Should you borrow to invest?

“Borrow against your house and invest in the booming stock market.” That became the mantra of many financial advisors and some well-known financial commentators during the heady days of the Great Bull Market of the 1990s.

Many financial planners were happy to jump on the leveraging bandwagon. Some genuinely believed it to be the right course for their clients at a time when conventional wisdom said stock markets could continue to rise for the next decade and beyond.

Others were at least partially influenced by the fat sales commissions and trailer fees such a strategy would generate.

People who took out a $200,000 line of credit against their homes and invested it in mutual funds created a very attractive profit for the advisor who handled the sale. That may seem like a harsh judgment, but it was a motivating factor, perhaps the primary one in some cases.

Financial devastation
Now, just a few short years later, many people have been left financially devastated as a result of leveraging decisions made in the late ’90s. It’s time to rethink the whole idea.

Leveraging is a technical term meaning borrong to invest. For years, it was mainly used in the form of brokerage margin accounts.

But the appearance on the financial scene of home equity lines of credit in the 1980s changed the dynamics fundamentally.

These lines of credit meant that ordinary people who had benefitted from the big run-up in housing values during the inflationary 1970s and 1980s suddenly had access to large amounts of cash. In most cases, these weren’t sophisticated investors. In fact, they knew little of the investment process.

But they had home equity, and they could suddenly tap into it. Some financial advisors saw it as an opportunity.

Seductive math
The math of leveraging has always been seductive, no more so than at a time when markets are soaring.

Effectively, you use other people’s money to enhance your own profits and get a tax break for doing so.

So it was easy to make a compelling case for borrowing against your home equity to invest. A financial advisor could sit down with a client and offer what seemed like an irrefutable case for using the family home for investing.

Next page: An example

An example
Here’s how such a conversation might have gone back in, say, August 1999:

Advisor: I’d like to show you a way that you could make an after-tax profit of more than $60,000 over the next five years. Are you interested?

Client: Sure, as long as it’s not too risky.

Advisor: It’s not. Now, I believe you had your house appraised recently. What is it worth?

Client: They said $300,000.

Advisor: Is it mortgage-free?

Client: Yes.

Advisor: Okay. You can get a home equity line of credit for two-thirds of that amount, which will work out to $200,000. I can handle the arrangements for you.

Client: At what interest rate?

Advisor: Prime plus a quarter percent. Right now, that works out to 6.5 percent. You won’t find a cheaper rate. But you won’t actually pay that much.

Client: Why not?

Advisor: That’s one of the beauties of this strategy. The interest is tax deductible. Let’s see. (He checks his file.) Your marginal tax rate is 50 percent. Let’s figure it out. (He punches numbers into a calculator.) That means that on a $200,000 line of credit, you’ll be charged $13,000 a year for interest at the current rate. But because the money is used to invest, that charge is tax deductible. The actual after-tax cost to you is only $6,500.

Client (dubiously): That still seems like a lot.

Advisor: Maybe, but that’s only one side of the equation. We take that money and put it into equity mutual funds. I have some terrific ones in mind. You know how well the stock market has been doing lately?

Client: I’ve been reading about it. Those technology stocks — I can’t believe some of the stories!

Advisor: Believe them. It’s just the beginning. I was at a presentation last week given by one of the fund managers. He said the growth rate in those companies could be better than 20 percent a year over the next decade. Now, I think we should be more conservative than that, so let’s say we invest that money in some equity funds and that they give us an annual return of 15 percent on average. I’ve prepared a projection for you, based on a $200,000 investment — I figured that would be about what you would have available. Let’s look at it. (He passes over a sheet of paper with the following numbers.)

Amount invested: $200,000
Annual return at 15 per cent: $30,000
After-tax cost of loan interest: $6,500
Tax on profit at capital gains rate: $11,250
Net after-tax profit: $12,250
Net profit over five years: $61,250

(Note: the numbers today would be even more impressive because the capital gains inclusion rate has been reduced to 50 per cent — it was 75 per cent in 1999. Also, lower interest rates mean lower loan costs.)

Advisor: What do you think?

Client (whistling): Wow.

Advisor: Yeah. Pretty awesome.

Client: You really think those profits are possible?

Advisor: Hey, nothing is guaranteed. But I think there’s a good chance you could do even better.

Client: Then let’s do it.

There’s no way of knowing how many people actually decided to go this route in the hopes of big profits from their home equity. All we can say with any degree of certainty is that a large number of them now wish they had never heard of the idea.

Next page: Look at real numbers

Look at real numbers
Let’s see what might have happened to someone who decided to use leveraging and invested in a portfolio of equity funds at the end of December 1999. Of course, much will depend on the specific funds that were chosen, so let’s look at two different approaches:

Aggressive Approach:

With an aggressive approach, the financial advisor and the client were swept along by the tide of the rising market and the tremendous enthusiasm over high-term. This was the prevailing mood of the time. The portfolio was constructed accordingly, as follows:

20 per cent AIM Global Technology Fund
20 per cent CI Global Telecommunications Sector Shares
20 per cent AGF Aggressive Growth Fund
20 per cent Elliott & Page Growth Opportunities Fund
20 per cent Janus American Equity Fund

Returns for 2000
In calendar 2000, here’s what happened in each case:

AIM Global Technology: –27.9 per cent
CI Global Telecommunications: –31.1 per cent
AGF Aggressive Growth: –14.2 per cent
E&P Growth Opportunities: +21.7 per cent
Janus American Equity: –19.1 per cent

Based on our portfolio weighting, the value of the portfolio on January 1, 2001, would have been $169,760, for a net loss for the year of $30,240, or 15.1 per cent. The after-tax interest charges would have added to the total loss.

Further disaster
But that was nothing compared to what was to come. The markets continued to head south in 2001. By mid-October of that year, here’s what had happened to the individual funds on a year-to-date basis:

AIM Global Technology: –52.5 per cent
CI Global Telecommunications: –55.8 per cent
AGF Aggressive Growth: –43.7 per cent
E&P Growth Opportunities: +3.4 per cent
Janus American Equity: –31.4 per cent

Disaster! The portfolio’s value has fallen to $115,669, a loss of more than 42 per cent from its original value of $200,000, and this in less than two years.

Only the Elliott & Page fund had made a profit. All the rest were dramatically down.

And our investor was still paying carrying charges on the loan. How long is he likely to hang on in these circumstances, despite the advisor’s pleas for patience?

Unfortunately, this type of portfolio is not untypical of the fund selection that might have been made in the market euphoria of the day. It is a classic illustration of the dark side of leveraging. The strategy can magnify your profits when stock markets are rising. But it has a similar effect on losses when markets are falling, especially if it is being aggressively managed.

Next page: Balanced Approach

Balanced Approach
Now let’s assume the advisor was wiser and recommended a more balanced approach. He still counselled putting the money into equity funds, but chose more diversified funds that were less exposed to the high-tech bubble.

Here is the selection that he advised for his client:

20 per cent Mackenzie Ivy Canadian Fund
20 per cent AGF American Growth Class
20 per cent Templeton Growth Fund
20 per cent Fidelity European Growth Fund
20 per cent Trimark Canadian Small Companies Fund

Performance in 2000
Here we have a nice mix of growth and value funds, along with good international diversification. Let’s see how the funds fared in calendar 2000.

Mackenzie Ivy Canadian: +20.4 per cent
AGF American Growth: –14.6 per cent
Templeton Growth: –0.8 per cent
Fidelity European Growth: –7.7 per cent
Trimark Canadian Small Companies: +16.5 per cent

Here the result after the first year is much better. The gains in the Ivy and Trimark funds slightly outweigh the losses in the other three, providing a net profit within the portfolio of $5,520 for the year.

That’s almost (but not quite) enough to cover the after-tax cost of the loan interest.

Bear market impact
Now comes the deep bear market of 2001. Let’s see how these funds fared for the year to mid-October:

Mackenzie Ivy Canadian: –4.8 per cent
AGF American Growth: –27.5 per cent
Templeton Growth: –9.1 per cent
Fidelity European Growth: –23.5 per cent
Trimark Canadian Small Companies: +18.9 per cent

Although four of the five funds lost money during the period, the results were nowhere near as bad as for the aggressive approach. The portfolio value at this point would have been $190,334, for an overall loss of less than 10 percent since the original investments were made.

Interest costs
Of course, the investor would have laid out thousands of dollars in after-tax interest costs as well, which wouldn’t have made him happy. But in this case, he might have been prepared to hang in and wait for better times given the fact the funds he owned had, collectively, held up reasonably well in very difficult markets.

The moral is obvious. If you are going to indulge in leveraging, take a balanced, or a conservative, approach in selecting your securities. You’ll limit the upside potential to some degree, but you’ll also reduce the downside risk considerably.

Next page: Not for everyone

Not for everyone
The problem with leveraging doesn’t relate to its potential value as an investment tool. Rather, the concern is that people are being persuaded to borrow against their homes or other securities without truly understanding the risks involved and the potential distress that losses may cause, especially if the money is aggressively invested.

In short, it’s a psychological concern. Consider this:
Suppose our fictional investor with the aggressive portfolio had gone home that night and told his wife what he had done. She may have expressed concern, but his arguments (or, more precisely, those presented by the advisor) would have persuaded her.

However, as stock markets began to weaken in the ensuing months, both of them would have become increasingly worried. After all, it was their home on the line. By the early autumn of 2001, the breakfast-table conversation may have degenerated into a running argument over whether they should hang on or take the loss and get out immediately, before any more damage was done.

Near panic
After the market plunge following the September 11 attacks, it would hardly be a surprise if the worry had degenerated into something approaching panic.

You can hear it now: “We saved and scrimped all those years to pay off our mortgage and now we’re right back where we started!”

The advisor’s reaction would probably be to hang on, that a recovery was inevitable. But given the mood of the moment, would the couple have been receptive to such counsel? Many wouldn’t. They’d flee.

Of course, over time that would likely prove to have been the wrong move. Even the aggressive portfolio, with its big losses, will probably bounce back eventually.

But emotion plays a major role in investment decisions, especially in situations like this when money has been borrowed against the family home.

For knowledgeable investors
That’s why we believe that leveraging is a suitable strategy only for very knowledgeable investors in most cases. Unless you’re prepared to deal with what could be severe short-term losses and stick with the approach for the long haul, you’re not a good candidate.

Some tips:
If you decide that you do indeed have the financial know-how and the stomach for leveraging, here are some suggestions that may be helpful:

Invest when markets are low, not high
There’s a natural tendency to avoid the stock market when the bear is in control and stocks are being ground down. Conversely, when markets are rising, everyone wants their share. That’s why it’s so easy to convince people to use leveraging when everything is on the rise and almost impossible to get anyone to listen when markets are in the doldrums.

Of course, that’s far and away the best time to use this approach. Stocks have been beaten down so badly that there is little downside left. Profit potential is at its maximum. Historically, the early legs of a new bull market are the strongest. Interest rates are low, so the cost of borrowing is minimized. There can never be a better combination for the dedicated leverager. It’s overcoming the generalized doom and gloom that’s the real problem.

Take a balanced approach
We’ve seen an illustration of the difference between an aggressive and a balanced approach in a terrible stock market. Those numbers should be all you need for guidance as to the route we recommend.

Take profits and pay down the debt
If you do use leveraging and have success, don’t keep reinvesting the profits. That’s like betting all your winnings on every new roll of the roulette wheel. You expose yourself to a higher degree of risk every time, and sooner or later you’ll lose.

Instead, use the capital gains and/or dividends to pay down the loan. That way, if the market goes into the tank, your exposure will be reduced.

Don’t mortgage the family home
There’s too much emotion attached to it. People can live with temporary losses against collateral such as GICs, bonds, or other securities. They have much more difficulty coping when the family home is on the line.

Pay the lowest possible interest rate
Even though the interest is tax deductible, you still have to pay some of it out of your own pocket. If the loan is substantial, that could amount to several thousand dollars every year. So shop for the best deal available.

Adapted from Secrets of Successful Investing, a new book by Gordon Pape and Eric Kirzner, published by Prentice Hall Canada.