The MYTH OF LEVERAGING
The regulators and most dealers discourage leveraging for retail investors, and especially those in or near retirement. It is just too risky. We investigate cases where clients have suffered a loss by reason of the advice from their financial advisers. These clients have suffered a loss by borrowing money to invest. Their loss may have occurred by reason of increased risk that results from borrowing to invest. Problems occur when:
- Clients can no longer pay the loans;
- Clients do not know if they have lost money;
- Clients have no idea how much they owe compared to the value of your portfolio, or
- Clients are not aware of how they pay fees or pay interest.
With that in mind, consider the strategy of borrowing to invest as a type of gambling strategy. You can buy different types of investments and increase the risk to increase the potential gain, but that could mean increased losses. And you always have to pay the interest and the costs of investing (commissions and fees). Leveraging magnifies the risk.
How does borrowing to invest work?
If an investor borrows $10,000 to invest, and the investment increases in value by 10%, then the investor has made $1,000 with no money down. On the other hand, if the investment drops in value by that same 10%, then the investor must repay the $1,000, but with less than $9,000 in investments to do the job. And the interest comes due every month, win or lose. Remember that there are fees – substantial fees – in the transactions. With mutual funds and segregated funds, there are management fees to consider.
In many cases borrowing involves pledging assets, such as the house, farm, business or other investments.
investors pay the interest
The investor must pay interest on the loan during the time in which the money has been borrowed. The interest payments and the substantial fees will eat into the profits so that the investments must grow at a rate faster than the interest rate. If the interest rate is 5.0%, and the costs of transactions are 2.0%, then break-even is 7.0%. Another risk is that early resale of mutual funds or stocks may incur sky-high fees that further add to the losses.
What are the risks?
Consider the risks that the investor faces. In all cases, the investor has to pay the interest on the loan and the costs of the transaction (or fees in the case of mutual funds). The investor faces the risk of suffering a loss in the portfolio, and having to pay off the loan. If the investment goes down, the loan still needs to be paid. There is no guarantee that your interest payments will be made from the portfolio. Also, the size of the potential loss is magnified by the amount of leverage, 2-for-1 loans for example. The interest payments and the fees add to the loss, and cut down the chances of profit and success.
Who always benefits from leverage loan investing? The adviser. The adviser gets to manage assets bought with the borrowed money, earning commissions at the risk of the client.