Today we’ll exploreÂ a commonÂ question I get asked all the time: **What is my thought processÂ behind leverage?**

The short answer is simple. I want to make high returns withoutÂ being exposed toÂ high risk. Normally the two go hand-in-hand. But leverage allows me to separate them.

For example, a speculative marijuana stock may growÂ **20% to 50%** a year. But it could just as easilyÂ 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 IÂ may determineÂ that there is a very high probability this stock will appreciate 4% to 10% a year. I can then apply a leverage multiplierÂ 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. đ

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

**The 3Â fundamental rules of practicing leverage**

- A 10+ year investment time horizon.
- An adequate diversification strategy.
- 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. đ In terms of diversificationÂ it can mean more than just having stocks and bonds.

## Seek OutÂ 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 favorableÂ risk to reward ratio. This simply means comparing the odds. For example, let’s say we are asked to rollÂ a normal 6 sided die. If it lands on 1, 2, 3, or 4, we winÂ $10. đ But if it lands on 5 or 6, we loseÂ $10.

So should we play? The answer isÂ a resounding yes every time! đ We have aÂ 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 aÂ 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.Â 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 amountÂ over anyÂ 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.

ThisÂ strongly suggests that we have a 95%Â chance (95/100 possibilities) of making at least 3% annual return from the stock market in any given 10 year period. Pretty neat eh? đ 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 workÂ in a real life example.

## Banking on Leverage

A couple of years ago I used leverage to buy RBCÂ 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 companyÂ in the country. Plus, there’s a lion inÂ the logo. That’s how you know it’s a top quality company. đ

I borrowed $4,000 to buy 55Â shares of TSE:RY and contributedÂ $0 of my own money. I wrote a full analysis on RBC and explainedÂ why I thought itÂ was a good stock to buyÂ 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 stockÂ 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 stockÂ was expected toÂ grow 8% to 10% a year for the foreseeable future. Historical data showed strong earnings growth and stock appreciation. RY’sÂ dividend would be enough to cover the interest cost of the debt. Thus, this would have a favorableÂ 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. đ But this shouldn’t be a big surprise. After all, stocks are fundamentally priced based on their earnings. And RBC has an impressiveÂ 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 alsoÂ **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. đ 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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