One of the ways that some people choose to make more money investing is to do so with leverage. This can be one way to boost your overall returns. However, you do need to be careful, though. Not only can leveraged investing magnify your gains, but it can also magnify your losses. Before you use this type of investing, make sure you understand the risks involved.
What is Leveraged Investing?
Leveraged investing involves borrowing money to invest a larger amount up front, rather than waiting for money to come available for investing. It’s a way to get a bigger lump sum at one point. While this does provide an opportunity to benefit from larger dividends and capital gains, leveraged investing presents some risks that you need to be aware of before funding investments with a loan or borrowing through a Home Equity Line of Credit (HELOC).
Risks Associated with Leveraged Investing
Perhaps the most obvious risk is that the value of the stocks you buy can drop while the amount owing on the loan stays the same. If the value of the stock rises dramatically, you can repay the loan and still come out ahead. However, if the loan is backed up by the investments as collateral, the lender could ask that you immediately pay back part of the loan. You’ll have to sell at a loss and repay as much of the loan as possible. You’ll still have to continue paying on the loan, though, which can strain your finances.
With a HELOC or personal line of credit, you won’t have this issue. You can use the money to buy stocks, and you won’t be forced to sell at a loss. If you have a long term investment horizon, the stocks would likely recover. However, when you use a HELOC, you do have your home on the line. If you get to a point where you can’t afford to make your payments, you could lose your home if you can’t sell some stock to save your home. You also have to watch out if you use a personal loan to leverage your investing. The higher interest rate is harder to overcome, even if an unsecured loan means you probably won’t be forced to sell stocks to pay the loan.
The next issue is that you can magnify your losses. Take a look at whether or not you could afford to pay for those stocks without the loan. If you were able to pay for those stocks anyway, then the loss is the same. However, if you purchased more shares because you had the available loan, then you multiplied the amount of your loss, since you still have to pay the loan and cover your losses.
While there are quite a few investment risks, another risk is related to the loan. You might be comfortable with your interest payments since the current interest rates are historically low at the time of this writing. But what if the rates increase? Will you still be able to afford it? With some loans, you’ll have a fixed rate, so it won’t matter. However, if you have a variable loan, things change. This is a real concern, as there is room to potentially double or triple the current rate. If your payments are interest only, this means a doubling or tripling of your required payment down the road, and that is a big risk as well.
Benefits of Dollar Cost Averaging
Another interesting risk you take with leveraged investing is that you miss out on dollar cost averaging. By investing all at once, whether leveraged or not, you miss the benefits of dollar cost averaging. Dollar cost averaging is when you invest an equal dollar amount on a periodic basis. This forces you to buy less shares when the price is high and more shares when the price is lower. Over time, this can have a benefit to your portfolio, and can be accomplished easily through robo-advisors or TD e-Series funds. If you can buy more when the price is low, as the price rises, you end up with a higher portfolio value.
While leveraged investing has the potential to provide an increased gain, you have to understand and be comfortable with the additional risks involved.