If you talk to the average person, they have no problem with the idea of taking out a mortgage on a house with 20% down. Most people would even agree that a guy who buys multiple properties with 20% down and uses them to produce rental income is a pretty smart dude; however, if anyone borrows money to invest in the stock market, most people I talk to believe the person is crazy! This makes no sense at all to me. Anytime a person borrows money to invest in anything, it is commonly referred to as “financial leverage.” So why is leverage ok in real estate investing, but not when you invest in equities? After all, historically, equities have much higher rates of return. When you actually stop to look at the raw financials behind these “commonly held truths” a mortgage with 20% down is actually using 400% leverage! Yet if a person uses 30% leverage within the stock market they are seen as a crazy risk-taker, often akin to someone pulling a lever repeatedly in a casino (with borrowed money). I don’t understand this way of thinking at all. Right now there are several dividend-payers out there (including real estate investment trusts) that will give you great returns on your investment dollars, and with low borrowing rates, I don’t see why this strategy is looked down upon so heavily.
Everyone Knows Stocks Are Way More Risky Than Real Estate
The defence of the “common sense” viewpoint is that stocks are much more risky than real estate, and that when you buy property you have a physical asset behind your dollars. I think this is just an emotional misperception. Because you can feel the walls of a house it gives the feeling of having more intrinsic value than a number on a line of your discount brokerage account. That type of thinking is what led to so many people in the USA going “underwater” with their current mortgages. People honestly believed that real estate would never see any major corrections. The conventional belief was that a market could soften or stagnate for a few years, but you would rarely ever lose a substantial amount of money. This “fact” was obviously flipped on its head the last few years as many homes in several different regions have lost 10%-60% of their value. With reference to volatility and risk in the stock market, I always respond that the risk is really only relevant when you discuss time frames and a lack of diversity. For myself, as a young investor with a 30-60 year time frame on my investments, I don’t see where people think the risk is. Sure, in any given year I could lose 40% of the value of my portfolio, but if I don’t need that money, the idea that the world economy is going to quit growing for 20+ years is ridiculous. I will say that if you’re “trading on the margin” there is definitely the danger of a margin call, but if you’re merely tapping your home equity to some extent, or borrowing to invest in your RRSP, there should be no fear of using leverage to your advantage over a long-term time horizon.
Financial Leverage – My Smith Manoeuvre Begins
When I tell many people about my plans to soon begin the Smith Manoeuvre they all say the same thing, “You mean you’re gambling your house on the stock market?!!!” I will soon do a post about the specifics of the Smith Manoeuvre, but the gist of it, is that you borrow money using a home equity line of credit (HELOC), and invest it in equities. The interest paid on any investment loan in Canada is tax-deductible, and usually HELOCs are available at the prime interest rate minus .5-.8%. There is a lot to talk about in regards to the SM, but what gets me is people saying, “You can take out a loan for that much money to invest in the stock market. That’s definitely using too much financial leverage.” There is absolutely no extra leverage there at all! The original leverage came in the form of the initial mortgage, this is just applying that same leverage in a much more beneficial manner (both in terms of return on investment and tax efficiency).
I understand that after the now infamous “lost decade” in the American stock market people are skittish about stocks, but if you look at the rolling 20-year averages, and at the world of stocks outside of the TSX 60 and the S&P 500, I don’t see where the real danger is. Anyone up for “gambling their house” and using their financial leverage with me?