Understanding the Risks of Leverage

Should you borrow to invest?
Understanding the Risks of Leverage
Stock traders work on the floor of the New York Stock Exchange on Oct. 1, 2013, in New York City. The new heights reached by stock markets in the U.S. in recent months have been tempting investors to use leverage to participate. (Spencer Platt/Getty Images)

Should you borrow to invest? Looking to add to their investment in a hot, new stock, or to get in on the latest investment fad, or just because the market is hitting record highs, many novice investors take this step in haste, only to repent at leisure. Borrowing to invest in the stock market, otherwise known as using “leverage,” is perilous.

First of all, you’ll need to be able to keep financing the debt when interest rates rise. Right now, rates are low. But they won’t stay low forever. Keep in mind that stock markets are volatile, and there is no guarantee that the return you get warrants the cost of the interest on the loan.

You’ll also have to be prepared for the eventuality that the value of your investment drops below the amount of the loan. So you’ve lost twice—once on the interest you’ve paid out on the loan, and again on the losing stock.

If you’re using a margin account (borrowing from the brokerage using other stocks as collateral), you’ll be asked to pony up more funds (a “margin call”) to maintain your position if the value of the stock falls. This type of leverage magnifies both returns and losses, so you really have to know what you’re doing here.

If you’re going to play in the leverage arena, be sure not to overleverage, and be sure to factor in the worst-case scenario. You will want to have enough cash on hand to pay off the loan if interest rates rise (or if you need to meet a margin call) and your investment is not performing commensurately (that is, with a return exceeding the cost of your loan).

Leverage works best over the longer term, and only for those with a very high tolerance for risk and with deep pockets. I don’t recommend leverage for the average investor.

Courtesy Fundata Canada Inc. © 2014. Robyn Thompson, CFP, CIM, FCSI, is president of Castlemark Wealth Management. This article is not intended as personalized advice.