Investment Strategy: Leveraging

Interest rates are at an all time low, with economies around the world maintaining low interest rates, or slashing rates, such as Bank of Canada’s recent decision to lower the interest rates to 0.5% in July 2015.

How can we take advantage of this? Low interest rates do have economical benefits, such as lower interest payments on debt. Keep in mind, due to low opportunity costs, lower interest rates tend to increase spending, thus increasing the prices of certain assets, such as family homes.

Leveraging

Leveraging is known as borrowing money to invest into an asset, typically stocks. The main objective of leveraging is to achieve a Return on Investment greater than the interest payments. The advantage of leveraging is the debt payments are typically fixed, and the capital gains are all yours.

Before leveraging, I highly recommend at least 2 years of a decent performance in your investment portfolio. Be knowledgeable about the markets, read different books on investing – make the most out of this learning experience.

Risk Level

Some would argue, and say that leveraging for stocks is too risky. However, let’s keep in mind that when you’re investing into stocks with borrowed money, it’s best to have a long-term investment objective.

While leveraging, don’t invest into one company. Reduce the risk and diversify, and have holdings within different industries as well. It’s best to aim for a mix of good dividend paying companies (it’s always nice to have some cash flow), small, medium, and large cap stocks.

When you invest into Blue Chip stocks (Cash Cows), such as Coca-Cola Co. (KO), and Wal-Mart Stores Inc. (WMT) typically have a lower Return on Investment than start-ups/small caps. However, Blue Chips are known to provide you with the cash flow from dividends. This is another reason why it’s always good to diversify; it’s optimal to have a combination of dividend paying stocks, and growth stocks.

Like what I’ve mentioned before, have a long-term investment objective for stocks. Stocks may go through a bumpy ride in the short term, and tank 30% in one year, like what happened during the Great Depression. However, despite the ‘stock market crashes,’ the S&P 500 Index has an annual average return of 7.48% the past decade.

Investing Case Scenario

Now let’s look into a leveraging scenario,using the US lending interest rate (%) data from the World Bank.  Using the calculator provided by DQYDJ, the S&P 500 annual return from July 2005 – July 2015 is 7.48%, with dividends reinvested.

Analysis

In both scenarios, leveraging paid off, even with the higher 2005 interest rates. Let’s take a closer look – the total return on capital at an interest rate of 6.2% is $7,635.41, whereas the total return on capital is $9,324.50 at an interest rate of 3.3%. That’s a $1689.00 difference.

Not only there is a higher return on capital, the payments were also 12.5% cheaper with the lower interest rate. This shows how today’s economic conditions are extremely beneficial for leveraging – as the interest rates are at an all time low.

Image Source: Trading Economics

Conclusion

If you’re a sophisticated investor, I would recommend leveraging for the long term. Check out Bay Street Blog’s article – To Buy or Not to Buy, for more information on how to choose the right stock. Remember to do your homework before buying into a stock; do prior research, and understand the business concept.


Writer: Jelani Smith

Disclaimer: All investing can potentially be risky. Investing or borrowing can lead into financial losses. All content on Bay Street Blog are solely for educational purposes. All other information are obtained from credible and authoritative references. Bay Street Blog is not responsible for any financial losses from the information provided. When investing or borrowing, always consult with an industry professional.