There is emerging trend of experts teaching folks to build wealth with the aid of leverage. Leverage means, using other people’s money, in a lot case the banks money, to aid you in building your asset base.
After the large DFA article last week, I do not really feel like writing a lot of stuff. There is probably a lot of other stuff I need to catch up upon then to do one humongous article every week.
So this week one is a little breather. It is some numbers that I ran some time ago.
I think I decide to bring it out.
You have folks like Kim Eng who is able to give to loan you currently a 3.28% interest rate loan on your shares. This enables you to buy shares more than you can afford to and speculate on them. When you earn as you sell off the shares, you earn a lot more. Conversely, if you lose as you sell off the shares, you lose a lot more.
Now, the idea for a lot of people is not to do leverage irresponsibly. We all want to do the sensible thing, but to make use of what is available to us so that we can accelerate our wealth building.
So basically, rather conservative wealth builders wish to use leverage to step up and build their wealth. It makes me wonder how conservative we are.
Here is the Setup
We are going to invest in good blue chip stocks and Real Estate Investment Trusts (REITs).
And we are going to choose to invest in 1, or more of these, to form a portfolio that gives us a 7.5% per year compounded rate of return (hypothetically). If you want to take a look at whether its achievable, you can take a reference on the dividend yield that you can get on my Dividend Stock Tracker. Those are dividend yields, and do not show the future compounded growth rate. The growth rate can be +2 to 5% or -2 to 5%, depending on which you choose. Not all stocks are appreciating over time.
Let’s say we make use of Kim Eng’s margin financing which enables us to invest in selected stocks and REITs at a rate of 3.28% (this rate used to be 2.88%. When the global interest rate moved up, it also gets shifted up. This gives you an idea that these rates do not stay stagnant).
According to the strategy, we want to use leverage to build up our financial assets.
However, we do not want leverage to kill us. So at some point, we will pay back the debt.
The strategy is touted to be able to let you build up your asset base. So it is suitable for those folks in the initial years of wealth building.
Every year you contribute $2,000/mth or $24,000/yr from your disposable income to this leverage portfolio. That is $24,000/yr of your own money.
On top of this, through Kim Eng’s financing, they lend you $24,000 more to purchase more assets in your leverage portfolio.
There is an interest cost on this $24,000. As you build up your leverage/debt/liabilities/margin, your interest cost increases.
At some point, instead of using that $24,000/year to buy more stocks in this leverage portfolio, you use this $24,000/yr to pay down the leverage.
So the idea is
- Use your own capital + leverage to build up assets
- Use your own capital to deleverage on debt/liabilities/margin
What you will end up with at the end is an unleveraged portfolio, or one that is entirely your own equity.
The total capital you put into the portfolio in both leverage and unleverage is the same.
Building Wealth for 15 Years without Leverage
I think 15 years is a good time frame.
If you are in a good job and you can put away $2,000/mth at 26 years old, 15 years will take you to 41 years old. A relatively young age.
We first take a look at the numbers without using leverage.
The table above shows the asset, debt and equity change over 15 years. It also shows us the net annual total asset growth over the 15 years.
We have probably contributed $24,000 a year for 14 years. Our assets grow from $0 to $543,784 in year 15.
Any return we have, we reinvest into the portfolio. So for example you can see the net annual total asset growth to be $1,800.
We can cash flow this and spend this in our daily expenses. But we do not do that, we reinvest back into the portfolio to grow it.
Since there is no debt, total assets – $0 debt = total equity. So Assets = Equity.
Also since there is no debt, there is no cash outflow as interest expense.
15 years and you can build up without leverage and get $3,185/mth or $38,222/year is pretty good!
Of course this is hypothetical that you earn such a consistent 7.5% on your total assets. In reality, your returns goes up and down. If you see a fund that gives you 7.5%, 7.5%, 7.5%, 7.5%… run from it. Most likely it is a scam.
Building Wealth for 15 Years with Leverage then Deleveraging in the 7th Year
Now let us juice up the portfolio by taking on 100% more assets using margin.
Then at the 8th year, we start using our $24,000/yr to pay off the margin. At the end, we should have zero debt at the end.
I have tried to put some explanation on the data so hope that helps. We spend 7 years using leverage to build up an asset from $0 to $380k. Then the asset grow on its own with the net annual total asset growth to $615k in the 15th year.
From year 8, we use our $24,000/yr to pay down the debt.
The total equity at the end is $615k. This compares to $543k without leverage. (13.2% more)
The potential annual cash flow you could generate at the end with leverage is $43,156. This compares to $38,222 without leverage. (12.9% more)
So using this strategy, we reached our objectives 2 year in advance. Not sure about you, but that does not look like something real big.
Unless I really hate my job.
Now let us compare the total equity growth side by side.
Somewhere after the 6th year the equity of the leverage portfolio starts deviating from the unleverage one.
The chart above shows the cash flow or the net annual asset growth increase over time. Notice the great boost of building up more assets for the first 7 years giving the leverage portfolio a $19k/yr cash flow versus $12k if its unleveraged.
Then as no more assets are added, the pace of the growth slowed down. The unleveraged portfolio maintain its pace and eventually came close to catching up with the leverage portfolio.
Both your capital outlay is the same at $336,000.
Building Wealth for 30 Years
I suspect that if we do it over a longer period, the leverage portfolio will show its quality.
So instead of 15 years, let us do it for 30 years. Instead of paying off at year 7 we start paying off at year 16.
The following is the result of the 30-year unleveraged portfolio:
And the following is the result of 30-year leveraged portfolio:
The leveraged portfolio builds $561,000 more than the unleveraged portfolio (26% more).
The leveraged portfolio eventually gives $40,000 more in annual cash flow. (27% more).
So we can see that as the duration increase, the leverage factor allows you to build more wealth and provide more cash flow (26% more versus 13% more when the duration is 15 years)
How Sequence of Returns affect the 15 Year Leverage Strategy
As I have said, your returns do not go 7.5%, 7.5%, 7.5%, 7.5%, 7.5%…….
In reality they go up and down if we are talking about total return. So this 7.5% for REITs can be the yield, but we can always look at it as a total return.
This means that you invest in a portfolio of REIT that gives you an average of 5.5% yield and a 2% compounded growth for a total return of 7.5% per year.
Now lets add a bit of sequence of return volatility into the picture.
I explained more about how a negative sequence of return can affect your retirement.
Basically, your returns over 15 year, 30 year can be of different sequence, and they affect your portfolio based on your objectives.
In the table above, I created 2 set of sequence. The first set is one where we have more negative returns first, follow by positive. The second one is more positive then negative.
If you look at the end result, both provide a 15 year compounded average rate of return of 7.5%.
The first sequence is bad for retiree. It is why I went through so much writing on retirement. To hedge this risk. However, this negative first follow by positive sequence is good for the wealth accumulator!
You get to accumulate more units when you are young. When you have more units, then when the bull market come later on, your wealth will grow.
For the leverage portfolio, I would expect this sequence to be favorable.
The second sequence, is good for the retiree but bad for the wealth accumulators.
So you can see the irony: If you have accumulate well and ready for retirement, you might be in the worst position as the negative sequence is coming. On the flip side, if you have struggle to accumulate for retirement due to poor returns, but you manage to get the amount you need, your retirement might be much smoother!
The assumption here is that market move in cycles.
How the Sequence of Returns affect an Unleveraged Portfolio
So first, lets see whether the fact is really a fact:
- The total equity build up at the end of 15 years for a uniformed 7.5%/yr return: $543,784
- The total equity build up for negative first then positive sequence: $759,390
- The total equity build up for a positive first then negative sequence: $487,547
So what I said previously checks out. If you are accumulating, it is better to have more negative years and then positive years.
How the Sequence of Returns affect a Leverage Portfolio
Now let us take a look when we applied leverage to it.
- The total equity build up at the end of 15 years for a uniformed 7.5%/yr return: $615,065
- The total equity build up for negative first then positive sequence: $913,906
- The total equity build up for a positive first then negative sequence: $601,602
Seems the dangers of leverage did not kill the portfolio. The negative first then positive sequence built $300,000 more wealth. Compared to the unleveraged portfolio which is $210,000 more only.
The positive then negative sequence was weaker but not by much.
Now let us take a look at the portfolio debt to asset to see whether, at any point the portfolio is in danger.
First let us examine the negative first then positive sequence:
I think this debt pay off thing might be working out. However, notice that when the -20% and -10% came in the debt to asset went above 50%. The debt is more than the equity.
Now I wonder whether if some of the stocks went down more on an individual basis, it will result in a margin call event. In those events, either you top up the equity to restore back to a maintenance margin ratio, or the broker force sell your assets.
Selling off at a low price. That might set your wealth building back for some time.
I think whether this becomes a grave event or not depends on the amount of capital contribution.
In those two years, although the net annual total asset growth was -10k and -11k respectively, the capital contribution and new investments dwarf that amount.
Your asset base have not gotten large enough.
It will take a few years for the new capital contribution to make up for those losses.
Let us examine the positive first then negative sequence:
Leverage in this sequence did not kill because by the time the -10% and -20% returns come in, the amount of debt left is only $24,000 compared to an asset size of $833,937.
You just faced the prospect of -$230,000 reduction in your equity base.
Depressing yes, but it does not kill you.
If you think about it, this deleveraging is pretty similar to how you move more of your portfolio to bonds as you approach retirement (read How Traditional Portfolio Allocation Strategies Can Alleviate Large Market Plunge Fears).
Instead of moving to bonds, in the case of leverage portfolio, the debt is being reduced so that as you approach the twilight of your wealth accumulation, your credit risk is reduced.
Notice also that since this is an all equity portfolio, and as you approach retirement for example, a -10% and -20% return would shave a large part of your portfolio.
This investor took care of the credit default risk, but didn’t take care of the portfolio and retirement risk.
What if we didn’t Deleverage, but also don’t Leverage too Much?
Now since I went down this rabbit hole, why not build on the last sequence of return experiment and see if we do not deleverage?
The first table shows the positive to negative sequence. Notice that from year 8 to 14, the investor did not deleverage the portfolio. She adds to the assets instead.
Observe that the total debt to asset gets a nice bounce from 17.51% to 22.39% from 14 to 15th year. That is a huge increase.
However, because this happened at the end of the wealth accumulation stage, and that the assets have accumulated far more than the debt, that even with the huge increase, it is still manageable.
For the negative to positive sequence, once you get past the tough year 3 to 4, the portfolio naturally deleverage from 50% to 14.5%.
This is probably what naturally happen to some REITs:
- They took on debt, but they never deleverage
- They just refinance the debt over time
- The assets appreciate in value over time
- The debt remains the same value, if the rental income can cover the interest payment, and the banks are willing to let them refinance
Let us compare the return if we deleverage versus if we do not:
- deleverage versus don’t (positive to negative sequence): $601,602 vs $582,414
- deleverage versus don’t (negative to positive sequence): $913,901 vs $990,861
Not so much difference. Just for one you are free from debt one you are not.
This article turned out longer than expected. I cannot write anymore.
Should you leverage up? Is there an advantage to doing this? Are the trainers trying to sell you a pipe dream?
Here are some of my conclusions:
- If you do not understand what I have written here, it means that you should not leverage. That does not mean that if you understand, you should always leverage
- The guys came up with a strategy, and you should understand that different parts of the strategy try to make this a success. Don’t go implementing this just because you understand part of it and do not understand other part of it.
- Leverage does speed up your accumulation of wealth assets, but the level of speed up depends on a few factors, notably how long you are letting the assets compound, the rate of return of the assets
- For those who are thinking of gaining early financial independence, the advantage might not amount to much. Certainly much less than anticipated
- Whether it is a positive to negative sequence, or a negative to positive sequence, leverage mathematically enhance the returns
- Notice that what made this strategy work was the consistent capital injection into the portfolio. The capital injection is so much when the portfolio is small such that even if there is a margin call event, the capital injection saves it. If you do it in lump sum, your mileage may vary. If you lose your job during a margin call event (when times are bad, these 2 events come together!), you can be really fxxked
- You could choose to be sensible and let the portfolio naturally deleverageby not taking on too much debt and letting the assets appreciate
- While negative to positive sequence is the most conducive to wealth accumulation, depending on your leverage, and the individual stock risk, you might face some nasty margin call
- Interest rate do not stay stagnant. Your rate of return is also uncertain. By leveraging you are taking on more complexity. The advantage might not be too much and you end up walking on a tight rope. Hope you don’t end up being strangled by the rope
- We are doing the experiment on a portfolio level. However, there are some stocks that will get impaired pretty badly. So much so that they do not come back. Their business or structure have been drastically altered in a negative way that they just do not come back. Active stock investing is a whole different ball game all together
- There are alternatives to this: Get better in your stock investing! You might not need to bother with things like this. I always find that leveraging up are people attempting to invest with something conservative, but putting on more risk on something conservative. It depends on which poison you prefer.
- Again, this strategy is based on a consistent capital injection. If it is a large lump sum investing, your mileage may vary!
Let me know if some of my numbers seemed weird. I do make mistakes here and there. I realize in this research, some numbers lead me to believe that an unleveraged portfolio generates greater equity than a leverage one. Which mathematically do not make sense. So I am rather lucky to find my own error.
Once again, this article is a guest post and was originally posted on kyith‘s profile on InvestingNote.
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