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.

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Apr 202017
 

Some people suffer from areophobia, the fear of flying. But this is plane silly. Flying is statistically safer than driving. Yet some people live entire lives without ever getting onto a plane due to this irrational fear. They believe merely walking into an airport could give them a terminal illness. 😄

Borrowing to invest is similar to flying. Nobody ever has to do it, but it can make life a lot easier. I can certainly take a train to get from Paris to Zürich. However, flying is much faster. I can retire comfortably some day without ever going into debt. However, using leverage will enable me to get there much faster. 🙂

If we tend to pick bad investments, then we should probably pay a professional to help manage our portfolio. But on the other hand, if we have a history of making mostly good investment decisions, then rationally speaking we should double down to boost ours returns unless evidence suggests otherwise. Leverage doesn’t change our odds of winning. It merely enhances our gains or losses based on the inherent odds of the underlying investment decision.

Using leverage removes the problem of not having any money to invest. It allows us to be fully invested at all times, but still have access to instant liquidity. This gives investors a huge advantage. Just ask any MBA graduate.

Next week I will blog about my 3 fundamental rules of leveraged investing. A lot of readers have requested this so I will break down my thought process and method. The extended bull market cycle we’ve been in has helped my investments tremendously. But when I use leverage, I also follow specific criterias that are meant to reduce downside risk in recessions and bear markets. 🙂

 

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Random Useless Fact:

Foxes are smarter than most, but not all, dog breeds.

 

Nov 142016
 

If our employer gives us the option to collect our paychecks one month in advance, but charge a one time fee of 1% then I’m sure a lot of people would like the idea. Maybe we won’t use it, but it’s nice to know we have that option to get paid a month early if we want to! 🙂 This is similar to when a bank, car dealership, or credit card company offers us a loan that has a 12% annual interest rate.

Both examples are essentially the same thing. We receive some money in advance, accrue a small fee, and eventually pay back the full amount with either labour or cash savings. Workers are willing to pay that extra 1% fee if it means giving them the freedom to choose when to spend their money. Maybe they really want to take a family vacation now instead of next month before the busy and more expensive holiday traveling season. It’s nice to have the option to do so even if it means giving up 1% of their income because of tradeoffs. Some people are even willing to accrue a 5% charge. In that case, they can take a vacation 5 months in advance. When most people think about debt, they focus on the borrowing cost or interest charges. But when they think about getting an early paycheque, they focus on the financial benefits of the premature income. But both situations can be thought of as balancing time and money. 🙂

I think if people start to look at debt as a financial tool rather than a burden, they will see that borrowing money is a natural part of life and we shouldn’t be afraid of it or patronize debtors.

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Random Useless Fact:

Sometimes the best response to provocation is not to engage.

16-11-dog-cliff-bird

Sep 192016
 

The Effects of Debt on Your Health

According to a Globe and Mail article I recently read, people have gotten sick and depressed thinking about their debts. “Researchers and health professionals are making the case for treating personal debt as a public health problem.” Oh no. 🙁 Dr. Donna Ferguson, a psychologist in Toronto says, “I think that it’s a major crisis. It’s an issue that needs to be addressed.”

The average consumer debt in Canada is only about $21,000. Personally I don’t think that’s a whole lot. Yet psychologists are calling this a “major crisis.” 😠 People are blaming debt for making them feel physically ill. But I have much more debt than they ever will. So if having a healthy relationship with debt is their primary goal, then they should do something to keep their stress under control. 🙂

Luckily I have a solution to help those consumers. If we want them to get better we have to address the root of the issue. The problem is with individual psychology, not with debt. Instead of creating more health problems for borrowers and increase the burden on our public healthcare system, like what Dr. Ferguson suggests, let’s try to educate people about the truth so we can prevent people from feeling ill in the first place.

So here’s my simple yet effective tip to help anyone who may have debt anxiety:

If you don’t think you can handle the debt, then don’t borrow the money. 😀

Sometimes the negative consequences of debt are blown out of proportion. The ASA, a financial support organization, has even made a horror video to show the trepidation and paranoia that comes with having student loan debt, which further supports the common narrative.

16-09-allow-debt-ruin-lives-meme

Some people have this irrational fear that if we have debt then somehow it will come to get us like the boogeyman. 😆 But the reality is nothing bad will happen as long as we make the payments on our debt.

Missing a Debt Payment is No Big Deal

The consequences for delinquent debt are very lenient towards borrowers. The bank can’t just take our house away as soon as we stop making mortgage payments. In my neck of the woods for example, the bank has to first draft up a foreclosure petition if a mortgage payment is 3 months late. Then the court hearing will be a month later. And then the property goes into a redemption period for up to 6 more months. So we have plenty of time throughout this entire process to get our payments back on track. We can even sell our house if it’s worth more than the mortgage balance.

For other types of debt, if money becomes tight we can enter into consumer proposal or apply for other debt relief options. We’re usually given at least 3 months to catch up on our payments before it goes to a collections agency. Despite the scary rumors, consumer debt cannot physically harm us. We won’t be assaulted or locked up if we’re late on our credit card payments. Nobody will drag us to jail because we failed to make a car payment, lol. The worst they can do to us is take the car away and tarnish our credit score. But I think that’s only fair. Our vehicle is being repossessed only because we broke the debtor/creditor agreement first.

So there’s no reason to get all worried and stressed out over a reasonable amount of debt. 🙂 We just have to be smart and not borrow too much.

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Random Useless Fact:

If the original Power Rangers series were made today in 2016, it would probably offend too many people and be banned from airing in most countries.

16-09-power-rangers-pose-faces

The yellow ranger was Asian. The red ranger was Native American. The pink ranger was portrayed as a ditsy white girl. The black ranger was black. And in later episodes they introduced the white power ranger who was the strongest.

Sep 152016
 

Staying in Debt Forever

Sometimes I get asked if I will ever be debt free. Unfortunately I don’t have a good answer for this question. In my previous post earlier this week I discussed the debt spectrum, which describes debt as a financial state along a sempiternal line. This line stretches out in both directions and has no ends in sight because it’s hard to put a limit on the amount of debt we can lend or borrow. For example, it’s common today for regular folks in Zimbabwe to hold literally quadrillions of dollars of debt in their outdated, but still existing currency. 1 quadrillion looks like this: 1,000,000,000,000,000.😁

Compared to a huge number like that, it would appear most Canadians have a much more reasonable amount of debt. 🙂

16-09-canadian-debt-environics-2015

Of course that’s not a fair comparison, but the point is almost everyone has some form of debt or another. Since I believe in the debt spectrum concept, I don’t view debt as something that I can ever remove from my life completely.

To me debt is a continuous road that I’m constantly on. There’s no beginning and no end. I’m either a net debtor or a net creditor. I’m either buying debt or I’m selling debt. I use leverage when interest rates are low. I lend money to people who need it when interest rates are high. I might do both at the same time. Debt will always be a part of my life just as it is a part of the broader economy. My position on the debt spectrum will constantly shift from left to right depending on changing circumstances. But I will never not be on the spectrum.

Even in a high interest rate environment where I’m a net creditor, there could still be unique opportunities where I would borrow money. For example, I could use promotional credit card rates where I can borrow money at 2% and invest in a safe bond that yields 4%.

So it’s hard to answer the question if I’ll ever be debt free, because the idea of being “debt free” is kind of irrelevant within the context of the debt spectrum.

Being “debt free” on its own doesn’t mean a whole lot anyway. A barista could be debt free with a net worth of $0. But a stock broker could have $5 million worth of index funds in his portfolio with the help of a $50,000 margin loan. The first person is broke while the second person is a financially independent millionaire. But it’s impossible to tell by simply looking at their debts. This is why the debt spectrum is much more useful.

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