Two weeks ago, we discussed the possibility of building a portfolio worth roughly 25K without a single penny in hand. This is called leveraging. Borrowing to invest on the stock market was very popular from 2003 to 2008. Since the market crash, most individual investors have stopped using leveraging as a strategy, incurring important losses. While small investors got burnt and gave up, bigger investors (such as hedge funds) are still in the hunt with leveraging. After seeing what is happening on the market right now, I think that borrowing a few thousand could do a lot of good for my portfolio. At the moment, I am considering borrowing money to invest in the stock market but I won’t start until January if I even do it. In the meantime, I’m getting ready to make a move. I’ve leveraged several times over the past 8 years and want to share my way of doing it with you. So here we go!
Borrowing to invest, start by… borrowing!
In my opinion, the financing structure is the most important part of a leveraged portfolio. No matter how great your stock picks are, if your debt structure is not flexible enough, you may end-up with some real problems.
In an ideal world, you are able to borrow a significant amount at a low interest rate requiring interest only payments. This can be done if you qualify for a home equity line of credit (HELOC). I already have mine setup from a while ago since as I have used it before for the same purpose. If you can’t go with a HELOC, your other option is to refinance your house with a separate account (important, especially for Canadians in order to be able to deduct interest paid on the loan). I’d suggest extending the amortization to the maximum in order to give you as much flexibility as possible.
The other option if you won’t want to touch your house would be to open a margin account with your broker. However, the margin account has 2 disadvantages:
1) It requires you to first deposit an amount of money (you are given a line of credit according to the assets in your account)
2) You will be required to maintain a certain level of value in your portfolio (called a default clause where you would be required to inject liquidity into the account if your stock values fall)
This is why I think that using your house as collateral is the best way to borrow money at low rates and have all the flexibility in the world in terms of repayment strategy.
Carefully select your stocks…duh!
Yeah… right… you are going to tell me that it’s a no brainer, huh? But let’s go deeper in the “stock picking process”. If you want your dividend stocks to pay for your loan interest (so your leverage loan is almost “free”), you need to make sure that you have built a solid portfolio. More than that, in order to be successful, you need to look at both dividend growth and capital gain potential. Since your dividends will be used to pay off your loan, you will be left to count on capital appreciation to make money from your loan.
This is why stocks like KO and JNJ should not make the cut in your dividend selection. Because both companies are as stable as a rock and this is not what you are looking for when leveraging. If your borrowing rate is between 3 and 4%, you need stocks that will not only pay a similar yield in dividends but that will also generate some growth at the same time.
Seems like mission impossible? Not right now, and this is why I’m talking about leveraging at the end of 2011! When you look at both stock markets (US and Canadian), you can find several high paying dividend stocks that should also produce some capital appreciation. Some of them will be generated in a traditional manner (through posting higher profits and revenue growth) while others will generate capital gains because you buy them cheap when they are undervalued (INTC was a good example of this in 2011).
I’m usually more aggressive in my picks when leveraging. While it may seem counterintuitive to select more aggressive stocks when you are adding more risk with a loan already, yet the point of leveraging is to make aggressive returns to be able to pay off the loan and make a profit at the same time! This is why I tolerate slightly higher dividend payout ratio, for example, in exchange of more potential growth.
Be Ready To Pull The Trigger
When you build your leveraged portfolio, you may want to be more active than when managing your “regular” dividend account. The main reason is that you can easily trigger a sale out of a stock if you have made a great return already. Since you are seeking growth, if you can make 20% off a stock on a quick trade, you might want to sell it and cash in the profit to reduce your leverage. This is another advantage of having a line of credit attached to your account: you can reimburse and borrow the money at will. So whenever I made a profitable trade, I used to cash out the money and pay back my line of credit and wait for another buying opportunity before pulling the trigger again.
Set an Exit Strategy
It is very important to have an exit strategy when you are leveraging. If not, you could get greedy and always invest more. In one way or another, you must plan a way to pay off your loan. Ideally, you should first have a plan with your investments and another one with your budget.
Unfortunately, this strategy is not risk-free. If your investments tank because you didn’t pick the right stocks, you will still have to reimburse your debt. This is why it is also important to not borrow too much if this is your first try with leveraging. You don’t want to owe 100K and have investments worth 75K! In other words, if you borrow money to invest, you should be ready to lose this money and pay off the debts without getting into some serious financial problems.
Are you planning to use leverage in 2012?
At the time of writing this article, I am fairly convinced that starting a leverage operation in early 2012 will be a good deal. In fact, my decision will not be influenced by economic or stock market data (I think that both are highly favorable to a leverage strategy) but more oriented according to my own personal situation. I will have to evaluate my budget and determine if this is the right time to pull the trigger or not. Are you following the same train of thought or are you too afraid of the market to leverage right now?
Good article! I’ve used a line of credit to invest, on and off. I think it all depends on your personal situation. You have to be sure that you can pay back the interest no matter what the market does. The future of the market is very uncertain most of the time, but right now, I feel that the downside risk is high. Maybe I’m wrong, I hope. Although I’m still fully invested in good dividend paying stocks.
Again, nice post!
I was looking to borrow to invest myself for a little while…
Even if interests won’t be deductible, I think I’ll do it with my TFSA. I will be limited to canadian stocks in the TFSA to avoid taxes.
My problem is that good canadian dividend stocks similar to JNJ, KO or MCD are a bit harder to find.
Do you have any suggestions?
JD
If you want to write off the cost of the loan then the account can not be an RRSP or TFSA – strictly investment.
Remember that US stocks will be taxed by Uncle Sam in anything other than an RRSP so that 5% US dividend may end up lower than 4%
Your dividends must, at a minimum, be able to pay the interest on the loan. Right now this is not too hard but keep your ears open to any B of C announcements.
I have a HELOC for stocks investment. The dividends earned in that account automatically go to the HELOC loan. Some people prefer to let the loan pay for itself but I prefer to lop off approx 1K per month plus interest. Although this will increase my taxable dividends due to lower interest payments on the HELOC, it does free up funds in case I spot a stock I want to pick up. This also lowers the interest on the loan so that it would be paid off sooner from the dividends. If I just let the loan take care of itself maybe I would not have that extra 10K in 10 months to re-invest. When we have it in hand we tend to spend it.
Thanks for the article Mike
Thanks to Mike for bringing this issue up, it’s a bit of a taboo topic most people (and financial writers/bloggers) think it’s a bad idea.
I have a couple of ideas that can add to the discussion. In typical broker account you can margin at 50%, or in the case of a HELOC, probably somewhere in the same vicinity. The interest rate for these loans will be from say 3-4% to 7-10% depending on your loan or broker.
Interactive Brokers offers an account that gives you 4-1 leverage at a margin rate about 1% above fed funds rate. When I looked into this they qualify the amount of margin depending on the risk profile of the investment (so everything isn’t going to get 4-1 leverage). This is an account if you really want to go big.
Another option (that I am doing now) is to indirectly get leverage from mortgage REITs. mREITS essentially borrow at the fed funds rate, leverage, and buy mortgage backed securities. These investments have legitimate 15-20% yields (I suppose you could pile it on with your own leverage 😉
The best company is Annaly (NLY) which only investis in government backed paper (Fannie/Freddie loans). If you want to go wild in the private MBS mREITS, try Chimera (CIM) which currently pays a 20% yield.
Hey thank you for the post. It is important for people to be aware of their options.
I use leverage to buy stocks. I’ve been using this type of leverage since mid 2011 and so far it has been successful. I know that 5-6 mths isn’t that much of a track record but I believe in my investment process.
I would like to mention, I personally do not agree with your statement:
“This is why stocks like KO and JNJ should not make the cut in your dividend selection.”
These companies, in my opinion, are the type of companies you want to invest with. Yes, with, as you are an owner of the company. My reasoning is: They are solid companies with great dividend growth. Currently, my dividend leveraged portfolio yield is currently just shy of my interest only LOC interest.
Being a Canadian, we can write of the interest on loans used to purchase income investments. Therefore, I am currently earning more yield from my dividends then paying on the interest of the LOC. Although I do not repay the loan with dividend earnings. I have set aside a % of my income to pay for investments. I use that money to pay the loan. Whatever is left over and the income from dividends is then put into my TFSA to buy more stocks.
Take care,
Rob
@Michel,
investing with borrowed money is definitely more risky but the reward is there also. If you look at it on the long run, your stocks should average a 7-8% yield while your loan should cost about 5% (which is obviously lower at the moment). So you can make a nice spread without having to invest your own money ;-).
@JD,
if you are looking for geographically and product diversification within the same company, you will have to look at US stocks. We don’t have much Canadian dividend stocks that are big enough to meet those criteria.
@Richard,
very good point on the “deductibility” of the interest. It’s even more complicated in Quebec since interest are only deductible against investment income. You have a good strategy to pay off your leverage slowly without touching your investment. this reduce your level of risk.
@SixFigureInvestor,
Great strategy but you are adding more risk to your investment :-). I actually like leveraging, I bought my first home with the profit I made from a leveraged operation on the market. While it can be devastating, it can also be awesome ;-).
@Rob,
While I like stocks like JNJ and KO (I have both in my portfolio), I would not use them for a leverage strategy as I look for more growth to compensate the risk. JNJ has a negative return of -4.2% over 5 years and a positive return of +12% over 10 years (total yield, not annualized). so for the past 10 years, you would have broke even with the dividend yield and probably a little bit under if you consider tax implication and interest paid. I think it’s important to look for more than a “stable stock” if you are doing leverage. But that’s just my opinion 🙂
Leveraging for investing was also very popular in the late 90s. Notice a pattern? 🙂
I had a margin account in the late 90s and it didn’t do very well. I stayed away from leverage investing since then. 2012 might be a good time to do it though, but I’m too risk averse for that. Good luck!
I was too busy playing RPGs to remember what happened in the 90’s 😉 lol!
If leverage and margin buys fit your risk profile, by all means go for it.
Hi, thanks for the article. I recently a post on my own desire to borrow to invest. I am just starting out with investing but I am comfortable borrowing (a small amount) to invest. I want to test the waters and see how it goes. Thanks for the reminder on the importance of having an ‘exit strategy’. I am already living through this lesson right now as my Sprott silver is down to $1700 verses $2200. I couldn’t made 20% gain if I had sold two weeks after I bought it but I didn’t 🙁 but I didn’t have an exit strategy.
It is almost impossible to make money with borrowed money. Serious investors recommend that you never do it.
The percentage spread has to be high enough to make it worthwhile because after 50% income tax, bank interests and fees, the profit from the spread will be cut by more than half. The ones who will make money with your money are the taxman and the banks while you take all the risks.
On a 100,000$ investment and 3% spread the profit might be 1,500$ for the whole year. Hardly worth the trouble.
Please, do not do it.
I tried this several years ago by taking out a Prosper loan and investing it into a CanRoy. It was great for the first 6 months and then my investment tanked. Fortunately, I only leveraged $1,000 which was easy for me to pay back. I will be interested to read up on your progress if you decide to go through with this in 2012.
@Nean,
I know it’s a controversial topic, but I was able to buy my first house with the profit generated from my leverage operations. In fact, when you think about it, you are already leveraged if you own a house with a mortgage (which is not even producing income). You are leveraging your future income in exchange of a better place to live. It’s the same principle than leveraging to invest in the stock market.
cheers,
Mike
“This is why stocks like KO and JNJ should not make the cut in your dividend selection. Because both companies are as stable as a rock and this is not what you are looking for when leveraging.” You couldn’t have been any more wrong when you made this statement. Banks, Insurance, Telcos, JNJ, KO, MSFT, DIS, MMM all great for this strategy. Love the article though, I give you credit for writing it. There should be more articles like this on investment blogs.