Time to Get Back Into Leveraged Investing?

Includes: DIA, QQQ, SPY
by: Roger Nusbaum

On Saturday a reader left the following comment:

Interesting WSJ article says now is a good time for disciplined investors to take on leverage. Any thoughts?

Without having read it, I simply said this was a bad idea. Well, yesterday I read the article and, before getting into this, I should disclose that I am very conservative with this sort of thing. I've disclosed before that my parents made some poor financial choices in their 30s and 40s which caused permanent obstacles for them, which has impacted how my wife and I manage our finances.

If it is not clear, the idea would be to take on debt, most likely mortgage debt, and invest the borrowings into the stock market. The article makes the point that mortgage rates are at about all-time lows, which is factually correct, and does some math about tax rates and needed returns and notes that now could be a great time to do this strategy. There are plenty of financial advisors quoted in the article to explain the merits of the approach, albeit with a few caveats. There are also examples of people taking mortgages out to beef up their portfolios, make up for lost ground and the like.

I've had a few clients ask me about this and I try to steer them away from the idea which so far I have been able to do. Now, keep in mind that if someone wants to cash out and have us manage the money it obviously means more revenue for our firm. The way I steer clients away is talking a little bit about the numbers and the risks and that it could work but that Joellyn and I paid off our house awhile ago and there is no chance we will be doing this.

I come at this sort of thing with a desire to understand what could go wrong and what the consequences would be if it does go wrong. It seems like the math from the article leads readers to needing a 5.015% return to break even and, if you buy into the idea that you wouldn't do this hoping to net an extra 100 basis points, then maybe the targeted return ideally would be 7-8% annually. Anything about 7-8% ring a bell? That is about the same number that is slowly blowing up state pension funds.

A big tenet here has been you can only take what the market gives you. If the next ten years provides an average annual gain of 3% it is very unlikely you will get 8% consistently. Of course you might, but have you ever beaten the market in this sort of fashion before? If you have, do you have any introspective thoughts about what role luck may have played? Are you willing to bet the equity in your home that you can repeat this?

And what if the market goes down 20% from here and trades between SPX 850 and 950 for a while instead of the current range? I might say down 10% in a down 20% world is a good result but that is still 10% of what was home equity now gone if the market stays in the above range for a while.

The next issue is the payment that would have to be made. A $400,000 loan at 5% requires a $2147 monthly payment. Um, isn't there something about a 4% withdrawal rate being sustainable? So maybe the article is aimed at people who are still working. Working or not, do you really want to take on an additional $2000 in monthly expenses?

One commenter on the WSJ article talked about the interest paid over the loan. Per the numbers I got from Yahoo Finance the interest over the life of the loan would be $373,000. If you are still working and could take on a new $2000 mortgage payment why not just save an extra $1600 a month which would about be the interest portion on that loan.

In that last paragraph lies a key point. If you need to beef up your portfolio and you can afford a new debt payment well then you can afford to just save more money without taking the risk of incurring more debt.

The article also talked about margin loans. Really? Margin is a good idea?

There are two ways to be rich. One is having a lot of money and the other is to have no overhead. Assuming you are not a trustafarian, you may end up with a lot of money but this seems less within our control. I believe it is easier to get the overhead down. If all you are paying each month are utility bills, various insurances, various taxes, groceries (including prescription costs) and gas for your car then $500,000 saved plus social security, plus maybe some sort of part-time work, has the makings for a pretty successful retirement.

A slightly bigger macro here is the idea of not learning from past mistakes. People have blown themselves up many times in the past by misusing leverage. This is guaranteed to happen again to people but it is pretty difficult to misuse debt if you don't have any debt.