The Preet Principle: Leveraging to Invest the Right Way! Part 3 of 4

Continuing from Part 1 and Part 2 in this series, this part will deal with looking at why most leverages fail.

Lack of Experience with Investing

MonthlyBudgetPicture.jpgIt is a big No-No in my books to even consider leverage without having been actively investing for AT LEAST a few years. Even better would be for the investor to have actually experienced a full market cycle (or two!) before looking at leverages. This is simply because if you have not experienced the ugly side of the markets, you really can’t prepare yourself for it. But even more importantly, if you HAVE been through a major correction or a bear market, then you’ll have also noticed that the periods following the dark times are among the brightest times. It would certainly help psychologically to have witnessed the rebound so that when your leveraged investment goes south, you will not be so easily tempted to bail on your strategy (i.e. exactly at the wrong time).

Leveraging at the Top of a Market

If you ever pay attention to the business media you’ll know that every month they report on the monthly "net inflows" or monthly "net redemptions" by mutual fund investors. A net monthly inflow means that people are contributing to or buying mutual fund investments at a rate greater than they are redeeming them – which signifies that investors have confidence in the markets. Having a net redemption for the month usually indicates people are getting weary of future performance. You may also notice that during periods of net redemptions is usually when the markets have been performing poorly; vice versa, there are massive net inflows when markets have been doing well.

Mutual fund investment flows are a good barometer of the average investor’s sentiment since mutual funds represent the majority of investment vehicles for retail investors in Canada. But if you remember that you make money in investing by buying low and selling high, then you’ll also realize that the average investor basically has no clue what they are doing if you look at the mutual fund investment flows and the corresponding market performance – the average investor is inadvertently buying HIGH and selling LOW by basing their contributions and redemptions on recent market performance.

If the market behaves in a cyclical manner (like it has since the beginning!), then a better time to invest is when the markets have just been performing poorly. If the markets have been performing really poorly, then it is an even better time to invest. Conversely, when the markets have just been performing well is statistically a worse time to invest since it is more likely that the markets will have a downturn the longer the current up-trend is.

However, similar to the mutual fund flows – leverages become more and more prevalent when the markets HAVE BEEN performing well since investors are enthusiastic about how they can magnify the good returns the markets have been returning if they employed some leverage. And this is one of the main causes of problems with leverage.

Investors had been thinking, "Wow, I’ve been making some good returns for the last 3 years – imagine how much more I would have if I borrowed to invest!". I have seen this first hand as there are tonnes of investors who borrowed to invest in high-tech stocks in the late 90’s. Needless to say – they blew themselves up hard and fast once the bubble burst. A second wave of leverage loans occurred in 2006 and 2007. These were normally younger investors who had missed experiencing the boom and bust tech cycle – BUT they had witnessed multiple years of double digit returns since then – the market had already doubled in Canada within 4 years of the tech bubble bursting and double digit returns have been the norm for many younger investors. This latest wave of leveragers have been having a tough time in 2007!

Lack of Discipline

Behavioural finance researchers have found that people are two times as emotionally sensitive to losses in their portfolio as they are to gains. That means that the absolute magnitude of their emotional reaction to a 10% gain is the same as for a 5% loss (of course the nature of this emotional reaction is much different in each case!).

Further to this, I believe that investors over-estimate their resolve when it comes to market volatility.  They tend to focus more on the possible gains than the possible losses. When the tough times roll around, it becomes harder to stick to their guns than they had originally thought.

Also, even though your mortgage is a form of leverage you wouldn’t particularly care too much if someone came to your house every day with an offer to buy your house for 20% less than you bought it for since you have a very in-depth understanding as to the value of your house. That’s because you really know the ins and out of your house. You can’t drive by your stock portfolio on the other hand and when the market offers you 20% less than what you paid you start to second guess yourself! 

Unrealistic Market Expectations

The long term market return is somewhere in the range of 8-11% nominal (nominal means NOT adjusted for inflation) which translates to about 5-8% real (real means that it IS adjusted for inflation). Of course, this doesn’t mean it will always be that way, but it does give us a starting point for our expectations.

These returns are quoted for a 100% exposure to equities. Equities are going to be more volatile than a balanced portfolio, but many people make the tradeoff for the higher return potential. But let’s go back to the Andex Chart from Part 1. If you look in the bottom right quadrant you will see a text box which shows the annualized returns since 1950 of various indices. You’ll note the performance of the Canadian stock market compared to a Moderate Balanced Portfolio since 1950. The risk is stated in Standard Deviation of annual returns during that time:

S&P/TSX Composite Total Return Index Since 1950: 10.9% Return, 16.2 Standard Deviation

Moderately Balanced Portfolio Since 1950: 10.4% Return, 9.8 Standard Deviation

The Moderate Balanced Portfolio consists of 10% Cash, 30% Bonds, 20% Canadian Stocks, 20% U.S. Stocks, 20% World (ex-US, Canada) Stocks. This is a hypothetical sample portfolio – but it illustrates that over a long period of time a portfolio that is well diversified can reduce risk (or volatility) without sacrificing as much return as you would think. I’m not saying you have to pick a balanced portfolio by any means, but just to consider that if your are magnifying risk by engaging a leverage strategy, it might be prudent to reduce risk in other ways.

Stretching Yourself Too Thin

This refers to the fact that with an interest-only loan – you are committed to making your payments every month without fail. Compare this to making monthly contributions to your savings – while it’s not a good idea to skip making a monthly contribution here or there, it’s not the end of the world. Also, it gives you a bit of flexibility if things get tight – you can peel back the amount of the contributions any time you want without having to explain it to anyone.

In addition, if interest rates increase then your monthly payments with a leverage will also increase (for the in

terest-only leverages and variable rate term loans). For example, if we look at our sample investor who had a monthly interest payment of $1,666.66 when interest rates were 7%, what would happen if interest rates increase by 2% over two years? His monthly payment is increased to $2,142.85 – a difference of $476.19 per month! If you find making the current interest payment a bit of a stretch as it is, an increase in interest rates is a double whammy: your payment increases which might facilitate collapsing part of the leverage in order to make your payments (and decrease them going forward) and it is more likely that you are selling part of your investments at an inopportune time as both stocks and bonds tend to decrease when interest rates increase. 

Adding it All Up

Many people will tell you that doing well in the markets is not about "timing the market" but rather "time IN the market" – and they are generally right. They are advocating that you can’t time the market as your only strategy as if you could predict the markets with any great certainty, you wouldn’t need to work for a living! Certainly more of the successful investors in history have been more of the buy-and-hold variety as opposed to market timers, but one thing to consider is that you can time the markets insofar as to take advantage of opportunities when they present themselves as good entry points for long term strategies.

For example, if the market has a correction and is off 15% in the span of a week, well you are 15% better off to engage in your leverage today than you were one week prior weren’t you? The tough part is having the strength to invest during pessimistic times – and there are no guarantees that the rebounds are just around the corner, you may have to wait it out still, or whether a few more corrections before the next bull run.

But people tend to do the opposite. They tend to leverage after the markets HAVE been performing well – at the height of market enthusiasm.

Also, if you start out your leverage and your first year or two has been bad for the markets, most people are inclined to collapse the strategy for fear of ever increasing losses. If the bad years happened after a couple of good years on the other hand, the investor may be more tempted to stick it out if they are "still ahead" on paper. For this reason, the first few years of the leverage are the most critical.

Add to this the loss of flexibility to deal with cash flow crunches, the risk of interest rate increases,  etc. and you can see that traditional leveraging is not for everyone at all. In fact I would be surprised if leveraging is suitable for even 10% of the investing public!

BUT – for those that do fit the criteria (which I will outline in the next post), I have a possible solution that is designed to address all of the above mentioned pitfalls. In Part 4, I will discuss this strategy, and provide supporting Monte Carlo Sensitivity Analysis data to provide what has humorously been nicknamed the Preet Principle. :)

CLICK HERE TO GO TO PART 4

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Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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  • FourPillars

    I did quite a bit of analysis for my leveraged plan and concluded that interest rates are the biggest risk you face. An increase of 2 or 3 percent might not affect your cash flow too much (unless you borrowed too much) but it will probably remove any profitability from your leveraged plan.

    Mike