July 1995

What is “Conservative Leverage”?

© Talbot Stevens

My research shows that based on average historical returns, conservative leverage is a more effective wealth building strategy than even RRSPs. After many discussions with investors and financial advisors, two issues arose.

First, there are misconceptions about the real risks of leveraged investing, and second, what defines “conservative” leverage?

Emotional Risk: The real danger of leverage is not the math, but the investor's emotions, specifically fear and greed.

Leveraging only works when you invest in equities, which fluctuate up and down. If fear forces you to “sell low”, then leveraging merely makes things worse.

On the other hand, greed may entice some people to leverage too heavily, which can make things worse. This is why I have a 5-point Conservative Leverage Checklist, suggesting investors only consider leveraging a conservative amount, without the risk of a margin call, long term, diversified, and with a trusted financial advisor.

Lender Risks: My definition of conservative leverage is to borrow conservatively enough to eliminate the “lender risks” which could force you to sell at the wrong time.

You might be forced by your lender to sell when the lender requires more collateral, or you can no longer make the loan payments.

Cashflow risk can be eliminated by only using a small portion of your available cashflow, and having an adequate emergency fund to cover 2-3 years of loan payments. For example, if you have $500 a month available, set up a leveraged program that only requires $200 a month.

Collateral risk occurs when investments are used as security for the loan. The “margin ratio” defines the maximum amount a lender will lend as a portion of the total securities they hold as collateral.

The risk of a “margin call”, where the lender demands more collateral, can be reduced by borrowing less than the lender would allow, to give you extra cushion during declining markets.

Using your house as security, via a line of credit or a second mortgage, is another way to avoid a margin call, because a drop in the stock market won't affect your collateral.

Finally, some lenders will not issue a margin call if the loan is amortized over say 15 or 20 years, instead of using an interest-only demand loan.

To conclude, the emotional risk can be eliminated by truly understanding the process and having faith to not sell when the leveraged investments are down. Lender risks are avoided by borrowing conservatively, so you always have more than enough cashflow and collateral to endure the inevitable tough times.

Another, perhaps better, definition of “conservative” leverage is to only borrow such a small amount that there is no emotional or financial strain.

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