I picked the title of this series with my tongue planted firmly in cheek. At my old firm, I created an analysis to look at a combination of financial strategies involving leverage that were designed to mitigate the risks involved with most leverages. One of the advisors decided that the strategy should be named "The Preet Principle" and actually referred to it as such – and I think still does! :)
A word of caution before proceeding. Don’t even think about implementing anything I write about (on this blog, but especially in this series) without first consulting your own professional advisor.
And with that, let us begin…
Certainly many people have heard the old adage "People get rich using Other People’s Money". They are referring to borrowing money to make a lump sum investment since this can magnify your absolute gains. Unfortunately, most advisors will gloss over the fact that it can magnify your losses as well! I forget the actual statistic, but something like over 50% of all complaints against advisors deal with leverages gone bad.
As you are probably aware, advisors sell the sizzle of quickly increasing your net worth through these leverage strategies – but many times, advisors will not spend enough time telling you about all the ways in which you can get burned. And since most advisors’ compensation is tied closely to the amount of assets they manage for their clients, they will be eager to set up these leverage strategies for their clients – sometimes too easily. I have seen many an advisor pitching leverage strategies throughout the year, and every year. I’ll explain later as to why this is the first sign that your advisor may not have your best interests at heart.
Why do people leverage?
First, let’s look at the basic premise behind a leverage. As I mentioned above, leverage can magnify gains versus monthly contributions. You could intuitively figure this out if you looked at a long-term graph showing the various stock market’s performance over the last 50 years. It basically goes "up and to the right" if you are standing far enough away from it! :) But if you start walking closer to the chart you will see numerous short-term gyrations that can make you sea-sick!
Unfortunately I don’t have a chart that I can post here to show you, but I CAN direct you to AndexCharts.com which sells updated charts like this to advisors and investors alike – it really helps puts things into perspective. I have no personal gain for saying this, but I recommend buying a copy of this chart and correlating all the market events, wars, inflation rates, etc. with the market performance at those times – most "crises" in the short term were just "blips" in the grand scheme of decades of data. CLICK HERE TO SEE A SAMPLE ANDEX CHART – you can spend hours looking at one up close – I know I do.
Here is some interesting food for thought:
1. Since 1950 there has never been a 10 year rolling period where the TSX lost money. The lowest 10 year average rate of return was 3.3% from September 1964 to September 1974. The best 10 year average rate of return was a whopping 19.5% from August 1977 to August 1987.
2. The lowest 30 year average rate of return was 8.6% from June 1952 to June 1982. The highest: 12.7% from August 1970 to August 2000.
3. The single worst 1 year rolling period for the TSX was June 1981 to June 1982 during which time the index lost a massive 39.2%.
4. The single best 1 year rolling period for the TSX was the very next year from June 1982 to June 1983 when the market returned 86.9%.
But the take home message for most investors is that we DO believe the markets generally go up, and given enough time the returns on our portfolios will be positive. In reality, it can be VERY hard to stay the course, especially after a year like 1981-1982. How many people had the discipline to stay the course and actually take advantage of the next year’s spectacular returns?
But back to my original question: Why do people leverage? To take advantage of the fact that a lump sum contribution now will be giving you the lowest possible cost on your investments compared to adding money periodically AS the market is going up – thereby increasing your average cost. And since you calculate your gain as "Price Sold at minus Price Paid" you can see why this is advantageous…
In Part 2, we are going to explore a simple concept that contrasts monthly savings versus leveraging in an apples to apples comparison.
In Part 3, I’m going to explain what normally goes wrong with these simple leverage strategies.
In Part 4, I’m going to actually introduce the "Preet Principle" which I believe addresses these concerns and I will back it up using statistical probabilities analyses. Having said that, it is still only intended for more experienced investors with aggressive risk tolerances – so keep that in mind.
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Interesting post. I’m looking forward to the rest of the series.