Jan 242019
 

Putting Household Debt into Perspective

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Canadian households currently owe more than $2 trillion. Our average debt to income ratio increased to 170%, making us number 1 among the G7 countries. ūüôā

But do we actually have too much debt? Well perhaps not. Comparing Canada to the G7 group conveniently omits other highly developed countries. Australia’s national broadcaster claims its country has a household debt to income ratio of 200%. And reports of Netherlands, Denmark, and other Nordic countries are even higher than that! So in reality Canada is far from being the most indebted country in the world.

The cost of borrowing also affects the degree to which people will go into debt. For example, in the U.S. a typical mortgage today would cost about 4.5%. But in Canada you can get a mortgage for only 3.0%.¬† If the debt is cheaper to service then people will be naturally inclined to borrow more. ūüôā

There’s a whole slew of other economic, legal, and political variables that make it nearly impossible to accurately compare household debt from one country to another. These kinds of comparisons would never be published as a scientific study because you have to correct for way too many variabilities. But they make for intriguing headlines nonetheless. ūüôā

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Jan 152018
 

How to Prepare for Higher Borrowing Costs

My debt to income ratio is about 500% while the national average is around 173%. Readers sometimes email me and ask what I will do when interest rates rise. My answer is simple.

I tell them I will pay down my debts in an accelerated manner prioritizing the highest interest loan first. I will limit my monthly interest expense to no more than $1,500. Doing this will adequately protect myself from interest rate risk. Sounds like a solid plan, right? ūüėČ

But I know not everyone will agree. :/¬†Back in 2014 I noticed some people were concerned that I had taken on excessive risk because my debt level was too high. This sentiment echoed around various internet forums. Here are some examples I’ve saved.

The last commentator wanted to know how I’m doing now. That’s what I’ll be discussing in today’s post. ūüôā

But first, here’s a look at my debt summary in 2014. The¬†numbers are taken from my net worth update¬†4 yrs ago.

Liquid’s 2014 Debts¬†Balance¬†Interest Rate¬†Annual Interest Cost
Mortgage$200,0002.95%$5,900
Farmloans$208,3003.40%$7,082
Margin Loans$52,9004.25%$2,248
HELOC$17,9003.60%$644
TD Line of Credit$33,7005.25%$1,769
CIBC Line of Credit$14,0004.50%$630
RRSP Loan$5,0004.00%$200
Total Debt Balance$531,800  
Average Weighted Interest Rate 3.47% 
Total Cost of Debts$18,474

 

Back then I had nearly $532K of debt, charging me an average interest rate of 3.47% per year.

I was paying¬†$1,540 per month in interest.¬†But I was cash flow positive and saving about $1,000 per month. I felt like I had everything under control. So I didn’t understand why people claimed I was overly leveraged. I thought maybe I was missing something. But as Bobby McFerrin would say, “don’t worry, be happy.” ūüėÄ So that’s what I did.

And here’s what my debt looks like today, 4 years later. ūüôā

Liquid’s 2018 DebtsBalance¬†Interest Rate¬†Annual Interest Cost
Mortgage$180,3002.80%$5,048
Farmloans$185,3004.30%$7,968
Margin Loans$57,0002.40%$1,368
HELOC$14,9003.70%$551
TD Line of Credit$5,0005.45%$273
CIBC Line of Credit$17,5005.00%$875
Total Debt Balance$459,000  
Average Weighted Interest Rate 3.49% 
Total Cost of Debts$16,083

 

So my debt costs me $16,083/yr or $1,340 per month right now. This is actually $200 per month lower than in 2014, despite interest rates being higher today.

Yay. Bobby was right. There was no need to be worried. ūüėÄ

Nearly every asset class I hold long positions in has produced decent returns since 2014. Had I not borrowed and used other people’s money to invest I would have missed out on all the investment gains.

 

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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. ūüėÄ

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. ūüôā 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. ūüôā But if it lands on 5 or 6, we lose¬†$10.

So should we play? The answer is¬†a resounding yes every time! ūüėÄ 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? ūüėÄ 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. ūüėČ

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. ūüėÄ 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. ūüėČ 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. ūüėĄ

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 Z√ľrich. 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. ūüôā

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. ūüôā

 

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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! ūüôā 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. ūüôā

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.

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