Yes, it still makes sense to use leverage today.
Let me explain… 🙂
Leverage in a higher interest rate environment
My margin interest rate used to be just 1.8% last year.
Borrowing money at this low rate to buy stocks was a no brainer since the stock market returns on average way more than that.
However, today my margin rate has gone up to 4.5% due to all the rate hikes.
So this presents a dilemma. Should I continue using borrowed money to invest or should I prioritize on paying back my debt?
I believe the right thing to do in my situation is to continue using leverage.
That’s because although interest rates are higher, the expected returns of my investments are also higher. 😀
The cost of borrowing is higher than before, but…
While the cost of money has been increasing, stocks and bonds have been losing value.
I recently explained how a stock market correction impacts future expected returns.
A 25% decline in the S&P 500 like we’ve seen this year has historically produced a 22% return just 1 year later, and a 37% return after 3 years.
For context, the stock market returns only 8% to 10% on average across all years.
Conclusion? Even though interest rates have increased by a few percentage points, the increase of expected stock returns are magnitudes greater.
In fact, I borrowed $100,000 earlier this year to buy a bunch of new stocks due to cheap valuations. This action hasn’t paid off yet. But let’s see where stocks end up a year from now. My guess is much higher than now. 🙂
Each economic crisis is unique. With inflation being so high this time it doesn’t make sense to pay down debt for me.
The recent inflation data shows that Canada’s CPI is at 6.9%. It’s down from earlier this year but still above the cost of borrowing money.
As long as real interest rates remain negative and stock are trading at a long term discount, I see no reason to de-leverage. 🙂
My primary focus is growing my net worth. So if the investment I own returns 10+ percent and I can borrow at less than 5 percent, then borrowing is a more efficient choice than selling. 😀
Random Useless Fact: