Investing and Leverage: What are the Opportunities? What are the Risks?
The idea of using leverage (in other words, debt) as part of an overall investment strategy scares most individual investors. Most of us are cautious about debt and for good reason. High student loan debt is currently preventing many young people from saving for the future. Another form of debt, the home mortgage, is the pathway to homeownership for many people; however, our memory of the 2008 financial crisis reminds us that home mortgages can go terribly wrong.
We are even more skeptical about using debt for investment purposes. The stock market crash of 1929 was fueled in part by speculation and investors buying stocks on margin. The more recent crisis was fueled by an overly leveraged housing market.
But, it’s important not to throw the baby out with the bathwater. Leverage is a tool, and like any tool, it can be used responsibly, or not. Let’s remember that debt finances much of our economy. When the government wants to finance a big public works project, they typically do so by issuing bonds—a debt instrument. Corporations use debt financing to fund acquisitions, research and development, and many other types of investments.
In general, the wealthy aren’t afraid of debt. They just call it “leverage.”
Although he publicly warns against the use of leverage, Warren Buffett has made strategic use of it at times. When he was just starting out as an investor, he borrowed 25% of his net worth to invest in the stock market. A few of his bets didn’t work out, but most did. His company, Berkshire Hathaway, has occasionally used short-term loans to free up the necessary cash to take advantage of investment opportunities.
Using leverage to reduce risk.
It sounds counterintuitive at first because debt is a form of risk in itself. So how can you use leverage to actually decrease overall risk?
Early in the 2008 financial crisis, two Yale economists, Ian Ayres and Barry Nalebuff, published a study making the case that young people should use debt to buy stocks. The study, Life-Cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk, was later expanded into a book. While it wasn’t great timing to make such an argument, it does raise some valuable questions about risk and diversification.
We normally think of diversification in terms of assets. We want to spread our investments across multiple assets (and multiple asset classes) so we don’t, as the saying goes, “have all our eggs in one basket.” But what about time diversification? Don’t we also want to spread our investments across time?
As the authors point out in an interview, if you invested in the stock market in only one year, it could be disastrous if you invested right before the peak of a market bubble. That’s why most experts suggest a regular schedule of investments over many years. But many young workers don’t have a lot of discretionary cash and end up making most of their investments in a single decade. If the market performs badly that decade, that will have real negative consequences for your retirement nest egg.
The solution, the authors say, is for young people to borrow money in their 20s and early 30s and use that debt to significantly increase their investment in the stock market. In other words, you take on strategic risk when you’re young and can afford it, but decrease the overall lifetime risk of your portfolio.
As an extensive critique of the book points out, the authors make an important contribution to investment theory by raising the issue of time diversification. But in practice there are simply too many things that can go wrong with this approach.
A better idea: use leverage for low-risk assets.
One of the problems with the lifecycle investing theory is that it uses leverage to purchase assets (stocks) that are already leveraged. For example, the average debt-to-equity ratio for a company in the S&P 500 is 1:1.
Famed hedge fund investor Ray Dalio, of Bridgewater Associates, has a sounder, more conservative approach to using leverage—and also identifies a common blind spot in the typical approach to diversification and risk.
As he points out in a long letter to investors, the typical portfolio of 60% stocks and 40% bonds isn’t nearly as diversified as it appears to be. Even a slightly more conservative 50/50 portfolio is divided evenly when it comes to assets, but not evenly when it comes to risk. Because stocks are so much more volatile than bonds, the vast majority of the portfolio’s risk is in its stock component. And the overall return on the portfolio is 98% correlated to stocks. With their more modest returns, bonds are not really an effective hedge against a significant downturn in stocks.
Traditionally, the only way to balance such a portfolio in terms of risk (to create what Dalio calls “risk parity”) would be to take money out of stocks and put it into bonds: to change the asset mix to about 25% stocks and 75% bonds. But this would also mean accepting a significantly lower return.
Dalio’s solution is to maintain, for the sake of example, a 50/50 portfolio, but to “lever up” the bond or fixed-income component. Leverage of 2:1 would allow you to substantially increase your exposure in the non-stock half of your portfolio. You would be taking on a small amount of additional, strategic risk. But your portfolio as a whole would be less risky and more diversified because the risk would be evenly split between two asset classes instead of concentrated in one.
How can the individual investor use leverage?
Dalio’s methods are geared mainly to institutional investors and professional managers. Leverage requires constant monitoring and the use of investment instruments not typically available to the average individual investor.
A paper published by J.P. Morgan offers some useful advice for investors looking to put Dalio’s principles into practice.
First and foremost, get a complete picture of your finances and holdings, and not just your investment portfolio. Thoroughly evaluate assets, liabilities, and cash flow.
Use leverage to free up cash for high-conviction, low-risk investment opportunities. That can include leveraged fixed-income investments through vehicles such as bond futures. As a general rule, you are looking for investments with 1) lower volatility, 2) shorter maturities, and 3) higher liquidity.
Avoiding using leverage for investments with lower liquidity and higher risk. Higher-risk assets like equities already have leverage “embedded” within them. As a New York Times column on the dos and don’ts of leverage puts it, “Leverage on leverage never ends well.”
Two final points.
Using leverage is a tricky business that requires careful monitoring. Seek the guidance of a trusted professional who has experience managing leverage.
Exercise patience. The risk-diversified portfolio of the sort Dalio recommends will often underperform a more concentrated, less diverse portfolio. In an environment favorable to stocks, you may lag behind “hot” index funds and be tempted by the classic “fear of missing out.” But your portfolio will be better protected on the downside, and you will come out ahead in the long run. Patience and prudence win out in the end.