The downside of leveraging

My first reaction on reading the following e-mail was to shake my head in frustration. My second was wave of sympathy for a married couple who are being torn apart by this situation. My third was anger at the financial advisor who had put them in this position. Here’s the letter:

“My husband and I are both 62 and still working. Because we had little put away for retirement our financial adviser persuaded us to take out $300,000 in leveraged loans for a seven-year period. This was in April 2006. As at the end of June, the mutual funds have already decreased from $300,000 to $290,000. I am terrified of losing everything and want to sell but my husband wants to hold on. We do not have many years to recover. If we sold now we have a loss of $10,000 plus the service charges of 5.5 per cent will cost another $16,500 for a total loss of $26,500. Is it better to take the loss now before the market sinks any further?” – C.G.

My frustration stems from the fact that for years I have warned people against falling into this trap in my books, newsletters, and articles. But it still happens repeatedly. So let me say it once more, wih emphasis: Leveraging should be used with great caution and only if you are prepared to accept the risks involved.

This phenomenon typically surfaces towards the end of a bull market. People see others making big money in stocks or equity funds and want a piece of the action. That makes them vulnerable to the idea of borrowing a lot of cash, sometimes by mortgaging the family home, to invest. It’s easy for an advisor to make the case because leveraging (borrowing to invest) can magnify profits when securities perform well. All the advisor has to do is to project historic numbers to make the case.

For example, the S&P/TSX Composite Index gained 22 per cent in 2005. Anyone can produce a chart showing you would have made close to that by investing $10,000 of your own money in a TSX index fund. If you doubled your investment by borrowing another $10,000, the return on your own money would double to about 44 per cent, less interest costs – which of course are tax-deductible since you are borrowing to invest. It makes for a compelling argument.

Of course, this assumes the markets will keep performing as they have in the past, which they never do. The other side of the coin is that leveraging magnifies losses if the value of the securities in the portfolio declines. If you invest $10,000 and the market drops 10 per cent, you are left with $9,000. If you borrow another $10,000, your loss compounds to 20 per cent (plus interest) and you only have $8,000 of your own money left after repaying the loan.

Leveraging can be a viable strategy at times for experienced investors. It should rarely be used by people without a lot of investment knowledge. However, there is an incentive for advisors to recommend borrowing large sums of money because it generates big commissions for them. Unfortunately, greed can sometimes trump prudence.

As a general rule, a leveraging strategy works best at times when the market is down. People who had the nerve to try it in late summer 2002, when the bear market was approaching its nadir, did extremely well. However, the concept is rarely promoted at such times because it isn’t saleable when pessimism reigns. People are only prepared to listen after stocks have had a strong run. Of course, leveraging at the top of the market is never a great idea but that’s when the concept is most marketable.

So what should be done in this specific case? We have a classic example of investing heavily at a time when stocks may be near their peak after a run of more than three years. Plus we have the makings of a serious domestic dispute – a wife who is deeply worried about the financial future and a husband who wants to grit his teeth and stick it out. That can only spell trouble over the breakfast table when the newspapers report the latest round of bad news.

It would be nice to be able to offer a pat answer in this situation, but there isn’t one. Telling this couple to lock in a loss of $26,500 after less than four months is not going to sit well although, given my view of the prospects for the markets going forward, it might be the most prudent thing to do.

The best step would be to sit down with the advisor who got them into this, have a frank heart-to-heart about the situation, and review the entire portfolio carefully. If appropriate, the investments should be restructured in a way that minimizes risk and is more defensive. For example, that could mean reducing exposure to funds which are heavily weighted to resource stocks and adding to those that favour utilities and financial services. If the whole market goes south, funds such as that should hold their value better than those that are more aggressively managed. Also look for funds with a proven track record in a down market. CI Canadian Investment Fund and Chou RRSP Fund are two that come immediately to mind.

Of course, the best solution would be to turn back the clock to the moment this couple was about to sign the papers and let them drop the pens and run. Unfortunately, that’s not feasible in their case but anyone else who is being pressured to use a leveraging strategy right now can take this approach. Head for the exit and save yourself a lot of grief.