Over the past six weeks, our clients have come to us with a wide array of emotions and questions. They’ve ranged from great concern to unabashed enthusiasm, and everything in between. On the upbeat calls, one question initially caught me off guard — “What do you think of me borrowing money and investing in bank stocks?”
I was surprised because usually this strategy comes up when markets have been good, and lenders are begging us to borrow money. Obviously, our current circumstance is quite different. Markets are down and have been hyper-volatile, partially due to the use of debt. Margin calls have caused forced selling which in turn has exaggerated price declines.
Look in the mirror
Nonetheless, I’m delighted by this contrarian thinking. After all, money is cheap and stocks are down, so the economics of borrowing to invest make sense. In the case of banks, the Big Five now have an average yield of over six per cent.
Even so, I don’t spend much time discussing the math when responding to these queries. My focus is on the behavioural challenges that go along with markets and leverage. Market gyrations like we had last month are difficult to navigate at the best of times, let alone when your market value has dipped below the loan value.
Investing with borrowed money can lead to disastrous results if you flinch when markets are down. Since this happens every two to three years, leverage is only for experienced investors who have successfully survived a bear market before.
Due diligence
It’s encouraging that the borrowing question is coming up at a time of upheaval and decisions are being based on the prospect of better future returns as opposed to great past returns. But the timing doesn’t make it a slam dunk. You still need to methodically go through a series of steps to determine if you’re ready to run your own hedge fund.
First, maximize the return from your existing portfolio. This means dialling up your equity content, which will increase the return potential and importantly, serve as a trial run for your leveraged strategy. If you can’t stomach the volatility that goes with an all-equity portfolio, then borrowing to invest is not for you.
Assume modest returns and higher interest rates. Make sure the strategy works even if stocks are slow to recover and the prime rate goes up. When debt is involved, you need a cushion.
Assess the stability of the loan, not just the investments. Remember, your interests aren’t aligned with those of the bank. You’re trying to buy low and sell high, but when stocks are down, your banker is more likely to be pressuring you to sell, not buy. Banks will do whatever it takes to get their money back, whether it suits your timing or not.
In for the long haul
Make a five-year commitment. This strategy must fit in with an overall financial plan that takes into account your future cash needs (i.e. renovations; college tuition; travel) and RRSP/TFSA contributions. You can’t count on the debt capacity you’re using to invest being available for other purposes for the next few years at least.
Diversify. It’s psychologically and aesthetically pleasing when dividends cover the interest payments, but this should be a secondary consideration. Diversification is job one, which means not limiting yourself to high-dividend stocks in a few industries (i.e. banks, REITs and telcos) that operate in one economic region (Canada).
Buckle in. We did some modelling a few years ago that compared an unlevered, all-stock portfolio to a balanced portfolio that was bought using borrowed funds. We went through a myriad of scenarios and kept coming up with the same conclusion. The returns and volatility of the two strategies were similar. A conservative portfolio that’s levered behaves much like a pure stock portfolio. In other words, you’re going to feel every little market wiggle, even if you’re invested in the bluest of blue-chip stocks.
Long-term investors should be taking advantage of lower stock prices, but using debt to do it is an aggressive strategy. It’s only suitable for investors who plan carefully, are already fully invested, and who know how they’ll react when the math isn’t working.
Tom Bradley is chair and chief investment officer at Steadyhand Investment Funds, a company that offers individual investors low-fee investment funds and clear-cut advice. He can be reached at tbradley@steadyhand.com
