Leveraging - should you borrow to invest?

From my CBC radio national column, August 27, 2009:

Between the plunge in the stock market and a drop in home prices many Canadians saw their nest eggs shrivel over the past year. Now with talk that the recession may soon be over, some are so keen to make up lost ground, they're taking out loans to throw money into investments, a strategy that concerns me.

How much is this trend is catching on?

The conditions right now - interest rates are low and stock and real estate markets that have been considered low and on the upswing, creating a breeding ground for the return of leverage. Some can’t resist the lure of easy quick money.

Plus as they contemplate the end of their working lives, people in the baby boom generation are keen to maximize their retirement income

Their thinking is that their return will be greater than the interest on their loan. In addition, if they invest in an investment that produces possible income or a capital gain, the interest on the loan is tax deductible.

A lot of the evidence about the number of people doing this is anecdotal right now. In a recent story on advisor.ca--which is a website for those working in the investment industry--that referred to financial advisers having to discourage some clients from borrowing to invest.

www.advisor.ca/advisors/news/industrynews/article.jsp?content=20090820_145107_9112

I did manage however to dig up some numbers that might be indicative of a trend. In June of this year, the Investment Industry Regulatory Organization reports that Canadians had approx $10.5 billion in margin accounts. Just so you know - a margin account applies specifically to money that’s borrowed from a broker to purchase stock. That’s up nearly 15% from the low in December of 2008.

Should people borrow to invest?

There was a recent that was written about on another website - investopedia - that compared buying on margin to borrowing money to gambling at a casino. And that pretty much sums up my reaction.

Borrowing to invest in anything magnifies your risk plus remember, if your investments drop, you’re still on the hook for the loan payments or even a dreaded margin call when you may have to come up with big bucks to keep the strategy going

So remember that there’s a fine line between investing and gambling, and in my view, buying on leverage kicks you into gambling territory, where the chances of big gains are offset by big losses.

Buying on margin is not for someone who has a low tolerance for risk, someone who needs their money soon, or someone just fed up with low interest rate GICs. It's a very speculative and risky adventure that might work for some, but the percentage of those who should consider leveraging is very, very small

Now, some people will borrow to top up their RRSP. This can be a good strategy, because you get a tax refund that you can use to help pay off your debt quickly, and that can help your retirement savings grow. Because RRSP loans tend to be small and short-term, most experts would categorize them as leveraging.

But I feel strongly that if you have any debt in your life, you should focus on paying that off first before ever taking on more in the hopes of a profit. It’s always a guaranteed return when paying off your current debt.

With stock markets increasing over the past few months, does this signal that someone interested in borrowing to invest should do so now?

You might think it says that markets are headed up and this is a great buying opportunity.

But while that might have been true a few months ago when markets were at rock bottom, there’s no guarantee now that they’re going to keep going up at this rate. So betting on a further increase in the markets is by no means a sure thing.

And keep in mind that whether you're getting in or out of the stock market, this should always be done with a plan - one that suits you, your risk tolerance and more...not just because it looks like a quick buck can be made. Actually, it's usually an investor's biggest mistake jumping in an out. If the pro's can't do it and make money consistently, there's little chance the average investor can

Final words of advice

If you are considering borrowing to invest, don’t get caught up in the hype of short term market spikes and the possible tax incentive. Make sure the person recommending the strategy is qualified, is a CFP and provides all recommendations in writing. Then, take that to your accountant or a reputable 3rd party for validation.

Remember, if someone is pushing for you to borrow money to invest, they’re benefiting from you doing so. And if you’re an investor that likes to sleep at night, err on the side of caution.