Leveraging: Where math and emotion are a bad mix

Leveraging is an investment industry term that is best defined as borrowing trouble.

Technically, it means taking a loan out to invest in stocks or funds. The more you invest with borrowed money as opposed to your own, the larger the profit you can "leverage." Losses are also magnified, which is why leveraging is a strategy you should avoid.

Warning: Leveraging proponents, and there are many in the financial industry, can be persuasive. If you're cornered by one, just say your life is exciting enough without watching stocks or funds you bought with borrowed money plunge in value.

Leveraging can be fairly described as a way of building wealth, which means it's a better kind of debt than borrowing for transitory things, such as trips, or depreciating assets, such as cars. Rather than investing bit by bit, leveraging allows you to put a big chunk of money to work immediately. Studies show this can achieve better results than gradual investing.

Also, repaying the investment loan imposes financial discipline. You may balk at investing in uncertain times, but you have to make your regular investment loan payments. At today's low interest rates, your cost of borrowing is nominal. And, when you borrow to invest in a non-registered account, the interest on the loan is tax deductible.

Investing industry consultant Talbot Stevens has for years worked with advisers to develop guidelines on how to make leveraging work for investors. But even he acknowledges that what works on paper often doesn't play well in an investing world where the risk of double-digit losses is omnipresent.

Investors, he says, are too prone to selling when their leveraged investments have fallen in value, thereby locking in potentially nasty losses.

"Behaviour trumps math 9.9 times out of 10," Mr. Stevens said. "Our reptilian brain kicks in before our mammalian brain gets a chance to analyze things. We get scared, we hit the panic button and sell. It's fear and greed, magnified."

For the investing industry, leveraging is a slam-dunk winning strategy for turning small accounts into big ones that generate more fees and commission. Expect to see lots of hype about RRSP loans now that registered retirement savings plan season is under way. Although not a classic leveraging situation, RRSP loans are still borrowing to invest.

Just this week, the Ontario Securities Commission issued a note to investors about the risks of leveraged investing. Two key points: Leveraging increases your investing risk; and you're on the hook to pay off your loan even if your investments tank.

You can see the need for such warnings in the rising number of complaints about leveraging. The Ombudsman for Banking Services and Investments received 30 complaints on this issue in the 12 months to Oct. 31, compared with 16 in fiscal 2010 and 12 in the previous year. Six complaints have been submitted in the first two months of fiscal 2012, which suggests unhappiness is growing.

Last fall, the Canadian Foundation for Advancement of Investor Rights (FAIR Canada) sent a letter to provincial securities regulators suggesting there be a presumption that leveraging is unsuitable for retail investors. The onus would then be on the person recommending the leverage to prove it's an appropriate strategy.

"We don't think most investors adequately understand the downside risks," said Marian Passmore, associate director at FAIR. "It's easy to get sold [on leveraging]without truly understanding what you're doing."

That point is backed up by the experience of Ottawa lawyers John Hollander and Harold Geller, who say leverage matters account for about half of the investor complaint cases they handle. The complaints are usually the same: The client didn't understand how much he or she could lose in a down market.

"Over and over, we're hearing clients say 'we did not know,' " Mr. Hollander said. "If one [client]said it, I'd say, okay, that's pretty self-serving. You were told there could be a hit and you didn't want to take it. But they all say it."

A powerful example of successful leveraging is the $250,000 investment loan that financial adviser Andrew Guilfoyle took out for himself in December, 2008, when the Canadian stock market was about 35-per-cent lower than it is now (read the details online here).

Mr. Guilfoyle is no leveraging booster, though. He argues that while an investment loan might conceivably pay off over a long period, short-term market turbulence will overwhelm many people and cause them to sell at a loss. "As much as we might say, look, close your eyes and come back to it in five or 10 years, our society doesn't allow people to go to that proverbial desert island."

Leveraging? Why put yourself through it.

For tips, stories, videos and live chats ahead of this year's RRSP contribution deadline, check the Globe Investor 2012 RRSP season section for daily updates.

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The two faces of leverage

How leveraging, as they call borrowing to invest in the financial industry, can work both for and against you. In this example, an investor has $5,000 to invest; the second column shows his leveraged returns after borrowing an additional $5,000.

Source: The Canadian Foundation For Advancement of Investor Rights

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