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Leverage lessons

Monday, August 15, 2011

Leverage – borrowing money to invest – is one of the biggest problems in our industry and subject to much abuse. Most financial advisors get paid partly on the assets they manage, and some try and sell the idea of leverage to their clientele in an effort to boost their “assets under management” (and hence the fees they get) without spending much time discussing the negatives with their clients.

I have seen many clients sold on leverage who were not good candidates for the strategy, but they trusted their financial advisors and went ahead with it anyway. Years later, they still have less than they borrowed – especially when markets become volatile or take a steep downturn, as they did last week. And they’ve been paying interest to boot. Yes, the interest is tax-deductible, but most people who have come to me with this problem wish they could get out of it. To add insult to injury, many people were also sold a fund or plan with a deferred sales charge (DSC), which would impose additional penalties if they collapse their plan early.

These are some important aspects to think about if you are considering borrowing money to invest.

1. You should maximize your RRSP contributions every year and have no available room. There is no point in looking at complicated strategies when you haven’t first covered the basics.

2. To benefit from the interest deduction, your income should be over $60,000 a year. You have to consider risk/benefits.

3. If you are borrowing as a couple, one of you must have a job that is very stable. To be out of work and stressing about a loan and an investment that may be under water isn’t worth the potential benefits from the strategy.

4. Do not buy funds with a deferred sales charge. You don’t want potentially high fees forcing you to hold on in a bad situation.

5. Pay off non-deductible debt. If you have a mortgage, for example, you would normally pay it off (or nearly so) to reduce risk. Again, why be risky with a complicated strategy when the basics haven’t been covered?

6. A stable marriage is essential if you are entering into leverage, because it’s a long term plan (five to 10 years).Going through a divorce is complicated enough, and this again could cause the leverage to collapse early.

7. If your advisor is pushing (selling) hard for you to borrow, ask to see realistic projections. Do the projections show, for example, steady 7% growth every year? When have we last seen steady 7% increases every year? I’ve been in the business over 16 years and I’ve never seen it. Ask your advisor to revise the 7%-plus every year and show one minus 35% in the first two years and see how that alters the projections.

8. If you are retired and comfortable, do you want the stress of leverage in order to save some taxes? Retirement should be a time of enjoying the fruits of your labours, not worrying about the markets.

9. Know how much you will save in taxes every year, because that is the only sure thing. Investment performance is conditional on a great many factors, most of which are out of your control.

10. If you worry about the markets under normal conditions, having borrowed money will only add to your stress. Avoid using leverage if you are in that camp.

My advice: If you your financial advisor pushes leverage or other complicated strategies too strongly, get a second opinion.



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The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. However, please call the author to discuss your particular circumstances.