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Shedding Light on Leverage

When is it a good idea for the average investor to borrow to invest in stocks or mutual funds? The simple answer is, "Never."

Borrowing money for investments is called leverage. The investor uses debt as a lever to increase the potential profits from an investment. Typically, individual investors who decide to take on leverage debt have assets and are already near to accomplishing their lifetime financial goals. However, they believe, or are led to believe by their financial advisors, that, through leverage, they can increase their net worth at a faster rate than by investing in the mutual funds without borrowing. They also believe, or are led to believe, that they are “putting their money (or house, or farm, etc.) to work” and earning “easy money.”

What these investors seldom take into account is that, in the investment game, with greater opportunities for profit come greater risks of loss, whether the money is borrowed or not. Let’s shed some light on those risks.

The Leverage Landmine

If an investor borrows $100 to invest, and the investment increases in value by 10%, the investor has made $10 with no money down. On the other hand, if the investment drops in value by 10%, the investor must repay the $100, but with less than $90 in investments to do the job. Also, there are substantial fees attached to investment transactions. In short, the leveraged loan is a financial landmine, which will remain dormant when the market is up, but upon which the investor will very likely stumble in a market downturn.

In most cases, borrowing involves pledging assets, such as a house, a farm, a business or other investments. For simplicity, let’s use the example of an investor who begins with $100 in investments and borrows another $100. Then the $200 of investment rises or falls by 10%. The impact on the investor will be twice as great in either direction. In this case, the investor has a return of less than $20 on the initial investment of $100, or the investor must repay $100 from an investment now valued lower than $180. In either case, the rate of return is plus or minus 20% – double the 10% change in market value, before even factoring in those substantial transaction fees.

In addition to the fees, the investor must pay ongoing interest on the loan. Because these fees and interest payments will decrease profits and increase losses, the investment must grow at a rate faster than the interest rate and cost of fees. For example, if the interest rate is 5%, and the costs of transactions are 2%, the break-even point will be 7%. And the investor should be aware that the early resale of the mutual funds (and of stock in a market downturn) may incur sky-high fees that further add to the losses.

In a “best-case” scenario, the investment will rise, the returns on the investment will continue to be higher than the interest paid on the leveraged loan, and that landmine will not explode. In a “worst-case” scenario, it will blow up, causing the investor some serious financial damage.

The Reality of Risks

In all cases, the investor has to pay the interest on the loan and the costs of the transaction or, in the case of mutual funds, the fees. The investor also faces the reality of a potential loss, and the risk that the loss will be a large one. The strategy of borrowing to invest increases both of those risks. The chance that the market will increase at a rate faster than the interest rate is less likely than that the market will increase at all. Also, the size of the potential loss is magnified by the amount of leverage, for example two-for-one as in the example used above.

The reality of the risks in leverage is that the interest payments add to the loss, and cut down the chances of success. The fees add to the loss, and cut down the chances of success. And someone other than the investor is benefitting from the fees.

The Fee Factor

Where an advisor tells a client that it is "safe" to use leverage to invest in "conservative" stock holdings or mutual funds, consider that the more conservative the holding or mutual fund, the lower will be the likely growth rate of the fund, and therefore the less likely that the mutual fund or stock portfolio values will increase at a rate that is faster than the interest rate.

Where an advisor tells a client that leverage can be made safe because the advisor has a sell signal system for protection from large losses in a market downturn, the client should be suspicious of the advisor’s motive. Mutual fund managers cannot, as a rule, outperform the market’s index because mutual funds have to pay their managers a fee to manage the fund as well as transaction costs to buy and sell. They also have to pay the advisors who sell the funds to their clients.

Therefore, when an advisor tells a client to borrow to invest, the advisor’s hidden agenda is to make more commissions and fees from the sale of the mutual funds, without any regard for the needs or risk exposure of the client. In short, the investor always has to factor this conflict of interest into the investment equation.

Fighting for Your Rights
John Hollander & Harold Geller

We represent clients who are looking for compensation for losses caused by the performance of their financial advisors. In some cases, the loss may have been the result of using a leveraged loan. If you think that you have suffered a loss due to the use of leverage, contact us for a free, no-obligation consultation.

Other blogs . . .
The Oil Spill Financial Fallout | The Greek Deficit | The Need for Speed – Time Limitation Periods
The Fraud Factor | Shedding Light on Leverage | The Stop-Loss Challenge
The Snag in the Sell  Signal System |