This is part 4 in a multi-part series, for an overview of what leveraged investing is click here
Understanding the risks of leveraged investing:
Risk one: Timing is wrong (your investments could drop in value)
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Leverage amplifies gains and losses, Using my example from the first article: say you bought a $400,000 home putting down 10% ($40,000). If two years later it was worth $420,000, your unrealized gain before costs would be $20,000 which is 50% of your $40,000 original investment! On the flip side if the market dropped 8% because of rising interest rates, your original principal would almost be gone. $40,000 - $32000 would only leave you with only $8,000 of equity (i.e. an 80% loss!).
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How to mitigate this risk:
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Don't buy after long up swings in the market, the probability of your money growing decreases. The best time to buy is when people are fearful and stocks are 'on sale', unfortunately that generally occurs when there is mass market selling.
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Think long term
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Diversify your assets
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Risk two: Interest costs could rise (it could cost you more money to service the loan)
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Rising interest rates can have a negative impact on loan profitability. Most leveraged investment loans are at a variable interest rates.
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Example: if you borrowed last year (June 2017) at Prime + 0.5%, it would have cost you 3.20%. Because the Bank of Canada has raised interest rates five times since then, your Prime + 0.5% rate now costs you 4.45%.
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In numbers, a $10,000 loan would now cost you around $125 more per year to carry
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How to mitigate this risk:
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Generally leverage should be employed in times where interest rates are being cut or held steady. Typically this occurs when there is a shock in the market (i.e. a recession/a stock market correction or both). The last leverage opportunity (late 2015, early 2016), saw two rate cuts. That helps with your loan carry.
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Risk three: Your cash flow could suffer
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What if you lose your job? What if something changes? Because of the way leverage works (amplification of gains/losses), it is important to understand this is a long term strategy.
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How to mitigate risk:
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Make sure you have stability (are you a fit for this strategy?)
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Buy when you have a high probability of being right (so if you need to get out it won't hurt as much if you're down)
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Risk four: You don't diversify:
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Don't buy one stock, even if you feel that stock is foolproof. What if you're wrong? If that stock goes to zero, you have no money and a new mortgage.
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How to mitigate risk:
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Buy a broadbased basket of stocks OR an ETF/Mutual Fund.
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Generally I would go with an ETF or manager (mutual fund). If I were to do stocks, I would NEVER buy something I couldn't explain what it is and how it makes money.
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We need to remember that proper leverage opportunities present themselves when the market is DEPRESSING! You need the stability to say yes when others are saying no. Doing this will maximize your probability of being successful. Please consult your investment advisor/financial planner to see if they feel it is a fit within your financial situation.
All the best,
Gary
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