Apr 242017
 

Today we’ll explore a common question I get asked all the time: What is my thought process behind leverage?

The short answer is simple. I want to make high returns without being exposed to high risk. Normally the two go hand-in-hand. But leverage allows me to separate them.

For example, a speculative marijuana stock may grow 20% to 50% a year. But it could just as easily lose half its value. The potential reward is tempting. But the high risk is not worth it.

Instead, I’m looking for a lower return, lower risk investment such as an established pipeline company known for its predictable earnings, dividend growth, large economic moat, and low stock volatility. Using historical data and fundamental analysis I may determine that there is a very high probability this stock will appreciate 4% to 10% a year. I can then apply a leverage multiplier of 5 times on this investment which means my actual expected rate of return is 20% to 50%.

In other words, I do not subject myself to the high risk that is typically associated with juicy returns. But I still get those juicy returns! Awww yeah. 😀

That’s pretty much it. The long answer requires some further explanation. Let’s start with the 3 criteria I look for before I borrow to invest.

 

The 3 fundamental rules of practicing leverage

  1. A 10+ year investment time horizon.
  2. An adequate diversification strategy.
  3. An asymmetric risk-return opportunity.

The first and second rules are straightforward. Billionaire Jeff Bezos recommends we think in 7 year terms to remain competitive. I suggest taking that up to 10 years just to be safe. 🙂 In terms of diversification it can mean more than just having stocks and bonds.

 

Seek Out Asymmetric Returns

Now comes the fun part. Rule number 3. As we all know there is no investment without risk. The third rule is about knowing which investment has a favorable risk to reward ratio. This simply means comparing the odds. For example, let’s say we are asked to roll a normal 6 sided die. If it lands on 1, 2, 3, or 4, we win $10. 🙂 But if it lands on 5 or 6, we lose $10.

So should we play? The answer is a resounding yes every time! 😀 We have a 66.7% chance (4/6) of success. So from a rational perspective this has an asymmetric probability in favor of us winning.

 

Analyzing Probable Returns with a Bell Curve

We can use a normal distribution to help identify favorable investment opportunities. In statistics, a normal (bell curve) distribution outlines all the possibilities with the most likely outcome being in the middle. The standard deviation can be used to measure the variation in a set of data. Let’s see how we can put this bell curve to use when we overlay it on top of a chart that shows how many times the stock market returned a specific amount over any 10 year period between 1916 to 2016. (source)

So over the last century, any 10 year period of investing in the S&P500 index would have returned somewhere between 6% to 11%, 40% of the time, or within 1 standard deviation of a normal distribution curve. Additionally, returns were between 3% to 14%, 72% of the time, within 2 standard deviations from the mean.

This strongly suggests that we have a 95% chance (95/100 possibilities) of making at least 3% annual return from the stock market in any given 10 year period. Pretty neat eh? 😀 Time in the market reduces risk in the market, and creates a huge asymmetric advantage to investors!

But enough theory. Let’s see this at work in a real life example.

 

Banking on Leverage

A couple of years ago I used leverage to buy RBC Royal Bank stocks. Let’s go through my thought process behind this decision.

Large cap, blue-chip dividend stocks are ideal to use leverage on. They don’t come much bluer and larger cap than RBC. It’s the largest company in the country. Plus, there’s a lion in the logo. That’s how you know it’s a top quality company. 😉

I borrowed $4,000 to buy 55 shares of TSE:RY and contributed $0 of my own money. I wrote a full analysis on RBC and explained why I thought it was a good stock to buy at the time. The reason I used leverage was because I didn’t have any cash and the investment fits my 3 rules of leverage.

  • First rule: I planned to keep RY stock for the next 10 years.
  • Second rule: I made sure RY would only be a small part of my total portfolio.
  • Third rule: RY’s P/E ratio, peg ratio, and other fundamental measurements looked appealing in 2015. The stock was expected to grow 8% to 10% a year for the foreseeable future. Historical data showed strong earnings growth and stock appreciation. RY’s dividend would be enough to cover the interest cost of the debt. Thus, this would have a favorable asymmetric risk-to-reward ratio.

My return on this investment so far, net of margin interest cost, is about 37% or $1,500. Not too shabby. 😀 But this shouldn’t be a big surprise. After all, stocks are fundamentally priced based on their earnings. And RBC has an impressive history of consistent earnings growth. Back in 2015, RY was expected to earn $7.35 per share by 2017. Fast forward to today, it appears RY may actually be on track to hit $7.40 EPS this year. We shall see.

This leveraging strategy is also recession resistant. For example, let’s say I did the exact same thing in 2007 at the peak of RY’s market capitalization, (the worst possible time to use leverage) right before the greatest recession of our generation. Yikes! Well despite the unfortunate timing, 10 years later I would still end up with a 70% positive return, net of interest expenses! This is why I am not concerned about future recessions. 😉 I know I can just hang on to RY until the stock market recovers like it always does after a major correction.

 

Why Rational Investors Use Leverage

My decision to buy RY is understandable from a rational point of view. If a stock’s price typically follows earnings. And earnings were projected to grow. Then logically it would make sense that the stock price would eventually grow proportionally. And looking back, it certainly did! This outcome was a likely probability from the very beginning. 😉 But without a rational understanding of leverage it may appear that my RY stock returns are simply due to sheer luck.

Emotionally, using 100% leverage may sound absurdly risky. But logically speaking it was my best chance at maximizing investment returns. I made a rational decision, and not surprisingly I was rewarded with a highly probable outcome.

Other outcomes were certainly possible. The EPS this year could turn out to be $6 or $8. Either number would still fall within my preferred range. However, the farther the actual outcome strays from the expected value (which is $7.35 in this case), the less likely it is to happen.

That’s the wonderful thing about bell curves; it’s predictable to some extent. This factor of predictability is what makes all of this “investing,” not gambling. 😉

 

In Conclusion

Currently I can borrow on margin at 2%. Therefore, if an investment’s expected return is 2% or higher in at least 1 (but preferably 2) standard deviations from the mean, then I will consider using leverage to buy it.

How much total leverage I should use is dictated by a series of stress tests. This means it changes every year depending on stock market values, interest rates, and other economic factors. As of now, I have $63,000 of margin debt.

If interest rates ever become too prohibitive, I would pay off my margin loan completely. It would be irrational to use leverage if the cost of borrowing is higher than the expected return from an investment.

For my Royal Bank investment, I determined the probability of a favorable outcome was 90%, which is a huge asymmetric opportunity! However, even though I have a 90% probability of winning, I still have a 10% chance of losing. We can’t ignore this fact.

In economic decision making, loss aversion refers to people’s tendency to prefer avoiding losses rather than acquiring equivalent gains. This behavior is irrational, but it happens. Many investors would let a 10% probability of failure stop them from using leverage, which is perfectly okay. I don’t judge. 🙂 But loss aversion is how people miss out on lucrative investment opportunities. So the important question to ask is; are you making a rational decision, or an emotional one? 😉

 

A Final Note About Probability Theory

If we flip a coin a few times it may land on heads each time (100% heads) or possibly be all tails (0% heads.) But if we flip the coin enough times, the actual ratio of heads will eventually approach the theoretical value of 50%. This is an empirical fact.

Of course a 50% chance of success offers no asymmetric investment value. But in situations where the odds are actually in our favor each time, such as the dice game mentioned earlier, then the law of large numbers guarantees that we will succeed, as a whole, if we play enough times!

This is why I love using leverage – as long as the outcome is objectively in my favor. I don’t have to be right the 1st time, or even the 2nd time. Mathematically speaking, I just have to invest enough times for the actual ratio of outcomes to converge on the theoretical (or expected) ratio of outcomes. 😉 It’s about the cumulative results. So it’s essential that we learn how to identify asymmetric return opportunities. Leverage doesn’t change our odds of winning. It merely extends our gains or losses based on the inherent odds of the underlying investment decision.

I believe someone who uses leverage in a rational manner should in theory outperform someone else who never uses leverage. But I’m just an amateur investor experimenting with different ideas. What do you guys think? Do you use leverage? If not, then at what probability of success, if any, would you consider using it?

<edit>My margin account is with Interactive Brokers. The margin rate is currently 2% for anyone who has a $CDN account, as of spring 2017. Here’s a full table of interest rates on the broker’s websites.</edit 02/05/17>

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40 Comments on "How to Rationally Think about Leverage"

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JC @ Passive Income Pursuit
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Leverage can be a wonderful thing and a horrible thing. Although the way you’re using it seems fairly conservative. The company was set to grow and the dividend covered your borrowing costs so it was a great situation for you. If my broker charged only 2% for margin I might be tempted to use it but the current rates are around 6.5% which is a huge hurdle to overcome and really skews the risk/reward profile.

ross
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ross

Interactive Brokers seems to be the one offering fantastic margin interest rates. I’m thinking about opening an account there at some point. maybe next year.

in the mean time, I use rrsp loans at prime (2.7) and a heloc.

my borrowing is not generally tied to a particular stock pick though. rather, I fund my portfolio in general.

Jeffrey
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Jeffrey

Nassim Nicholas Taleb got famous in the last 15 years in financial circles for showing how disaster ensued from finance risk management models that assumed a bell curve distribution. Read “The Black Swan”, “Fooled by randomness”, and “Anti-fragile” for details. If your modelling of risk is based on the normal Gaussian distribution, you are in for quite a few surprises down the road. I wish you well!

Finance Journey
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Hey Liquid,

Great post,

I use exactly same leverage strategy you mentioned. I borrow money from different sources (average less than 3% interest rate) and buy blue-chip dividend growth stocks with 3% or more dividend yields. It works really well for me so far. Right now, I have a over $200K diversified portfolio 🙂 . It is bit of risky approach, but if you use it right, it will workout well 😀 .

Best Regards,

Liquid
Admin

Good for you. That is why we will both retire early. 😀

FI3000
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Liquid,

I’m a big proponent of using leverage as long as it’s in a sustainable and responsible way. Probably my biggest lost financial opportunity was not using leverage in my 20s. I just wrote a post about how I use leverage if you’re interested.

dipu
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dipu

Interesting article enjoyed reading it. i currently am fully invested within my tfsa a/c and rsp a/c and do not have extra money to start a margin a/c to pour additional money into market. I am a typical buy and hold dividend investor and all my investments doing well. I would very much like to borrow money to invest to increase my return . so what are my options of borrowing and which will be the best one can u please share. i will very much appreciate it.

John R
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John R

Interactive Brokers probably has the lowest margin interest rates.

Liquid do you know if it’s possible to take money out of a margin account, which would be a sort of ‘margin loan’?

Example: say the margin trading account has $100,000+ in equities fully paid up currently no margin owed on the account. The equities in the account are’Blue Chip’ stable dividend paying. The account holder wants to take $30,000 out in cash – if that is possible & the margin interest rate (IB) is 2%, then with the $100,000 of equities earning say 5% dividends, the account can pay itself from those dividends.

The $30,000 taken out of the account moved to a bank account could be used for further investing or to pay off higher interest LOC, HELOC, other loans.

Would that be a case for ‘good leverage’?

RICARDO
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RICARDO
Different strokes for different folks. I also use a HELOC to leverage investments and it has worked out well for me to now. I am paying 2.9% and pulling sufficient dividends each month to pay the HELOC interest as well as pay down some of the principal each month. So over time interest charges decrease and more of the money goes to the principal. What I have now run in to is my OAS being decreased, clawed back, as my net income is in excess of the starting cut out for OAS. As I am retiring this year and will not have a full year’s salary I am starting to sell out some of the stocks to bring down my net income, less dividends, and get back some of that OAS claw back. A bit of a balancing act. When you net income increases to the point of OAS claw back it makes one wonder just how much non-registered investment you want to have when you retire. I know that a lot of people do not have this “problem” but none the less when you are at that claw back sweet spot you do not really want to give any… Read more »
SoreKnee
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SoreKnee

“I know I can just hang on to RY until the stock market recovers like it always does after a major correction.”

“How to Rationally Think…”

Lal.

John R
Guest
John R

@SoreKnee, some truth in that

On any ‘stock market’ investment there are no guarantees that holding a particular position it will sustain or remain at the average price the person paid for it. Doesn’t matter if it’s Canadian – Bank, Telecom, utility or transportation stock, or that folks keep on DRIP’ing, buying more to cost average.

Folks will be told (sold on)it’s all about the long haul and that Mutual funds are the proven investment to ‘you need at least a million dollars of investments or cash’at retirement, which is all BS to my way of thinking, then again – ‘what do I know’

Or that folks have 25+ stock positions.

It’s how to master the downside of the positions, take a gain and to always be able to get those dividends that make up passive income with whatever else folks are doing like Liquid with his real estate income generator

John R
Guest
John R
@ RICHARDO, regarding the OAS clawback and the fact that you are retiring this year. As you know OAS is just under $7000/yr. Clawback is calculated on all income line 234 of your reported income before deductions of any interest payments, CPP or RRSP contributions. It’s a tough world when a persons income is so much they lose part of their old age security. We are 70 years old, live in the GTA. Before age 60 started melting down, so that at age 65 we had no RRSP’s not even a RRIF. Made sure we had minimum non-registered investments, no leverage, loans or HELOC, contributed the max to TFSA and opened two guaranteed investment funds (no loss of capital) where over the long haul capital is paid to us on a monthly basis till its fully repaid, then in 10 years any gain (which there is) will be capital gain. Today we have zero risk So, here we are today, wife & I at 70 our gross income is just over $65k/yr, zero liabilities, our all in expenses are around 30% ish of our income and we pay almost zero tax. And we gift cash to our adult children &… Read more »
Patrick
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Patrick

John, really appreciate your posts! Would love to know more about how you melted down your RRSP. I know there are various strategies out there but would like to know the method you went with and why.

John R
Guest
John R
@ Patrick, Folks have different need and wants in life, for us it was simple.We’d been mortgage free since age 27 & did this without any handouts or help from anyone. I’d already retired previously from a day job at age 44 in spring 1991, at that time with two children aged 12 & 4. we lived on a small income from our side business, savings & RRSP’s withdrawals. I went back to University, completed a graduate degree, then in 1994 went back into the workforce & started contributing to RRSP again. At age 55 stopped contributing to RRSP’s. What we had jointly was mostly ‘spousal RRSP’s’ The meltdown began. From 2002 till I retired from the daily grind in 2010 we accumulated as much cash as possible, contributed max to TFSA. At age 65 (wife & I born the same year) the RRSP were zero. Along the way we had a side business, income properties which sort of helped accumulate assets and a certain amount of cash. Today we have jointly approx $123k in TFSA in a solid 5% earning vehicle, capital is intact, as well as two GIF’s purchased with the cash we had, leaving us today at… Read more »
Patrick
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Patrick

Thank you so much for the detailed reply, John!

Ahh yes, the spousal RRSP, as a single guy I forgot about that, that’s a powerful weapon in the arsenal to melt down the RRSP.

My RRSP is a pretty decent size (a little over $170K) so I’d have to take out a pretty huge loan to get enough interest expense to melt it down, and it will take a long time. My RRSP is all dividend stocks and has a yield of about 7% (due to dividend increases from the companies over the years). Had a shower-thought awhile back and realized at some point I’ll need to quit working for tax reasons so I can melt this thing down. But for now I’m still contributing and maxing out my RRSP.

Congratulations on a life well-lived and a retirement well-done!

John R
Guest
John R
@ Patrick. Depends on your age right now, the time horizon, or that you want to retire. Take the $170k RRSP as it is today dividends at 7% is growing & compounding at a rate of 7%/yr. In 2017 alone that’s approx $11,900/yr in dividends. Even without making another RRSP contribution for the next 10 years the RRSP will compound & grow to $344,415. At that time aged ?? the individual decides ‘hey I can retire’ due to the following, well maybe, depends on the individual needs. In 2027 dividend 7% x $344,415 = $24,109/yr. As of today if one has already maxed TFSA since 2009 to 2017 that’s $52,000 contribution. From 2009 to 2016 the contributions (growth year over year) earned 7% dividends & compounded, in April 2017 it would be approx $69,778. If one was to continue to contribute $5500 to a TFSA every year till the end of 2027 with the 7% dividends compounding & growing – then at the end of 2027 the TFSA should be worth approx $228,182. Dividends x 7% = $15,972/yr. In 2027 with no further RRSP contributions since 2016/17. At some point between 2017 & 2027 maybe had a huge salary/bonus in… Read more »
Patrick
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Patrick
Thanks for your insight and doing the math! You’re right, between just the RRSP and TFSA (yes, I maxed that out too), I think if I were just let it compound for 10 years it will provide a very nice income. Some additional information, what if I told you that aside from the RRSP and TFSA, I also have a taxable account that is much bigger than both the RRSP and TFSA combined? And I’m already living on less than $40K per year, and my dividends from all my accounts combined currently are higher than $40K per year? What you pointed out very clearly and astutely is this: I have some soul-searching to do, and it’s not about how to save, how to earn more, how to invest, or anything financially related. It’s about what I want to do with my life, now and in the future, what makes me happy, what makes me fulfilled. Went through a heartbreak recently (2.5 months ago) and when what I tend to do when I get hurt is to retreat to my comfort zone where I feel more strong, and that’s in my career/financial life. But slowly the heart is healing and I’m… Read more »
John R
Guest
John R
Thanks for the discussion Patrick. I wish you a speedy recovery on the personal issue. On the RRSP what we discussed up thread. For anyone looking in, from my personal experience I believe folks have been brainwash on the RRSP concept, for most it isn’t necessary. Anyone with an ounce of investing skills should look at the alternatives, take into consideration mix & max taking into consideration the tax at the end of the road, not just focus on the small tax return from RRSP contributions today. In your case Patrick (not knowing your age) what you have now, letting the RRSP compound, keep on contributing to the TFSA and use any what would have been RRSP contributions for non-registered investments & maybe leverage those funds. From what you’ve posted you seem to be on the road to your final destination. KISS principle – stop the RRSP at a point along the lines discussed above and let it compound healthy to the retirement date, keep topping up the TFSA in a good return portfolio, then use what would have been any RRSP future contributions to invest in a decent return compounding non-registered dividend paying securities or something else such as… Read more »
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Brett
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Brett

How are you able to get a margin loan for 2% interest? What broker/bank do you trade with? I find that more amazing than the content of this article as I’ve wanted to use smart leverage for quite sometime. Unfortunately I’ve only been able to do it with rental properties but my preference would be with equities, a lot less of my time to manage.

Brett
Guest
Brett

Where did you get a 2% margin rate from? That’s wildly low and I can’t seem to find anything like that online.

John R
Guest
John R

@ Brett, let me jump in on this one.

In the Interactive Broker link Liquid provided above the information on rates is lower in the page & for Canadian dollars $0 – $140,000 it’s benchmark + 1.5% = 2%

CAD 0 – 140,000 2% (BM + 1.5%)

https://www.interactivebrokers.com/en/index.php?f=interest&p=schedule2

Brett
Guest
Brett

Sorry for the double post, didn’t know it put it on the bottom. Do you have an excel spreadsheet to calculate the loan interest / dividend payout to see how much leverage makes sense? I sort of made one but it’s not working the way I want. I’d rather modify one that works.

John R
Guest
John R

I don’t use a leverage/margin calculator. There are ones you can google. Also googlefinance has tools that you can use to track your investments

On the leverage margin calculator, take a look at the following

http://saviifinancial.com/seg-funds/leveraged-investment-calculator/

John R
Guest
John R
I was having a senior moment on this leverage point & figured ‘what if’ might work on the following Using an IB margin account to purchase 1000 shares of a $20/share 7% dividend stock that moves within 5% of it’s price range in the last 18 months $19-$20 Paying the full $20,000 in the account the dividends will be $1400 or 7% with no margin and no protection on the downside Using a margin account to purchase 1000 shares of the $20 stock, Leveraged 70/30, the margin account has $14,000 cash in it, margin of $6000 at 2% At the end of 12 months without DRIP’s the account balance should look like a return of $1400 – $120 interest charges on the margin = $1280/$14,000 = 9.14% Now if that stock was also optionable, the return could be higher and the risk lower $20 stock optioned long 12 months deep in the money (DITM) at $16. The option pays the difference $20 – $16 strike price = $4. No up premium since its a low implied volatility as well as it being in the money. Right so $4 x 1000 shares = $4000 in the account to use to buy… Read more »
Brett
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Brett

Does someone have an excel sheet that I can run the mechanics on to see if the loan is worth the dividend paying stock. I’d like to input the following: Loan Term, Loan Interest, Loan Amount, payment periods, compounding periods. Then I input: My cash amount (invested in the same thing), dividend amount, dividend payment periods. And it tells me what my cost of borrowing is, how quickly it will be paid off, and what my net is. If we want to get fancy i can input my tax bracket. I can’t get my spreadsheet to work correctly.

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