Category: Investing

Almost 3 years ago I started up a Smith Maneuver leveraged investing plan which involved borrowing money using an investment loan (home equity line of credit) to invest in dividend stocks.  I wrote extensively about this process (see list at the bottom of page).  Over time I have seen this account go through some unbelievable volatility, have almost no dividend increases and watched interest rates plummet which meant that the account was quite profitable on a net cash flow basis.

Last week I decided to sell all the stocks in the leveraged investment account and pay off the line of credit loan.  I had been debating for a while if I should continue the leveraged plan and since it was at a point where there was a small capital gain, it made the decision very easy from a psychological point of view.

Why did I end the Smith Maneuver plan?

A lot of things had changed for me in the 3 years since I started the plan.  My opinion of leveraged investing hasn’t really changed but I didn’t feel that it was a good fit for my situation anymore.

Extra risk. When I started the plan I wanted some extra risk.  The problem is that as time went on and it became apparent that we were going to be a single income family and my company had several rounds of layoffs in the past year – my appetite for that extra risk diminished.

Another issue concerning risk is that when I started the plan, my portfolio was 80% equities and 20% bonds.  It didn’t occur to me until much later that adding leverage to a portfolio that isn’t 100% equities doensn’t make any sense.  All I had to do to increase risk was to decrease the percentage of bonds in my portfolio.  If your portfolio is 100% equities and you still want to add some risk then using leverage is a good tool for that.

Hassle – Having a leveraged investment account means doing a bit of work.  You have to open the account, buy stocks, transfer money, keep track of purchases for ACB values.  Transfer dividends out of the account to help pay the interest.  You also have to account for the earned dividends and interest payments when you file your taxes.  This isn’t a huge amount of work but again, my life has changed in the last few years – one more child plus a home business which takes time means that I’m a lot less inclined to want to do extra financial activities unless there is a clear benefit.

Motivation – Another thing that changed was my motivation – at this point in time we have a decent standard of living.  It’s likely that I’ll be able to retire at a reasonable age with an adequate income so the question is – why bother with extra risk?  Extra money is nice but if there is a downside then it’s not worth it for me.

Would I recommend doing or not doing leveraged investing?

My opinion on borrowing to invest hasn’t changed much – I think it is a valid tool to increase your portfolio risk as well as make extra purchases when the market is down.  Just be prepared for a bit of extra work.  Handling volatility is something that I have no problem with but if you have a hard time watching your unleveraged portfolio go down in value then be prepared for the fact that watching a leveraged portfolio go down is much more difficult.

The original leveraged investing plan

This post lays out the grand plan for leveraged investing.  I had a chuckle seeing Frugal Trader’s comment about my projected borrowing costs of 6% – he suggested increasing that estimate a bit.  As it turned out the borrowing costs were much lower than both of us anticipated.

The risks of leveraged investing were discussed in great detail.
Here is one risk which I found amusing

Future growth rate of dividends: If this doesn’t happen then the plan will fail. Not much I can do here other than to try to pick good companies with proven histories of both paying dividends and increasing them. Based on the last 10 years this looks like a slam dunk. But as William Bernstein wrote in Four Pillars of Investing “Ignore the last ten years” when looking at trends. I’ll have to ignore William on this one.

Lesson learned – Don’t ever ignore William Bernstein!

Interest rate exposure.  This is the risk I was most worried about and ironically it was a non-factor since interest went down and stayed down.  This is still a risk factor for the future however.

Conclusion

I’m glad I did the leveraged investing plan, it was quite interesting and I learned a lot.  My advice to anyone thinking about it is to start small and make sure you are comfortable with all the different aspects of leveraged investing before you go in deeper.

One and a half years ago I did a post about Labour vs. Investment Income and Mike did a post about Do You Really Earn Your Investment Income? The point of both of our posts was that there is an expected investment return (ROI) that an investor can’t really take credit for.  If you match the average market return, have you proven your skill as an investor, or have you just been in the pool when the water level went up for everyone?  In my post I focused more on whether you want to improving your ROI or on just increasing your income, depending on how much you have to invest.

Beyond these considerations, I also think there are a number of investments that blend labour and investment. Flipping real estate is a prime example. You can’t buy the run down property without some cash to invest, but then you get the (sometimes) crazy returns because you work 80 hour work weeks fixing the place up. Someone without many marketable skills might be best served starting their own company that they run (such as a convenience store or a franchise).  This, in a sense, lets them “buy” a better exchange rate on their labour then they might be able to get from a job by putting capital in with their labour.

In situations like this, it becomes very easy to fool ourselves about how well (or badly) we’re doing.  As Mike points out in his post, if someone was day-trading full time, they have to be making MORE money than they would get from an index-fund and a full time job to really justify it (which I think would be highly unlikely).  The day trader who looks at his account and is proud of the money he’s made is ignoring the opportunity cost of his lost salary.

Flippers are notorious for this.  Even when you get them to be honest about their actual costs (often they like to omit transactions costs from their profit statement), you’ll NEVER get them to even account for the amount of time they put into repairs.  Get them to include this and the time they spent setting up that deal, investigating deals that didn’t work out, marketing the repaired property, meetings with partners and completing the purchase and sale transactions and you’ve got a proper picture of their real investment INCLUDING their time (which will let them accurately calculate their profit).

Even people who buy-and-hold real estate long term are guilty of this.  If you aren’t hiring a property management company (and I’d personally be very cautious before you do this), you have to account for doing this work yourself.  The best way to do this is to pretend to “pay” yourself what a PM company would charge, and add this to your cost.  John T. Reed estimates that self-managed real estate takes 3.6-4.6 hours / unit / month to manage (remember although some months you don’t do anything, you’ll have the times where Murphy strikes and you keep having to go back to a unit to do one thing after another).  An index fund or GIC takes FAR less time and this has to be factored in if you want to honestly compare the investments.

One approach to honestly compare such investments is, as already mentioned, determine what others would charge for this and add it to your costs.  For real estate this would be what a property management firm or contract would charge, while for a self-run business it would be what you’d pay a clerk at your convinience store or a manager at your Subway® franchise.  If you’re unhappy working for such a low wage, then you’d be best served to hire someone to do that work for you, and get a job earning the higher wage you think you can make.  Don’t fool yourself into lumping the franchise profits into your salary and think of yourself as the highest paid convenience store clerk in the world.

Similarly, once you have an honest appraisal of the ROI from your venture, if it no longer looks lucrative with your time factored in, dump it and put your money where the ROI (based on your time and money) *IS* reasonable.

Hi Mr. Cheap, I just wanted to get your opinion on this theory and if you think its worthwhile in the long run. The theory goes like this; for every dollar you have in a trading in account, you can borrow a dollar on top of that. In some accounts, even more than that. Now, I’m a young guy(21) and plan on investing in dividend stock that offer me a decent yield(over 5%). I have an account with scottrade and the most they will charge you on inteest in a given year is 7.5%.

My question is, if I started off with $2,000 in account and therefore have buying power of $4,000(due to the 1 for every 1 rule), would it be better to buy $2,000 worth of  shares as I can of a stock like MO(altria) using only my cash which gives me a 7.5% dividend or $4,000 worth of shares? The idea behind this question is that in the first year, the money I make on the extra shares earned on the first year would be canceled out with the interest paid to scottrade for the borrowed money but every year after that, my extra shares earned off the borrowed money would be able to compound interest free. Another note is that as time goes along after my initial deposit of $2,000 into my account, I would continue to put in about $200/month and hopefully more as I earn more. This would allow me to buy more shares and therefore earn more more interest on the shares as time went along. Does this make sense? After the first year, am I right that I would be making pure profit off the extra shares that I earned from the borrowed money?

To start with, I’m not 100% sure what changes after the first year.  If you borrowed $2000 and bought stock with them, and if the dividend payments EXACTLY matched the interest payments, you’d keep paying on the debt forever (not just 1 year).  If you mean that you’d be paying off the margin debt with $200 added to the account each month, yes you’re right (I guess you’d pay it off in about 10 months ignoring dividends from the stock you bought that wasn’t on margin and decreased interest payments as you paid down the debt each month).  I wrote a post about doing something similar to this.

I always enjoy question / discussion about buying on margin (or with other borrowed funds). I share you sense of excitement when considering constructing such financial vehicles, as it almost has the feeling of playing alchemist, creating wealth out of nothing. Please be aware that this feeling is *FALSE*, and there’s nothing magical about buying on margin. Basically you’re exchanging increased risk for increased reward (as they say, there’s no free lunch).

To begin with, Altria is a great company and a great dividend payer. At it’s current dividend yield of 7.36% you’re right that its dividends almost match the interest you’d be paying, and it *looks* like you’d be owning the stock for free. That’s how I felt when I bought Bank of America (BAC) on Feb 4th, 2008 for $44.46. At that point it had a dividend yield of 5.8% and had been increasing its dividend for 30 consecutive years (read over the analysis and look some more at the company’s recent history since this was posted if you want to be impressed by Dividend Growth Investor and his analysis).

To make the analogy perfectly clear, Altria may be a great company but you never know what the future holds. I was shocked that BAC cut their dividend. I was floored when Washington Mutual went bankrupt. The future isn’t certain, and nothing makes it impossible for Altria to cut its dividend or go bankrupt (perhaps Obama might decide everyone in America has to stop smoking since Michelle made him quit).

If Altria cut its dividend a number of things would happen:

• Your dividend payments would no long cover your interest payments and you’d have to make up the difference yourself
• The value of the stock you own would probably plummet, meaning that you’d owe more money than the stock you used it to purchase is worth
• If the stock price dropped enough, you’d get hit with a margin call, which would force you to repay a portion of the money you owe, otherwise they’d sell stock (at a loss) from your portfolio to cover it.  We regularly get people complaining on our brokerage posts about having been forced to sell at a loss due to a margin call.

One of the other considerations is that borrowing to invest is great from a tax perspective, but as a young guy, your income probably isn’t in the highest bracket, so you won’t be able to benefit from this (as much as a 50 year old medical doctor might for example).  I’ve been backing off on my margin debt for partially this reason:  I’m a poor grad student, so the tax deductions don’t help me.

I know I shouldn’t make investment recommendations, but I can’t help myself.  Personally (and remember, I’m just some guy who likes to blog) I’d suggest you save up cash in a high-interest savings account (and keep adding the $200 / month to it).  As a 21 year old, who knows what the future holds and you may find capital preservation most valuable at this stage in your life (you could use that money to start a business, deal with a financial emergency, as a down payment on a condo or house, to pursue further eduction, to get married without going into debt, etc, etc, etc).

If you *insist* on getting the cash into the stock market, I’d follow Canadian Capitalist‘s sleepy-mini portfolio (or one of the other easy, passive investment vehicles).

If you *insist* on buying an individual company, and understand that you’re massively increasing your risk & volatility by doing so, I’d buy MO (or whatever company you decide on) in a low fee brokerage account (Scottrade is pretty good at $7 / trade) WITHOUT using margin.

If you *insist* on buying on margin, I’d suggest you consider a strategy I mentioned at the start on using margin to lower trading costs and keep the margin debt below 10% of your portfolio value.  When I was 58% on margin, the Canadian Capitalist wisely assessed this feelings on this as “Ouch. What are you thinking Mr. C?” (read over the comments on that post, a lot of smart people there recommend approaching investing on margin VERY cautiously).

Do any commenters have additional / alternative suggestions for a 21 year old thinking about getting into margin investing?

There’s probably a decent chance this post will make you angry.  Feel free to skip it if you want to stay in a good mood.  If you decide to read it anyway and are looking for ways to vent your anger, insulting the author (Mr. Cheap) or announcing that you’ve unsubscribed to our feed are both popular options :-).

Some time ago Larry MacDonald wrote an interesting article on socially responsible investing for The Globe and Mail. For those unfamiliar with the term, SRI is a mutual fund which only buys stock of companies that meet the ethical criteria of the fund. As an example, almost no SRI would ever buy Rothmans or British American Tobacco stock, since they wouldn’t want to profit from tobacco sales.

What was most interesting about the article, is that Mr. MacDonald points out that SRI funds have performed as well as general funds. The explanation for this is that ethical companies are less likely to be involved in a lawsuit or to have a business affecting PR nightmare if their unethical practices come to light.

I owned Rothmans stock and have actually suffered from ownership on two occasions. I was briefly corresponding with a reasonably famous investor and after I admitted that I owned Rothmans stock he stopped corresponding with me. Another time a reader (who was clearly crushing on me) and I exchanged a few e-mails, and after it came up that I unabashedly own tobacco stock she told me off and stopped writing as well.

I always wonder about social beliefs that the main argument for them is people who say “believe what I believe or I won’t be your friend”. I have friends who are pro-choice and pro-life, chums who are pro and anti gun control, religious (from numerous faiths) and atheist pals, I have socialist buddies and capitalist buddies. I have my own firm opinion on each of these issues, but it has never prevented me from enjoying the company of someone who has another point of view.

SRI are fine for what they are, but I somewhat disagree with the underlying philosophy.  To use my Rothmans stock as an example, not a single additional cigarette was sold because I’m the owner of part of the company.  If I had sold my Rothmans stock to Mike, the company would continue to function in EXACTLY the same way it had before the sale.  The only difference is that Mike would be collecting the quarterly dividend instead of me (and he would be able to vote on shareholder issues instead of me).  I was one owner of a well run, very profitable Canadian company that makes money selling legal products to people who want to enjoy them. I would have been delighted to continue owning it if the sale hadn’t been forced, and I’ve considered buying Altria on a number of occasions.

Say now, someone objects to ownership (fair enough).  They sell their Rothmans stock, because even though they aren’t materially affecting the operation of the tobacco company, they don’t want to profit from the supposed suffering it causes.  They can’t own most mutual funds (which might buy Rothmans or another unethical company at any moment), or index funds (which will almost certainly own unethical stocks).

If we object to being a shareholder in these companies, which doesn’t affect their day-to-day operation, we certainly can’t be CUSTOMERS:  which DOES affect their day-to-day operation.  If I buy Rothmans smokes, the company has more money to spend on advertising, improving their operations and other business activities (such as paying those nasty dividends to shareholders which I’m opposed to).  I also can’t sell Rothmans smokes, or patronize companies that do (for the same reasons I can’t buy their product).

At this point I’ve isolated myself from pretty big part of the economy (convenience stores, most grocery stores, etc).  Certainly if I can get enough fellow consumers to join me, we’ll be pressuring stores not to do business with Rothmans, and hurt their business. Alternatively I could lobby the government to make smoking illegal and criminalize people who choose to smoke and the companies that try to sell to them. If I’m not doing either of these things (and just not buying sin stocks myself), I’m not really accomplishing anything except letting others collect the profits from these companies (and if enough people refuse to buy them, it WILL drive profits up for the remaining buyers).

To focus on a specific example, tobacco companies, I can understand why people are against smoking: it kills people. If someone asked my opinion whether they should start (or continue) smoking, my advice in EVERY case would be “don’t smoke”. HOWEVER (and this is my personal politics creeping in), if an adult CHOOSES to smoke, with full awareness of the consequences, who am I to try to force them to stop? Should I try to stop obese people from eating junk food? Should I try to stop skiers from skiing (and other sports with a danger component)? Should I try to force people to stop drinking (and stop myself)? Putting aside the “addictions” argument, people engaging in “harmful” activities have weighed the possible consequences and made decisions for themselves. Without knowing everything about them, how could I possibly make a better decision for them then they could for themselves?

Some people bring up the health care costs, and how people engaging in self-harm drive up costs in taxes or health-insurance premiums. Again, look at the examples in the previous paragraph. Are we really ready to ban everything that’s harmful?

I have no problem investing in a company that I wouldn’t shop at (I *HATE* BMO as a customer, and it’s one of my main holdings). Given this, if a company does a good job delivering a legal product, why should I avoid investing in it? Not that it’s at all relevant to this post, but I don’t personally smoke cigarettes (I occasionally share a hookah with friends, and VERY occasionally enjoy a cigar).

Do you invest in “sin stocks” or do you try to follow a SRI approach?

On Tuesday I posted about Beginning Investment Strategies to Consider, and as promised, in this post I’ll detail investing strategies I think beginner investors should avoid.

There are countless people who want to get your money for a “can’t lose” investment.  I’ll try to talk about general “warning signs”, but inherently this is a topic that you can’t give a definitive list of what to avoid.

Zero Sum Investments

Gold, Forex, commodity, options and futures trading all have the characteristic they are zero-sum games (as wikipedia says, “a participant’s gain or loss is exactly balanced by the losses or gains of the other participant(s)”).  This means that to make money you have to be better than the average participant.  By definition, as a beginner investor you’ll very likely perform worse then average, so the people trying to involve you in these markets want to make money by either a) selling you a strategy, b) charging you for participating, or c) taking advantage of you and making money off of you.

Buying Trading Strategies

Some individuals will sell you a trading strategy for a zero sum investment, or even for other markets (particularly real estate or equities).  Usually there’s a good story behind what they’re selling, and they’ll talk about how they’ve made lots of money doing it.

There’s a saying at the horse racing track that “those who know, don’t talk and those who talk, don’t know”.  The idea behind this is if someone really had valuable information about an upcoming race, their best strategy would be to place a bet themselves and not tell anyone (since more people following the same betting approach will adjust the odds and make them less money).  The same is true for other investments.  If more money is chasing the same strategy, it becomes less lucrative for everyone participating.  This has happened with house flipping.  So many people are pursuing properties that are in need of cosmetic renovations that the price has been bid up to the point where it’s no longer a good way to make money.

If someone is selling their investment strategy instead of just following it themselves, that tells you something important:  they feel they can make more money selling it than following it.

Individual Bonds or Stocks

Evaluating the purchase of individual bonds or stocks requires a complex understanding of the market and the company’s place in it.  While knowledgeable investors can and do make money off of these, for the majority of investors (and especially beginning investors), ETFs or Index funds that track entire markets (or segments within them) are a far better choice.

Real Estate

We’ve posted on real estate investing extensively, and I certainly think it’s an interesting investment vehicle.  HOWEVER, I disagree with those who feel that it’s easy or simple.  Beginners can be eaten alive by “professional tenants” (deadbeats who work rental laws to avoid paying rent) or unintentionally running afoul of local rental laws.

Again, people do make money in real estate.  John T. Reed feels that to be competent in real estate requires mastering:

• the real estate law of your state (or province in our case)
• federal income tax law
• property management
• real estate finance
• real estate leasing
• real estate sales
• real estate appraisal
• construction (in some strategies)
• securities law (in some strategies)

How many beginning investors are going to have ANY understanding of these areas?

Multi-Level Marketing (aka Pyramid schemes)

You’ll know you’re in MLM territory any time you hear a friend, family member or acquaintance start talking to you about a “business opportunity” or how to make money “selling to yourself”.  While some “investment gurus” will advocate these as a way to learn how to sell, as an investment they’re pretty miserable.  Any money you do make will probably be from friends who want to help you out (and view buying from you as a donation to the cause) rather than a true investment return.

Lazy Man and Money posted about Montavie (and was promptly sued), so that should tell you the kind of company behind these “investments”.

Innovative Investment Vehicles

It’s always tempting to get in on the ground floor of something new, and I put a little cash into peer-to-peer lending.  For the most part, I think the danger of something new far out-weighs any benefit from being one of the first people involved.  If it’s a worthwhile new market, very smart people will quickly move into it and being there ahead of them by a few months probably has limited value.  In the far more likely case that it isn’t worthwhile, it’ll be easy to lose any money you’ve put into it.

How to Gain the Experience to Invest in These?

While I feel that some of these investments areas are inherently flawed and should be avoided by everyone, some are worthwhile for knowledgable investors and a valid question might be how will I become an expert if I avoid them?

Some would advocate learning about them wthout any money on the line (e.g. trading stocks in “dummy” accounts without real cash in them).  Personally I don’t think you’d get much out of the experience if real cash wasn’t on the line.  One way to learn about these areas is to put a small amount of your investment dollars into them, keep the investment small, and learn as you try to grow it.  This could mean buying an older condo instead of a new 12 unit apartment building, buying $200 / month in stock usuing DRiPs instead of sinking a $100K inheritence into Nortel stock or putting 5% of your portfolio into futures trading (and refusing to add more money to it, you only reinvest your earnings).

I’ve commented before about how dangerous it is to give investment advice to friends and family.  I keep running into people who are very bright individuals in other areas of their life, but just throw up their hands in frustration and give up when it comes to managing their money.  Never one to learn from my experiences, my goal is to put together a couple of posts, one on easy to understand and set up investment strategies and the other on investing strategies to avoid unless you REALLY know what you’re doing.

Short Investing Horizon

If you had a chunk of money sitting around that will be used for something within the next 5 years, your priority should be capital preservation (not losing it!).  A post a while back on Canadian Money Forums asked about investing $15k for 2 or 3 years, and the consensus seemed to be that for this short a time frame GICs or high interest savings account are the best place to put it.  I agree wholeheartedly.

If a person with a lump sum of money to invest for 2 or 3 years has any debt (even a mortgage), I think an even better use would be to pay down the debt.  It should PROBABLY be possible to borrow it again (assuming a decent credit rating) if the money is needed after a couple of years, plus you’ll have avoided all the interest that you would have paid in that time period (which  I can guarantee will be higher than the return on a GIC or savings account).

10 Year Investing Horizon

If you won’t need the money for at least 10 years (usually this is for retirement funds) things get interesting.  Equities (stock) are more volatile (meaning they can move up and down unpredictably).  Obviously people prefer a guaranteed return, not an uncertain one (and prefer to make money, not lose it), and therefore equities offer a greater LONG TERM *AVERAGE* return than GICs or a savings account.  To capture this higher return you need to stay in the market for longer lengths of time, to catch the periods when the market does really well (to make up for the times it does very poorly).  The longer you stay invested, the closer you should be able to get to the long term expected return (which should be around 7% by some measures).

Rather than picking specific companies, these strategies focus on asset allocation.  Read over these short descriptions, pick the one that sounds most interesting.  Spend an hour or two reading the links in its description and you should be good to go!

Couch Potato Portfolio

MoneySense magazine has what they call the couch potato portfolio (based on a US version by Scott Burns).  The idea is an intensely simple portfolio that takes minimal time or thought to maintain (they estimate 15 minutes per year and no investing knowledge required).  The core idea of this is a portfolio that has very broad diversification.  It is broken into four components, and each year these are “re-balanced” so that they will be worth the same amount.

e.g. say you put $100 in A, B, C and D .  At the end of the year A is worth $120, B and D are worth $110 and C is worth $80, you would buy and sell until you had $105 in each of the components and they’re “balanced” again.

There are SLIGHT differences in what you choose for your four components, but it’s not worth getting too hung up on.  If you want to get started with retirement savings but keep putting off “figuring out investing” and never get around to it, picking a couch potato portfolio and getting started would probably be very worthwhile.

In addition to the information at the MoneySense site, the Canadian Capitalist has summarized the portfolios.

Sleepy Portfolio

The Canadian Capitalist took his inspiration from other lazy portfolios and created the sleepy portfolio (a “fire and forget” portfolio for large sums of money, if you get a surprise inheritance this might be a reasonable place to dump it) and the sleepy mini portfolio (for small sums of money on an ongoing basis).

The sleepy portfolio is targeted for young, aggressive investors (so if you only have 10 years until retirement it might not be the allocation for you).

Others

Larry MacDonald proposed the One Minute RRSP Portfolio for those who want the barest of bare bone portfolios (it consists of 2 ETFs with an optional third cash component).  Scott Burns, Ted Aronson and the Coffeehouse Portfolio each have their own version of a “lazy” portfolio that’s worth looking at if you have the time and inclination.

If you prefer to get your investing advice from a book and not from yahoos on the internet (why are you reading this blog then? 🙂 ) Unconventional Success by David Swensen, The Smartest Investment Book You’ll Ever Read by Daniel Solin (allocation overview here) and The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein each contain easy to assemble / maintain portfolios as well as the rationale behind their construction.

How to do it

Once you’ve picked one of the above strategies and read about it, summaries of the the actual asset allocations can be found here (for all except Solin’s and MacDonald’s).  Sign up for a discount brokerage account (I like iTRADE / E*TRADE, Mike uses Questrade) and buy the ETFs that make up them up.  Wait a year and rebalance.  Repeat.

If you’re working with a small amount of money (maybe under $25k), follow Canadian Capitalist’s sleepy mini portfolio (or save in a high interest savings account / GIC) until you’ve got $25K, then move to one of the others.

Keep learning.  If you develop a deeper understanding of investing and want to follow a more complicated approach (and manage to convince yourself that it will provide higher returns than passive investing in one of these flavours), then switch.

Three years ago I got into Lending Club with an American friend of mine (she could open the account, whereas I couldn’t).  This is a summary of my experiences.

Three years is a reasonable length of time to get a feel for a new investment vehicle like this, as this is the time length of loans Lending Club provides.  I’ve had people pay on time every month, pay late then get caught up, pay off their debt early and borrowers default on their debt – the full range of what can happen.  I’ve gained an understanding of why banks are as risk-adverse as they are (and am amazed that bankers don’t hate everybody – the amount of deceit in loan applications is shocking).

The concept behind peer-to-peer lending (I describe it to friends as “E*Bay for loans”) is that the company (Lending Club) acts as the middle man for lending between people.  Borrowers post a request for money, then lenders “bid” on how much they’ll loan that person, and at what interest rate.  Say I ask for a loan of $100 and Mike offers $60 at 12%, Squawkfox offers me $25 at 8% and the Canadian Capitalist offers me $75 at 10%.  The loan will be arranged at 8% 12% 10% between Squawkfox & CC (Mike will have been underbid) and myself.  Lending Club handles the loan documents, processing payments and discharging bad debts (so neither the lenders nor the borrowers need to understand the full legality of lending money – the company takes care of that).

Lending Club makes its money by taking a cut of the loan when it’s issued then taking a small portion from every payment.

Initially my friend and I put in $250 each, quickly loaned this out and were happy to see our account value growing from the high interest rate (and consistent repayments).  I congratulated my friend on how skilled we were in evaluating borrowers (since we hadn’t had a single default or late payment) and suggested we leverage her strong credit to borrow money from Lending Club to re-lend (with friends like Mr. Cheap, who needs enemies?).

Come August 2006, we borrowed  $2,500 and were quickly able to lend it out again.  We decided to pour all the repayments into early pay off of the debt (and were talking about starting lending again once the debt was repaid).  Projections looked good, and I was bragging to my friend (and other people I told about the concept / website) how we’d be making money unless there were a massive number of defaults.  On the forums, people were happily cackling about how much cash they were making and we were all patting ourselves on the back for getting in on such a good thing early.

Of course, that’s when the massive number of defaults hit.  Some lenders had talked about the insanely low rates that had been offered in the early days of Prosper (when there were far too many lenders and loans got bid down to very low rates).  Of course, we’d all done the exact same thing (and just didn’t realize it at the time).  Some new lenders were bragging in the forums about how skilful they were that they hadn’t had a single late payment or default (after two whole months!) and the old guard started to warn them to just wait, they soon would.

In April 2009 we paid off the last payment on our $2,500 loan (which had MOSTLY been covered by debt repayments, but we’d had to transfer in small amounts to cover it twice).  We put a total of about $660 into the account, and it’s currently valued at $318.62 ($234.91 in loans, some of which will probably default, and $83.71 in cash).  This is a LOSS of 48% 52% over 3 years.

Of the 50 loans we made, 12 have been paid back, 20 have been charged off (defaulted and sold for pennies on the dollar to a collection agency), 14 are current (payments up to date) and 4 are past due (and VERY likely to be charged off, two are heading to bankruptcy and I’m pretty pessimistic about the 3rd, which is 3 months late).  The one person that REALLY burned us was a fire fighter who had excellent credit, borrowed the money and never paid a single cent towards it (to me this was clearly fraud).

Some might argue that we must have been scraping the bottom of the barrel for loans, but this wasn’t the case.  Our portfolio was a mixture of A’s, B’s and C’s (we avoided people with lower credit scores).  We also ruled out people who had gone through bankruptcy or had a number of delinquencies on their credit report.  In spite of this, we had MASSIVE defaults BEFORE the financial crisis hit.

Another friend borrowed a few thousand from Prosper to start a business and got an excellent rate and got the loan more easily than getting a comparable loan from a bank (and at a very decent rate).

In summary, I would say first and foremost that investing with Mr. Cheap is almost always a bad idea (I should start a hedge fund and you can all short it!).  Peer-to-peer lending is an exciting concept, but the risk is currently being mispriced (in my opinion).  The rational response to this is to use these service as a BORROWER, not a lender.  If enough people do this, perhaps these services will get better at pricing risk and a fair reward will be offered for the risk the lenders are accepting.

Peer-to-peer lenders include Prosper and Lending Club in the US, Community Lend here in Canada and Zopa in the UK.

Other resources

• Lending Club – Why I Chose Not To Invest
• Investment Recommendations for Friends,
• Canadian Peer-to-Peer Lending
• Is Lending Club Bankrupt?

At the end of this post there will be a technique for getting a MASSIVE ROI on your investment.  Truth be told, this can be pushed a little further and get an infinite ROI.  Much like having to eat your vegetables before desert, you’re not allowed to skip to the end of the post (and if you do, in fact, do so, I guarantee it will make baby Jesus cry – baby Mohammed and baby Moses will be rather annoyed too, but they aren’t the crybabies Jesus is).

I’ve written before about how important I think measurement is.  To just go by your gut in the investment world is INSANE (I guess this would be called gambling).  The pendulum can swing too far in the other direction where people start believing that metrics provide more information than they really do.  One example of this is the much maligned Value at Risk (VAR) which has been said to have lead to the subprime meltdown.    I don’t feel that VAR as a measurement is inherently bad, or that CDOs are evil (to me that’s like saying a rock is evil, what does that even mean?).  I just think both were misused in ways that lead to very large problems.

Many rookie real estate investors are attracted to the idea of “no money down”.  They’re focusing on one particular part of the deal (the downpayment) and judging the ENTIRE deal by it (lower is better).  The deal must be judged as a whole, not just by one factor (it is VERY easy to lose LOTS of money on a no money down deal, in fact it can be easy to argue that they’re pretty hard to make money on).  In the linked-to article, John T. Reed argues that profit is a better number to focus on than the down payment.

Even focusing on profit has many pitfalls.  Say I offer you a deal that’ll give you a 100% profit in 1 week.  Sounds good?  The only catch is there’s a 99% chance the deal won’t be completed and you’ll lose your entire investment along with the profit.  Still interested?  Say you want a high EXPECTED profit.  Fair enough, I’ll offer you an expected profit of 25%:  I’ll give you a 25% chance of earning 4 times your life savings, and a 75% chance of losing everything (you’ll have a networth of zero).  Interested?  If you’re reckless and ARE interested in this deal, how about if we set the pay off date as 75 years in the future?

With dividend stocks, it’s often enticing to look at the yield and get greedy imagining the higher pay-offs with larger yields.  Of course, the stocks usually have a high yield for a reason – the market doesn’t feel the dividend is secure.  With companies like Bank of America, the yield was sky high, right before it was cut.  With companies like Washington Mutual it kept going up and up:  until it was cut to $0.01 right before they went bankrupt.

There’s a line from “get rich quick” circles where you say to a seller “You name the price, I’ll name the terms”.  This will get stupid people interested in doing a deal with you so they can get “top dollar” for their property.  The sad truth is, ANY purchase price can quickly be made into a bad deal with certain terms (and offers must be evaluated based on the price AND the terms).

So finally, thanks for your patience and for not making baby Jesus cry, here’s the punch line.  In order to get a 49,250% ROI on an investment, find a fast food restaurant that charges it’s employees for their uniform.    Buy two uniforms for $40, then work there for 40 hours a week for minimum wage ($9.50 in Ontario) for 1 year.  After earning the $19,760 you’ll have an ROI of 49,250% (19700/40).  Feel free to buy two more uniforms in your second year working there and do it again!  To get an infinite ROI, just work at a place that doesn’t charge you for the uniform.  Wow!!!