This quote is most appropriate for a discussion on leverage. Leverage amplifies both good and bad decisions, so it has to be used responsibly and only when an outcome has a very high degree of certainty.
Where you can find leverage
You can leverage anything. Allow me to explain with an example.
Suzy has index funds worth $100,000 and cash of $10,000. Adam has $10,000 invested in index funds, and a $1,000 emergency fund.
Neither person is using direct leverage (a margin loan) on their stock holdings. So one might say that neither Suzy nor Adam are using leverage at all. But there isn’t enough information to know. If Adam has $9,000 in credit card debt, or Suzy has a home loan for $90,000, both investors are using substantial amounts of leverage in their portfolios.
How to use leverage
Leverage comes down to your own comfort with any particular investment. In my view, there are investments that absolutely should be leveraged, and some investments absolutely should not be leveraged.
Let’s go through a few common assets and their potential for leverage:
You can easily leverage any stock investment with a margin account. A margin account allows you to borrow money from your broker to buy more stock or funds with low interest financing. For every dollar you have in your account, you can purchase $2 of stock.
Leveraging a stock portfolio is very dangerous, however. A 50% drop can wipe out your portfolio entirely. From peak to trough, the S&P 500 index fell by more than 50% from 2007 to 2009. If you had leveraged your portfolio at 2:1, your investment would have gone to zero during the financial crisis. The broker would have called your investment right at the bottom of the stock market. Other investors who did not employ leverage to boost returns still have claim to their initial investment, which is more valuable today than at the 2007 peak.
Individual stocks are much more volatile. La-Z-Boy Incorporated, the company known for its recliners and branded furniture, fell from more than $10 per share in 2007 to $.90 per share in 2009. Anyone who owned it on leverage lost everything. Those who held patiently without leverage throughout the crisis now own a stock worth more than $18 per share, an 80% return in just 6 years.
Real estate is one of the few assets that I believe should always be leveraged because the tax code subsidizes investors who buy investment property on leverage. Mortgage interest on a rental property is tax deductible as a business expense, which makes leverage cheaper than it appears. If your marginal tax rate is 25%, a loan at 4% interest actually costs 3% after taxes.
Investors shouldn’t go nuts with leverage, however. Famed personal finance expert Dave Ramsey went broke in real estate because of his tolerance for leverage. He purchased real estate with short-term financing, building a portfolio worth more than $4 million. He got greedy, however, financing his purchases with short-term loans that were later called by the bank. Had he simply financed his purchases with 20-30 year mortgages that cannot be called by the bank, he would still be in the real estate business and likely in possession of a real estate portfolio worth hundreds of millions of dollars.
Investors can safely leverage real estate with 20% down and fixed-rate financing. Banks are more than willing to make low interest loans to investors who have stable income and the capacity to put 20% down. Leverage becomes more appetizing as your income grows into new tax brackets where the after-tax cost of debt falls.
Loans and fixed-income investments
You can leverage fixed-income investments from loans to bonds. Doing so requires very careful consideration. You can leverage a bond portfolio with margin loans from a broker. You can leverage loans, like P2P loans, either by borrowing from the P2P site at a low rate, or by investing funds you might otherwise use to pay off your existing debt…say, a long-term mortgage.
Leveraging a loan or fixed-income portfolio isn’t something I would ever recommend, especially if it is a very sizable part of your invested assets. You are very much exposed to factors outside your control, like rising interest rates or peer to peer lending defaults.
3 rules for leverage
Whether or not to use leverage comes down to only three factors:
- Your level of certainty with an investment outcome.
- The source of financing (a margin loan, home loan, or…gasp, a credit card).
- The after-tax cost of financing.
The best leverage is that which avoids risks that you cannot control. A long-term fixed-rate mortgage is a very good and inexpensive source of leverage because the rate cannot change, the repayment plan for the loan is fixed, and the interest is tax deductible. I can certainly understand why some avoid rapidly paying down a mortgage to instead invest more in their retirement accounts or new investment properties.
A margin loan from a broker is a poor source of leverage because interest rates are not fixed, and the loan can be called at any time (a substantial decline in the value of your investments is the most common reason for a margin loan to be called.)
The worst source of leverage is a student loan. Student loans are money that you will always have to repay, even if you go bankrupt. Low rates may tempt you to repay loans slowly and send cash to other investments, but the risks are massive. Besides, paying off a student loan is a risk-free way to generate a positive return on your investment.
Leverage adds an equal amount of risk to an equal amount of potential reward. When in doubt, an investment is best left unlevered. Only when you are most certain about an outcome and the availability of funding should you be willing to double down on your decision by leveraging it with other people’s money.