Leveraged investing: real returns & real risks

Dawn and Murray Franklin of Hamilton, are pretty good at buying property. In 10 years they've bought three houses and a fourplex. A fourth house will be added in April. But they aren't flipping. They're living in one and getting rental income from the others.

They've also piled on debt. By spring, they'll be carrying about $600,000 in mortgages plus a line of credit. Ms. Franklin says they've run the doomsday scenarios many times and feel they can handle adversity.

"We would have to have a catastrophic series of events for us to be in economic trouble -- if both of us lose our jobs, or two or three units are empty at one time. We've looked at the numbers and we've never had an issue," Ms. Franklin says.

The Franklins (not their real name) are part of the growing borrowing class of Canadians who believe leverage is good. Yesterday, Finance Minister Jim Flaherty took steps to address this group by announcing plans to tighten mortgage-lending practices.

Historically low lending rates have boosted borrowing. From 1999 to 2005, total debt in Canada increased by 47.5%, largely due to mortgages. A new study by The Vanier Institute of the Family has found many households sank even further into debt in 2009, creating the highest debt-to-income ratio ever seen in Canada, according to its Current State of Canadian Family Finances, released yesterday.

The study showed the average Canadian household debt climbed to $96,100, creating a debt-to-income ratio of 145% in 2009.

While much debt is due to personal consumption, some is for investing. The goal and motivation of assuming debt and risk for an investment is that the rate of return exceeds the cost of borrowing -- and the level of risk is manageable.

At this time of year, perhaps the most common leveraging tool is the registered savings plan (RSP) loan. The risk of this seasonal leveraging is mitigated by the immediate realization of tax savings, normally applied to the loan balance. In most scenarios, a $15,000 RSP loan will produce a $6,000 tax refund.

"Risk management comes into the equation any time you are talking about borrowing to invest. It's generally been seen as a 'safe' situation to be doing an RSP loan to fund a contribution than maybe other forms of borrowing to invest," says Jason Round, financial planning consultant at Royal Bank of Canada in Vernon, B.C.

Certainly, margin and leveraging on a micro scale in an upward stock market can prove its worth. With a margin account of $2,500 in 2000, Torontonian Stuart MacDonald bought and sold technology stocks for 12 months, accumulating gains of $40,000. Mr. MacDonald (not his real name) got out just before the dot-com bust and bought a house.

Some argue it's best to start leveraged investing when young. Yale professors Ian Ayres and Barry Nalebuff, in their study Life-Cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk, say people should start buying equities in their 20s. A 25-year-old with $5,000 to invest should borrow another $5,000 and put it all in a stock-market index. He should do that for another 15 years or so before slowly de-leveraging in his 40s.

The paper concludes by saying that, "[It] is possible for people to retire with substantially larger and safer retirement accumulations, and they can do this without having to save more. All they have to do is invest using leverage while young."

But leveraging can end badly. This was evident in 2008 when stock markets tumbled and investment income could no longer service the loans taken to make the investment. The Ontario Securities Commission was so concerned about market losses that it published a cautionary guide called Borrowing to Invest: Is it the right strategy for you?

Financial planners argue that leveraging is for the long term -- often at least 10 years -- and should only be done by investors who have cash flow to cover payments in absence of income.

When leveraging goes sour, it's often because of poor planning. "[Leveraging] is more prone to fail because there's not a road map to try and deal with the upside and downside consequences of what you put in place. The chances of success [increases if one has] a financial plan in place, whether you are leveraging or not," says planner Jason Round.

But easy credit at low interest rates can blur good judgment.

John Panagakos of The Mortgage Centre in Toronto normally doesn't pass judgment on what his clients are using their second-mortgage money for. But sometimes he feels a responsibility to say something. "If they are green as grass and they don't know what they are doing, I'd advise against it and tell them to go do more homework," he says.

Another consequence of leveraged investing is the "panic effect." Many will abandon an investment at a loss.

"Given the way investors react to volatility, in a lot of cases having leverage on a stock portfolio can often lead an investor to sell at a time when losses look intolerable. And that can be precisely the wrong time to sell," says Larry Berdugo, a financial consultant with Wealthmore Financial Strategies.

(prepared by James Pasternak/Financial Post/Vancouver Sun)