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Leverage Part 2: The Dark Side!
So now that you are all hot and bothered about getting an investment loan (aka leverage), let me take you down a notch! (Trust me, it’s for your own good…) :)
Okay, so let’s now say that Greg, who if you remember had learned that he would be $2,000 ahead by getting a loan, decides to calculate a few “what-if” scenarios…
1. What if the investment only earns 6%?
In this case, the investment’s rate of return and the interest on the loan are equal. How much does Greg have at the end of 10 years? In this case the leverage will leave him with just $13,487 at the end of the 10 years. If he had made the annual savings of $1,000 into a 6% investment – he would have $13,972 – almost $500 more. So in this case the leverage would’ve been the wrong decision.
2. What if the investment makes no money after 10 years?
Depressing, but a lot of investors guide themselves to a 0% rate of return by switching their investments around too much – always a step behind “the next hot pick” (but that’s another story!). Okay, in this case the “straight savings” (putting $1,000 per year) will give you, yep you guessed it $10,000! The leverage? Another no brainer – Greg’s loan for $7,531 doesn’t grow and that’s all he has at the end of 10 years. I think you can see that we’re getting further and further behind with the leverage…
3. What if the investment loses 10%?
We looked at a gain of 10% in Part 1, so let’s look at a loss of 10%. It would take real skill to lose 10% per year over 10 years – but I suppose it could happen if someone were really clueless… The straight savings will leave Greg with $5,862. Yikes! But if that wasn’t bad enough, the leverage would leave him with $2,626!!!
I think I have built a solid case for why you may want to think twice about leveraging. But there is SO MUCH MORE TO THIS STORY than just the examples I have given. From here on in it’s going to get even wilder (both in terms of potential and volatility). Near the end of the series on leverages, once I have shown enough case studies to educate you to the level of an average financial advisor (on THIS topic), I will show you some advanced leverage strategies that I use with my clients on a regular basis – but it is much more complex than the stuff we’ve just talked about – because I am not a fan of risk – and neither are my clients!
Leverage Part 1: What is Leverage?
Leverage: Think of it as using “other people’s money” to make money more quickly. Probably another topic that is best explained with an example.
Greg has $1,000 a year to invest for 10 years. Assuming a rate of return of 10%, at the end of 10 years he will have $17,531.
BUT, we know from the post on the magic of compound growth that TIME has a large effect on growth. The philosophy is that if you could instead take all that $10,000 over 10 years and just put it in now, you will have more money than by putting it in over 10 years.
Okay, let’s look at a simple use of leverage: Greg only has $1,000/year, so he can afford a loan payment of $83.33/month (That’s $1,000 per year). First we have to figure out how much of a loan he can get. Assuming a 6% interest rate, $83.33/month for 120 months (10 years) will allow him to borrow $7,530.89. So he isn’t starting with $10,000 since we have to compare apples to apples (in the form of how much cash flow he is willing to dedicate to his investment savings).
Okay, so now let’s calculate how much $7,530.89 will grow to if invested and assuming the same 10% rate of return… My trusty financial calculator tells me $19,533. So in this case he has roughly $2,000 MORE through the leverage than with the yearly savings (which yielded him $17,531).
Now before you go out and get a loan to invest, remember that a lot of people get burned on leverages – as they magnify RISK as well as return. In Part II of “Leverage” I’m going to look at a negative scenario.
You know, the topic of leveraging is a big one – I envision that I could easily write a 10 part series of posts on it, and probably will. It’s glamorous, but please make sure to consult with a professional before getting one! This post is in no way meant to be taken as advice to get an investment loan.
Having said that, if you own a house and have a mortgage – you already have a leveraged investment! :) You have borrowed money to buy an appreciating asset.
What is a GIC?
GIC: Guaranteed Investment Certificate. In the US these are known as CD’s (Certificate of Deposit). This is pretty much as safe as you can get when it comes to investing. You buy a GIC at an advertised rate (say 4% as an example) and you earn 4% per year for the duration of the term.
They are guaranteed in that it doesn’t matter what happens to the stock markets, or with interest rates after you buy the GIC, if you bought a 4% GIC, you get 4% annualized for the duration of the term you chose. (Term is just a fancy word for how long you want to hold this investment.) The only way you could lose out is if the bank went under – even then, your money is insured up to $100,000 through the CDIC (Canadian Deposit Insurance Corporation) in the event of insolvency of the issuer (aka the bank goes under). So, it’s as safe as your savings account and pays more interest in other words.
These days, there are about 100 different types of GIC’s to buy! They vary on a few features, one of which is TIME. You can buy a 30 day GIC, a 60 day GIC … a 5 year GIC, etc. Note that the longer the term, the higher the interest rate they will pay. The bank is willing to pay a premium if you promise to give them your money for a longer period of time. Note that unless you have a cashable GIC you can’t get out of the GIC (and if you can there are penalties you have to pay).
They also vary on whether they are “Cashable” or “Non-Cashable” – as alluded to above. Again, the bank will pay a premium (in the form of a higher rate of interest to you) for selecting the “Non-Cashable” feature since it means they are more likely to have your money for a longer period of time than with a cashable GIC.
These are the basic differences, but I will post on some other types of GIC’s, as well as when they make good investments and the pro’s and con’s, etc. in other posts.
Use our strong dollar to save on online purchases…
Our dollar has been hovering around $0.95 USD. So to figure out how much you pay for something that is listed in US funds, just divide the US price by 0.95. Now you have how much you will pay in Canadian funds.
To take advantage of this you need to know that the price spread of an item (the difference between how much it costs in US funds and how much it costs in Canadian funds) is greater than the price spread between the loonie and the US dollar. (The price spread between the loonie and the US dollar is 5 cents divided by 100 cents). <– THAT’s the philosophy, but what you really need to know is that when you divide the US priced item by the exchange rate, is the result less than what the items sells for in Canadian funds? Let’s take an example:
I posted that I recommend “The Richest Man in Babylon” as a great book to buy. If you look on Amazon.COM, it is $6.99 USD. If you look on Amazon.CA is it $9.99 CAD.
$6.99USD / 0.95(Exchange rate) = $7.36 CAD
So it is actually cheaper to buy it on Amazon.com since our loonie has made such a dramatic increase in value over such a short period of time. HOWEVER, you have to note that to qualify for free shipping on the US site, you need to spend $25 USD. To qualify for free shipping on the Canadian site you need to spend $39 CAD. In addition, the US site will not ship for free to Canada, so to really save money you need to find a friend with a US address and have it sent there and then arrange to get it across the border. That’s a fair bit of trouble for a small savings, but for electronics…. :)
Inflate your tires properly and save $432 per year!
The EPA (Environmental Protection Agency) says that for every 2psi (pounds per square inch) of under inflation in your car’s tires, you lose 1% in fuel efficiency. In a recent study (not to exacting scientific method, mind you) students at Carnegie Mellon University found that out of the 81 cars parked in a nearby parking lot, only 1 car had all four tires inflated to the proper tire pressure. Further, they found that on average tires were under inflated by 20% – which translates to about 7 psi. If you go by the EPA’s assertion, the average person is losing 3.5% in fuel efficiency. According to the mathletes at Carnegie that works out to $432 for the average person…
Let’s apply that to me: I drive 30,000km per year. I get 600km to a tank. A tank costs $50. So if I apply a 3.5% decrease in fuel efficiency, I will only get 580km to a tank. So according to my math, I only save about $87. What are they smoking at Carnegie Mellon? Read about their study here – then do the math. It is flawed.
I decided to do some digging – I checked Edmunds.com which is a decent resource for car buying tips – they did an extensive review of various ways to save on fuel. They found a small difference as well.
But, I CAN tell you that by having properly inflated tires will probably save you $200 per year on tire wear! So if you factor that in, I would estimate that checking your tire pressures once per month and keeping them in spec will probably save you a couple hundred per year in fuel and tire costs, but not quite $432 in gas alone!
Side note: For every 5 degree increase/decrease in temperature your tire pressure will increase/decrease by 1 psi. So make sure to pay closer attention when there has been wild temperature swings (like change of season) - your tire pressure will have changed!
Can you Diversify too much?
This is a tricky topic to talk about. So please read the caveat at the bottom of this post!
The wealthiest people in the world have, on average, made their fortunes on ONE stock… and that is usually the stock of the company they themselves founded and ran in the form of a small business that just kept expanding. But of course for every small business that becomes the next GOOGLE, there are countless more that fail and go under. This is the ultimate example of why you won’t get rich quickly by diversifying AND how you could lose everything quickly by NOT diversifying.
Understanding this debate is understanding the trade off that you want to make between risk and reward. You take on an astronomical amount of risk by buying only one company’s stock, but if that company is indeed the next GOOGLE well then it was worth it, wasn’t it? :)
Similarly, a lot of successful investors advocate buying only a handful of stocks (maybe 10-20) that they KNOW and BELIEVE in and expect will grow faster than the rest of the economies in which they are domiciled. They understand it will be a rockier ride than holding every stock in the world, but expect to be rewarded over the long term for the increased amount of risk they expose themselves to.
By properly diversifying, you virtually guarantee you will never get rich overnight, but you also virtually guarantee you won’t lose your shirt either. Conversely, by under-diversifying you open up the possibility of making a lot money very fast… or losing it!
For new investors – you will want to diversify as much as possible, and across multiple levels of diversification as well – see “What is Diversification?”. (At least until you get your feet wet and experience a full market cycle.)
What is "Diversification"? There is more to it than you might think!
Diversification basically means not putting all your eggs in one basket. If you hold only one stock and that company went bankrupt, then you would have lost all your money. If you hold two stocks and one company goes bankrupt you have only lost half your money. And so on, and so on.
But there is a BIT more to it than just that. If you held two stocks in companies like Sprint and Verizon and someone invents a device that makes phones obsolete, then both companies might go under. In this case you have diversified by holding two companies, but you picked two companies in the same industry!
Further, if you held two mutual funds that both invested in large Canadian companies (and each fund held 100 stocks), but the Canadian economy as a whole declined, both your funds would lose money.
So there is more to diversification than just holding more than one stock. The key to proper diversification is to pick different stocks (or other investments) that are NOT CORRELATED to each other. i.e. the values of each do not move in tandem. So when one is up, the other is down, and vice versa. (You still want to pick only investments that are expected to appreciate long-term.)
There are many different way to diversify – something known as “Multi-Level Diversification”. You can diversify by:
1. Holding more than one stock
2. Holding investments from different sectors (Telecom vs Banks vs Mining, etc.)
3. Holding investments in different Asset Classes (Stocks, Bonds, Cash)
4. Holding investments in different Markets (Canada vs US vs China vs Europe, etc.)
…and that is just scratching the surface.
So the take home message is that proper diversification means holding numerous securities that are as uncorrelated to each other as possible, in order to reduce risk. Let’s say that ALL investments in the universe returned 7% over the next 100 years, BUT each had their own “cycle” of when it was up or down in the short term. If you held only one, then perhaps it made a killing in the first 50 years, but got slaughtered in the second 50 years. And maybe a different one returned 14% one year and 0% the next, and continued to alternate for the next 98 years in a similar fashion, and so on. Imagine that there are 1000 different investments in this universe and each has a very unique pattern of returns, but ultimately returns 7% over the 100 years. Well if you held them all, you would still get your 7% over 100 years BUT you had a MUCH SMOOTHER RIDE and the variance of any annual return from 7% would be minimal. Risk is another word for variance – so to reduce variance is to reduce risk – which can be accomplished with proper diversification.
Please note that you can not entirely get rid of risk and that the examples given in this post (as always) are fictitious and intended for educational purposes only.
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