Think Seriously about Leverage for Your Investment Portfolio - dummies

Think Seriously about Leverage for Your Investment Portfolio

By David Stevenson

Leveraging in the UK clearly has its risks and dangers. Many voices are out there telling investors leveraging is always bad. For balance read some of the strategy’s advocates.

In 2010, Time published a fascinating article called ‘Why Young People Should Buy Stocks on Margin’.

Writer Barbara Kivia talked to two respected economists, Ian Ayres and Barry Nalebuff, who created quite a stir by suggesting that debt could be good and that young people should consider using leverage to increase their investment returns.

Their central insight is that investors need to be committed to investing over the long term with a proper diversified mix of assets. Although young people don’t tend to have enough money to build a healthily diversified portfolio, leverage can help them get the money they need.

That the cost of borrowing is so low helps, of course: since the global financial crisis of 2008, interest rates have collapsed globally and even rates on margin accounts are now at all time lows, although those costs increase as leverage moves beyond 3 times. According to Ayres, the benefits of diversification are ‘lost’ when the cost of borrowing increases through increased gearing.

Perusing what works over the long term

Obviously Ayres and Nalebuff’s argument in the preceding section (that if you’re going to take a risk using leverage, spend your borrowed money investing in shares) depends on the fact that shares have been a great investment for those investors willing to stick with them over the very long term.

The historical evidence does indeed back up this argument. In virtually every study of extremely long-term data on returns from the global stock markets, shares have walloped both bonds and cash.

Examining the research

The most definitive source proving that shares have largely moved upwards since the middle of the nineteenth century (with a long-term trend return of just above 6 per cent per annum) is by a group of British academics based at the London Business School: Professors Elroy Dimson and Paul Marsh and Dr Mike Staunton.

They’ve delved back into market data and looked at comparative returns – and, in a series of papers and books, reached fairly unequivocal conclusions. For instance: ‘over the last 109 years, the real value of shares, with income reinvested, grew by a factor of 224 as compared to 4.5 for bonds and 3.1 for bills’.

Other long-term studies for the US market vary slightly, but the message is unambiguous: shares worked in the past as a risky investment. If the average cost of margin loans has been just over 5 per cent for the last 100 years, but the returns from shares have been between 6 and 7 per cent, using leverage would have kicked in an additional 1 to 2 per cent in extra returns over the last century.

That would have equated to a massive gain for a committed long-term investor using leverage over many decades.

Just because shares have been worth betting on based on historical data, however, doesn’t mean that you aren’t taking a risk that they may fall in value. Shares can and indeed have fallen by much more than 20 per cent in any one year.

And they can also be a hideous investment not only for just a year, but also a whole decade. Over the 20 years between 1989 and 2009 shares have been a lousy investment compared to bonds.

Investing in shares isn’t guaranteed to be a successful approach over the long term!

Yet on balance the historical evidence suggests that, in recent times, investing in shares has been worth the risk compared to supposedly safer assets like bonds and cash – in fact, in the UK, the return from shares has been worth about 4 per cent extra on average since 1900.

The bottom line is that, if you had to bet on an asset increasing in value by an average of between 5 and 10 per cent per annum, in a compound manner over the very long term, you’d probably start with shares. That means that if you do use leverage to increase your gains from an investment, think about starting with shares.