Investment leverage is borrowing to invest. That is, it is using someone else’s money to achieve your investment goals. Whether you know it or not, you may have already taken advantage of this strategy. For example, if you’ve had a mortgage, a student loan or an RRSP loan, you’ve used someone else’s money to achieve your goal of home ownership, higher education or a more comfortable retirement.
Investment leverage is similar to the examples above. Leverage is simply borrowing money to purchase investments with the goal of achieving greater wealth. Now, it’s probably easy for you to see how a mortgage can help you achieve the goal of home ownership. However, it may be less clear how taking out a loan to buy an investment can help you achieve the goal of greater wealth.
Leveraged investing involves more risk than traditional investing. However, there are a number of things you can do to reduce the risk of this strategy:
Invest for the long term
The amount of risk involved in leveraging decreases as your investment horizon (the length of time the money is invested) increases. This is because the return of stocks and stock-based investment funds varies widely from year to year. But these fluctuations tend to even out over the longer term. It is advisable to plan to leverage for 10 years or more to reduce the impact of short-term market movements.
Commit to the strategy
Even for long-term investors, short-term market volatility carries the risk of emotional decision-making – i.e. selling at the first sign of trouble. Emotional decision-making can derail an investment strategy before it has time to work. Ensure that you are in this for the long-term. Start your investment plan with the expectation that, in some years, the value of your investment will rise and, in others, it will fall. Keeping your eyes on the long-term results will reduce the risk that you will get cold feet and lock in short-term losses.
Borrow less than you can afford
Since a long-term horizon is key to the success of this strategy, the last thing you want to worry about is being forced to cash out early because of an unforeseen change in your ability to make interest payments. Start by borrowing less than you can afford so that you can comfortably absorb the bumps that life may throw your way without abandoning your investment strategy.
Consider a “no margin-call” loan
When you take out an investment loan, the lending institution holds the investment you purchase for the loan. If the value of your investment falls below a pre-determined level, you will be asked to make an additional deposit to the account. This is a margin call. Many investment loans now offer a “no margin-call” feature (sometimes at a slightly higher interest rate). Unless you could easily come up with cash to cover a margin call, choose a loan with a no margin-call feature.
Diversify your investments
Don’t increase your risk by investing in a single investment or by investing in high-risk investments. While the goal of leverage is to accelerate investment growth, it works best with a diversified portfolio of long-term investments.
Make principal payments
If you’re particularly concerned about the amount of risk involved, you can reduce the risk by repaying the loan gradually over time. This will reduce the magnification of potential losses but it will also reduce the magnification of potential gains.