Leverage InvestingLeverage or Leveraging has a specific meaning in the world of financial or investment planning. A well used and understood strategy employed by experienced investors to increase gains by using borrowed money. But for many novice investors It can be a perplexing and terrifying technique--especially if you don’t have a full understanding of all the implications. First off let’s examine the strategy. Leveraging--in a nutshell is an investment strategy of borrowing money to buy assets, as a way to magnify the rate of return. A 7% rate of return (ROR) on a $100,000 investment is is ten times more money than an ROR of 7% on an investment of $10,000. The two keys to successful leveraged investing are not--rate of return or whether the market goes up or down--because we all know that the rate of return will fluctuate from positive to negative (the market will go up and down). The keys are: the spread and the time frame.First of all the spread--is the difference between the cost of the borrowed money and at the average rate of return you can expect.Let's look at an an example of leverage that most people don’t think of as a leveraged investment -- a mortgage. When you buy a house most people use borrowed money--a mortgage. In this case--instead of living in the house, we bought the house to earn an income--we plan to rent it out. You would want the rent money coming in--to be more than or at least equal to--the mortgage payment going out. The idea being the rental property creates an income stream while the asset (the house) gains in value over the years. This same strategy can be used to earn an income from other assets whether they'd be stocks, bonds, mutual funds, segregated funds or real estate. Any income stream is going to be subject to tax. To counterbalance this you are allowed to write off the cost of borrowing the money against your tax payable, which is one of the reasons that leveraging can make sense for people. But leveraging only makes sense if you can reasonably expect the difference in the spread--between the cost of borrowing the money and the profit you can earn--will be more. Assume you borrowed money from the bank--at a cost of 5% interest. Now assume you've taken that money -- $100,000-- and have invested it into equity investments. That could be stocks, mutual funds, or segregated funds. These are all equity investments. The idea here--is that the equity investments will earn a rate of return--greater than the 5% cost of the borrowed money--let's say 8% is the average rate of return you can reasonably expect to earn over the long term (10 years or longer). Our second condition for success with leveraging--is length of time. Go back to our real estate example. In most cases people will have a mortgage for between 20 to 30 years. They plan to make the mortgage payments on the property--whether a rental--or their home over a specific number of years. This is the long term view. In investing--the longer you hold a balanced portfolio the more likely you are to succeed and succeed well. This is the advantage of a balanced portfolio. Different sectors go through cycles with some sectors being up, while others are down. If your investment portfolio is properly balanced you will be constantly taking advantage of they up sectors while the others sectors are flat or even negative. Equity investments have for centuries proven themselves to produce awesome results when held by the investor for a long period of time.
This is leveraging in a nutshell.Leveraging works when you make a rate of return (ROR) on your investments that is greater than your cost of borrowing. This concept can be very attractive to many people, but what are the risks?The main risks involved with leveraging are--first and foremost market risk--the risk that the investment doesn’t preform--earn enough or any gains. The second most significant risk is the spread risk -- if the cost of the borrowed money is too high even good solid ROR will not produce positive results. Example--suppose someone were to borrow on their credit card at 19%! A cost of borrowing that high would mean they would have to get a 20% or higher ROR--on their investment just to cover the spread. This kind of strategy is completely ludicrous and can only result in failure. If an advisor recommends a leveraged strategy to you. Make sure you do your homework on---the type of investments and a reasonable expected rate of ROR for them. The length of time you are prepared to hold those investments to achieve the results you want. What will--the ongoing cost of borrowing the the cash be? These are all very important considerations before you weigh against the potential return on a leveraged investment. Leveraging is a great strategy that works very well to create wealth and reduce tax --when it is done right!! Return From Leverage To Investment Research Terry Johnston J C Mitchell Financial Services Inc. Phone: 866-721-7781 ext. 232 |
