October 2000

Reducing the Risks
of Borrowing to Invest

© Talbot Stevens

In my years of researching the strategy of borrowing to invest, I have identified 7 leverage-related risks. These risks can be reduced or eliminated by following my 5-point Conservative Leverage Checklist.

1. Stay conservative. The most important risk-reduction strategy is to stay conservative. By borrowing less than you could, you will reduce most of the risks, including the most critical emotional risk.

For example, if you can afford to invest $500 a month, consider using only $250 a month to finance an investment loan. By using only half of your available cashflow, even if interest rates double, you can still handle the payments.

Also stay conservative on your emotions. Even if you understand all of the other risks better than anyone in the country, the biggest threat to leveraging successfully is the emotional risk. Borrowing to invest magnifies good returns and bad returns. It also intensifies greed and fear.

2. Eliminate the risk of a margin call. A margin call occurs when your lender forces you to provide additional collateral. This only happens when you use leveraged investments as collateral, perhaps by buying on margin with a broker, and those investments drop in value.

If you are forced to sell when the investments are down to either satisfy the margin call or reduce fear, borrowing will increase your losses.

The easiest way to totally eliminate the margin call risk is to not use investments as collateral. Using home equity as collateral is practical for many homeowners and results in the lowest interest rates.

Another approach is to provide more collateral than is required, so that even a 40% or 50% drop in the investments would not trigger a margin call.

3. Invest long term. I recommend leveraging over at least 8 to 10 years. This reduces the risk that returns will not be as high as expected. It also reduces the risk of the strategy itself, because the breakeven point decreases over time.

4. Diversify. Stock investors should hold many quality stocks. The best diversification for the average investor is to leverage into several global equity funds, or perhaps balanced funds for those who prefer less volatility.

5. Use a trusted financial advisor. Because borrowing to invest is an advanced strategy or tool that can either help or hurt you, a trusted financial advisor can be critical to leveraging successfully.

A professional can help you understand the pros and cons of leveraging, and help you implement the strategy responsibly as an integrated part of a financial plan. In addition to helping choose good, diversified investments, the most valuable benefit of using a trusted advisor might be to help you stick to the long-term plan when you want to bail out, even though you know you shouldn't.

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