With interest rates low and headed lower and bargain-priced stocks generating healthy yields, some investors may be tempted to borrow money to invest, or "leverage."
There has always been a small segment of financial advisors who promote leverage, whether because they believe it's in a client's interest or -- less nobly -- because it can double or triple commissions on, for example, rear-load mutual funds.
But pundits like David Chilton consistently oppose leverage. He prefers dollar-cost averaging: investing gradually over time with money as you earn it. Over the years, I've leaned to Chilton's view but concede that if there ever were a time to consider leveraging, it would be now. The Federal Reserve recently cut the rate at which it provides money to American banks to almost zero, though consumers pay more; In the U. S. the prime rate is 4%. In Canada, it's 3.5%. If you can get an investment loan at prime plus 1% (or 4.5% all in), you can find stocks that pay dividends yielding 7% or 8% annually -- more than enough to service the investment loan from the dividends.
But there's no guarantee the firms will continue to pay high dividends, and the risk of capital loss on the underlying value of the stock is always there.
This is why London-based financial educator Talbot Stevens advocates conservative leverage. Those who view that term as a classic oxymoron might prefer the alternative term, responsible leverage. In a recent interview (available at www.wealthyboomer.ca), Stevens describes this as borrowing an amount small enough that there is "negligible financial and, perhaps more importantly, negligible emotional strain. On a quantitative basis, that usually means borrowing less than half what a responsible lender thinks you can handle."
So, if the bank thinks you can handle $100,000, you should consider borrowing $50,000 at the most. "Frankly, the sweet spot for those who fit the right profile, with long-term, good cash flow and who really understand the nature of fluctuating markets, it would be maybe borrowing 20% to 30%."
While most advisors I polled are opposed to leverage, a surprising fan of the practice is respected finance professor and author Moshe Milevsky of the Schulich School of Business. "I have always been a fan of leveraging into the stock market -- especially for those people who consider themselves to be 'human capital bonds' --although the last few months have been challenging to keep my faith," Milevsky says. As rates continue to decline and with valuation multiples at historically attractive levels, "I can't think of a better time to take on prudent leverage." Milevsky says leverage can make "prudent financial sense" as long as you have the cash flow to service the loan and the assets purchased are sufficiently diversified.
Adrian Mastracci, president of Vancouver-based KCM Wealth Management Inc., says returns magnify when levered investments deliver but vanish when they go sour. As illustrated in a recent excerpt from my novel, Findependence Day, loans still must be repaid even if markets don't cooperate.
When questioned further, even Stevens gets defensive: "I'd like to clarify -- I'm not really an advocate of leveraging. What I'm trying to do is help people better understand this controversial strategy ... Leveraging is just a tool that magnifies our results; unfortunately, it magnifies our emotions as well."
Clay Gillespie, portfolio manager with Vancouverbased Rogers Group Financial, concedes that now "would be a good time" for the few for whom leverage may be appropriate. However, "I would only recommend its use if your normal cash flow can pay the debt. Most individuals who use leverage get in trouble when they assume the investment can always pay the debt. This will not always be the case."
Bob Cable, head of ScotiaMcLeod's Cable Group in Mississauga, flat out avoids leverage and does not advise clients to use it at any time. He maintains that you lose control when you borrow and "the lender takes that control. Sometimes it forces you to sell when you should be buying."
Markham-based advisor Robert Smith also counsels against leverage. Beatendown stock prices and low borrowing rates may improve the "tough odds somewhat" but the fact remains "leveraging is a very risky strategy and there is nothing conservative about it. Few can stomach losing their own money. Losing someone else's will be far more painful."
Warren Baldwin, regional vice-president for T. E. Wealth, warns leverage can be "hazardous to your financial health." But for the few who first conduct hard-edged risk analysis, leveraging might make sense. "With interest rates compressed to really low levels, it would be worthwhile to at least do some analysis on the structure. For some investors it might be an acceptable risk."
TD Waterhouse Canada Inc. vice-president Mark Krygier agrees current conditions may be more favourable for leverage but warns clients should adhere to "very strict rules for managing a portfolio. I don't believe the majority of investors have the stomach or the cash flow to support such a strategy." - The first of two interviews with Talbot Stevens can be viewed atwealthyboomer.ca.