How to Rationally Think about Leverage

Borrow money to make money

Today we’ll explore a common question I get asked all the time: What is my thought process behind leverage? The short answer is simple. I want to make high returns without being exposed to high risk. Normally the two go hand-in-hand. But leverage allows me to separate them. For example, a speculative marijuana stock may grow 20% to 50% a year. But it could just as easily lose half its value. The potential reward is tempting. But the high risk is not worth it.

Instead, I’m looking for a lower return, lower risk investment such as an established oil/gas pipeline company known for its predictable earnings, dividend growth, large economic moat, and low stock volatility. Using historical data and fundamental analysis I may determine that there is a very high probability this stock will appreciate 4% to 10% a year. I can then apply a leverage multiplier of 5 times on this investment which means my actual expected rate of return is 20% to 50% before subtracting the cost of borrowing.

In other words, I do not subject myself to the high risk that is typically associated with juicy returns. But I still get those juicy returns! Awww yeah. 😀

That’s pretty much it. The long answer requires some further explanation. Let’s start with the 3 criteria I look for before I borrow to invest.

The 3 fundamental rules of practicing leverage

1. A 10+ year investment time horizon.
2. An adequate diversification strategy.
3. An asymmetric risk-return opportunity.

The first and second rules are straightforward. Billionaire Jeff Bezos recommends we think in 7 year terms to remain competitive. I suggest taking that up to 10 years just to be safe. 🙂 In terms of diversification it can mean more than just having stocks and bonds.

Seek Out Asymmetric Returns

Now comes the fun part. Rule number 3. As we all know there is no investment without risk. The third rule is about knowing which investment has a favorable risk to reward ratio. This simply means comparing the odds. For example, let’s say we are asked to roll a normal 6 sided die. If it lands on 1, 2, 3, or 4, we win $10. 🙂 But if it lands on 5 or 6, we lose $10.

So should we play? The answer is a resounding yes every time! 😀 We have a 66.7% chance (4/6) of success. So from a rational perspective this has an asymmetric probability in favor of us winning.

Analyzing Probable Returns with a Bell Curve

We can use a normal distribution to help identify favorable investment opportunities. In statistics, a normal (bell curve) distribution outlines all the possibilities with the most likely outcome being in the middle. The standard deviation can be used to measure the variation in a set of data. Let’s see how we can put this bell curve to use when we overlay it on top of a chart that shows how many times the stock market returned a specific amount over any 10 year period between 1916 to 2016. (source)

So over the last century, any 10 year period of investing in the S&P500 index would have returned somewhere between 6% to 11%, 40% of the time, or within 1 standard deviation of a normal distribution curve. Additionally, returns were between 3% to 14%, 72% of the time, within 2 standard deviations from the mean.

This strongly suggests that we have a 95% probability (95/100 possibilities) of making at least 3% annual return from the stock market in any given 10 year period. Pretty neat eh? 😀 Time in the market reduces risk in the market, and creates a huge asymmetric advantage for investors.

But enough theory. Let’s see this at work in a real life example.

Banking on Leverage

A couple of years ago I used leverage to buy RBC Royal Bank stocks. Let’s go through my thought process behind this decision.

Large cap, blue-chip dividend stocks are ideal to use leverage on. They don’t come much bluer and larger cap than RBC. It’s the largest company in the country. Plus, there’s a lion in the logo. That’s how you know it’s a top quality company. 😉

I borrowed $4,000 to buy 55 shares of TSE:RY and contributed $0 of my own money. I wrote a full analysis on RBC and explained why I thought it was a good stock to buy at the time. The reason I used leverage was because I didn’t have any cash and the investment fits my 3 rules of leverage.

• First rule: I planned to keep RY stock for the next 10 years.
• Second rule: I made sure RY would only be a small part of my total portfolio.
• Third rule: RY’s P/E ratio, peg ratio, and other fundamental measurements looked appealing in 2015. The stock was expected to grow 8% to 10% a year for the foreseeable future. Historical data showed strong earnings growth and stock appreciation. RY’s dividend would be enough to cover the interest cost of the debt. Thus, this would have a favorable asymmetric risk-to-reward ratio.

My return on this investment so far, net of margin interest cost, is about 37% or $1,500. Not too shabby. 😀 But this shouldn’t be a big surprise. After all, stocks are fundamentally priced based on their earnings. And RBC has an impressive history of consistent earnings growth. Back in 2015, RY was expected to earn $7.35 per share by 2017. Fast forward to today, it appears RY may actually be on track to hit $7.40 EPS this year. We shall see.

This leveraging strategy is also recession resistant. For example, let’s say I did the exact same thing in 2007 at the peak of RY’s market capitalization, (the worst possible time to use leverage) right before the greatest recession of our generation. Yikes! Well despite the unfortunate timing, 10 years later I would still end up with a 70% positive return, net of interest expenses! This is why I am not concerned about future recessions. 😉 I know I can just hang on to RY until the stock market recovers like it always does after a major correction.

Why Rational Investors Use Leverage

My decision to buy RY is understandable from a rational point of view. If a stock’s price typically follows earnings. And earnings were projected to grow. Then logically it would make sense that the stock price would eventually grow proportionally. And looking back, it certainly did! This outcome was a likely probability from the very beginning. 😉 But without a rational understanding of leverage it may appear that my RY stock returns are simply due to sheer luck.

Emotionally, using 100% leverage may sound absurdly risky. But logically speaking it was my best chance at maximizing investment returns. I made a rational decision, and not surprisingly I was rewarded with a highly probable outcome.

Other outcomes were certainly possible. The EPS this year could turn out to be $6 or $8. Either number would still fall within my preferred range. However, the farther the actual outcome strays from the expected value (which is $7.35 in this case), the less likely it is to happen.

That’s the wonderful thing about bell curves; it’s predictable to some extent. This factor of predictability is what makes all of this “investing,” not gambling. 😉

In Conclusion

Currently I can borrow on margin at 2%. Therefore, if an investment’s expected return is 2% or higher in at least 1 (but preferably 2) standard deviations from the mean, then I will consider using leverage to buy it.

How much total leverage I should use is dictated by a series of stress tests. This means it changes every year depending on stock market values, interest rates, and other economic factors. As of now, I have $63,000 of margin debt.

If interest rates ever become too prohibitive, I would pay off my margin loan completely. It would be irrational to use leverage if the cost of borrowing is higher than the expected return from an investment.

For my Royal Bank investment, I determined the probability of a favorable outcome was 90%, which is a huge asymmetric opportunity! However, even though I have a 90% probability of winning, I still have a 10% chance of losing. We can’t ignore this fact.

In economic decision making, loss aversion refers to people’s tendency to prefer avoiding losses rather than acquiring equivalent gains. This behavior is irrational, but it happens. Many investors would let a 10% probability of failure stop them from using leverage, which is perfectly okay. I don’t judge. 🙂 But loss aversion is how people miss out on lucrative investment opportunities. So the important question to ask is; are you making a rational decision, or an emotional one? 😉

A Final Note About Probability Theory

If we flip a coin a few times it may land on heads each time (100% heads) or possibly be all tails (0% heads.) But if we continue to flip the coin more and more times, then the ratio of heads will eventually approach the theoretical value of 50%. This is an empirical fact.

Of course a 50% chance of success offers no asymmetric investment value. But in situations where the odds are actually in our favor each time, such as the dice game mentioned earlier, then the law of large numbers guarantees that we will succeed, as a whole, if we play enough times!

This is why I love using leverage – as long as the outcome is objectively in my favor. I don’t have to be right the 1st time, or even the 2nd time. Mathematically speaking, I just have to invest enough times for the actual ratio of outcomes to converge on the theoretical (or expected) ratio of outcomes. 😉 It’s about the cumulative results. So it’s essential that we learn how to identify asymmetric return opportunities. Leverage doesn’t change our odds of winning. It merely extends our gains or losses based on the inherent odds of the underlying investment decision.

I believe someone who uses leverage in a rational manner should in theory outperform someone else who never uses leverage. But I’m just an amateur investor experimenting with different ideas. What do you guys think? Do you use leverage? If you wouldn’t under normal circumstances then at what probability of success, if any, would you consider using it?

<edit>My margin account is with Interactive Brokers. The margin rate is currently 2% for anyone who has a $CDN account, as of spring 2017. Here’s a full table of interest rates on the broker’s websites.</edit 02/05/17>

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