My SECRETARy, MAUREEN ROSS, is one of my all-time favourite people. I know it’s politically correct to call her an executive assistant, but labelling me an executive is a stretch. Plus, it seems odd to call her an assistant when she does everything and I do nothing.
When I first met Mo back in the ’90s, she was managing a res- taurant that I frequented. We chatted often and over time I learned that she had read The Wealthy Barber, liked the first half, found the insurance chapter boring, thought many of the jokes were lame (some things never change!) and was annoyed that it wasn’t a true story.
I’m still not sure what made me hire her.
Anyway, during one of our conversations, Mo told me that she and her husband had recently borrowed money and invested it in stocks through mutual funds. Their advisor felt it was a prudent move.
He pointed out that they could finance on an interest-only basis at seven percent — at the time, a very competitive rate. What’s more, he explained, because the loan’s proceeds were being used for investment purposes, the interest would be tax deductible. The after-tax cost would be only four percent or so. He finished his rather persuasive case by noting that the equity funds he
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was recommending had averaged 15 percent annual returns over the prior 15 years. And because the returns were made up primarily of tax-advantaged capital gains, way more than half of the growth was staying in investors’ pockets.
Holy smokes, sign me up! Borrow cheap, earn big — what a great country!
Intuitively, though, we all know that it can’t be that simple. There
must be some risks. There must be potential drawbacks. That
doesn’t mean borrowing to invest is never a good idea. But you should know the full story before jumping in.
Let me start by saying that there are no hard-and-fast rules for investing success. But if there were, this would be one of them: Don’t borrow money to buy an investment that has just produced an incredible 15-year performance.
Regression to the mean lurks.
That seems obvious, yet over and over again, I find many Cana- dians are much more comfortable borrowing to invest after stock markets have enjoyed big run-ups. Excited by excellent past-performance numbers and emotionally far removed from the last painful major correction, they get caught up in the excitement and assume the good times will keep on rolling. When I first started out, I mentioned on stage one night that over the preceding few months an unusual number of teachers had asked me about taking out loans to buy mutual funds. I kidded with the audience that maybe we should all be lightening up on our stock positions: “If the most conservative investors are not only rushing in but also doing so with borrowed money, the market must be nearing a top.” Soon after, a major pullback occurred.
It’s a pretty sad commentary on my career that what turned out to be my all-time most insightful advice was meant as a joke.
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But the more I thought about “the teacher indicator,” the more prescient it seemed. So in 2007, when I again received a dispro- portionate number of questions from teachers about “lever- age programs” (borrowing to invest), I paid attention. Having learned my lesson, I quite seriously cautioned audiences, say- ing, “This is hypocritical as I don’t believe in trying to time the markets, but....”
Well, we all know what 2008 brought.
In 2009, as the markets bottomed out during the credit crisis, I witnessed another fascinating example of how emotions impact investing and, in particular, investing with borrowed money. I was talking to Jonathan Chevreau, the fine personal-finance columnist at the National Post. Although he’s normally quite guarded about borrowing to buy mutual funds, he pointed out that for those who like the idea, they may never have a better opportunity. Interest rates were at multi-generational lows and unlikely to rise quickly. What’s more, stock markets had been cut in half. you could finance cheaply and buy low. A pretty strong argument.
The very next day, I was eating lunch at Wildcraft in Waterloo (that shout-out should score me another free meal!) and bumped into a local advisor. He had been an advocate of leverage pro- grams over the years, but said he was now avoiding them because of the market collapse.
On the surface that made no sense, yet I completely understood his position and could sympathize with it. A number of his cli- ents had just seen the value of their portfolios fall precipitously while their debt levels stayed constant. Not a fun mix. That would upset, scare and humble any of us. The advisor wasn’t being irrational. He was being human.
When it comes to the stock market, perceived risks are inversely correlated to actual risks. It’s precisely when almost everybody
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thinks the market is safe that it isn’t. And when most think it isn’t that it is.
I remind myself of that constantly.
Beyond the market-timing issues, there are other potential prob- lems with borrowing to invest. The biggest among them is the psychological pressure borrowers feel when markets struggle. Watching your funds’ values fall when you have your own money invested is stressful. Watching your funds’ values fall when you have the bank’s money invested is incredibly stressful.
Stressful enough that it often causes sleepless nights, panicked exits or both. This is not a theoretical argument — I’ve seen it many times. Maureen and her husband? They’re out, and I assure you, they won’t be trying that again.
Figuring out how much volatility you can stomach ahead of actually experiencing that volatility is an inexact process. But for most of us, it’s less than we think. And for investments made with borrowed money, it’s generally way less.
One final caution: The math behind borrowing to invest isn’t quite as good as it’s often advertised to be. Canadian and American markets have averaged between nine and ten percent annual returns over a very extended time frame. But remember, that’s before investing costs. The mutual-funds’ managements have to be paid and so does the advisor. That’s only fair but it obviously leaves less for the investor. Some will argue that they can pick the future outperforming funds, leading to a better return. Hey, not impossible, but for reasons outlined earlier, I think it’s unlikely. Plus, who knows what returns will be going forward? History is just that. I’m an optimistic guy, but even I’ll admit that the debt situation in the developed world could create strong eco- nomic headwinds for quite some time. And with dividend yields at close to their historic lows, logically stock-market returns may be somewhat muted for the next decade or so.
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But who knows? I guess that’s the point: No one does. So it’s prob- ably wise to invest as though stocks are likely to be reasonable- to-good long-term performers but not sure to be.
Despite everything you’ve just read, I’m not always against lever- age programs. I’m really not. For the right person at the right time, they can make sense. In fact, even some of the best and most conservative advisors I know have suggested them to select clients. But the approach is frequently pushed too aggres- sively and is clearly not for everyone. And even in cases where it may be appropriate, the recommended amounts are some- times nutty.
Out of fairness, I should say were sometimes nutty. Since the recent recession, I’ve found the industry is suggesting much more reasonable amounts. Also, a lot of advisors have moved away from large, interest-only loans to more modest term loans amortized over 10 to 15 years. The rates are a little higher and only the interest portion of each payment is tax deductible. But most borrowers are more comfortable with the smaller debt and, as importantly, soothed by the knowledge that it is being paid down over time. A less stressed investor is a better investor. Again, I’m not telling you not to borrow to invest. But make sure you think it through from every angle. It’s another one of those ideas from the financial world that often works better in PowerPoint presentations than it does in real life.