed to those nearing retirement. “At that point, you’re thinking about how to scale back and invest a little more conservatively,” says McGavin. For anyone comfortable with risk, however, a leveraged investment is something to consider. You just might want to wait until the market takes a tumble.
MORE ABOUT INVESTING:
