If a person is unfamiliar with the benefits of leveraged investing, they can easily become informed by consulting an investment salesperson who is paid by commission. I’ve even got unaddressed mail recommending borrowing to invest (with a particular salesperson). The benefits are real and borrowing money, or leveraging, to invest can work. But it’s unlikely that a sales pitch will include a serious reflection on the dangers of leverage. Because when things start to go a little wrong in investment markets, leverage will magnify the trouble caused to an investment portfolio.
Rising interest rates. When interest rates rise, in increases the cost to an investor who has borrowed money to invest. If rates rise too high, the investment may become untenable. In that case, the investor would be forced to sell their investment to pay back all or part of the loan, whether or not the timing is beneficial. Fortunately, interest rates tend to rise as the economy strengthens and markets tend to rise at the same time. Having said that, there are exceptions such as the early 1980s.
A margin call. A margin call happens when markets fall and the remaining value of the investments isn’t enough to provide collateral for the investment loan. The investor has two choices, either deposit more cash or sell investments. Since people often take a loan because no cash is available, it’s most common to see investors squeezed and forced to sell their losing investments. An unleveraged investment account can weather a market downturn, but a leveraged account risks being taken out near the bottom and realizing the loss.
Poor buying decisions. When capital is limited, an investor must make choices in how to allocate that capital. Sometimes the decision must be made between two attractive investments. As an example, an investor might be tempted to buy an investment, but to fund it would need to sell an existing investment. This should incite research and careful consideration. Using leverage, however, would allow the same investor to own both investments, regardless of their relative merits. If proper research is done, this might not be a problem, but leverage makes it easier to “pull the trigger.”
Never paying it off. I don’t know if people fall into this trap, but governments certainly do. They borrow to fund programs during a period of reduced revenue, but there is no plan or political will to repay the debt (with interest). If an investor borrows to buy a stock, it’s intended as a long term investment. That means there is no plan to sell the stock in order to repay the debt. Will the debt payments come from earned income? Only if the loan is structured to require more than interest-only payments.
Overstating returns. It’s very easy to feel proud of a portfolio that returns 10%. But if the first 4% are paid to the bank as interest, the correct return is just 6%. Whether or not that’s a wise investment, it’s easy to forget the true return when a performance report says that the portfolio returned 10%. It’s also possible to experience a negative return when the market is flat. And of course, as interest rates rise, the true return becomes that much lower than the nominal return.
Confession time: I wrote this article as a reminder to myself. I borrowed money to invest with a very specific plan to pay it back. In a couple years, I plan to sell my house and move abroad (with employment income and an allowance to cover rental costs), and it made sense to buy into the stock market earlier. But then the recent market correction happened. Fortunately, I didn’t get a margin call, but it must have been avoided narrowly. I decided to sell some stock that had increased in value to buy another that had fallen a lot. After buying, I decided not to sell, since I was receiving a healthy dividend from the winner. Oops. Now I’ve made a weak decision and I’ve lost the ability of my debt repayment plan to cover the entire amount. So far, I’ve been lucky. Interest rates haven’t risen and aren’t expected to during the next year. In the end, I don’t feel very comfortable with my level of borrowing (even if it represents a debt-to-equity ratio of only around 35%) and I will seriously consider selling into the market rally that I expect sometime over the next two years.