Leveraged Investments – The Risks

This is the second post in the “Leveraged Investments” series. Check out the first post entitled “Leveraged Investments – My Grand Plan” .

Two main assumptions for the success of my leveraged investment plan are –

  1. Interest rates staying at reasonable levels and
  2. Steady dividend increases.

Although the interest rate is tax deductible, if interest rates increase, the interest amount (the interest payment minus the tax deduction) payable goes up as well and this results in a lower profit or higher loss for the investment plan.There is certainly some room for interest rates to go up and I can still make money but if they get too high and aren’t matched by offsetting increased dividends then the plan won’t be profitable.The other problem with increased interest rates which I’ll cover in great detail tomorrow is cash flow.If I borrow too much and then interest rates increase then my personal cash flow will be affected which I would like to avoid.

I can’t do much about the risk of increased interest rates affecting the profits of this plan other than perhaps locking in the loan for a longer period of time.As far as the interest rate risk with respect to cash flow – I need to make sure I don’t borrow more than I can handle.

There are many other risks involved with this plan:

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.

Investment diversification:Having only Canadian dividend stocks in your portfolio is not very diversified.This risk I can mitigate by treating the leveraged portfolio as part of my regular investment portfolio which is quite a bit larger and I can adjust the asset allocations accordingly so that the diversification is not an issue.

Capital gains:At the conclusion of this plan I’ll want to sell the stocks at a (great?)profit.If the dividend increases go according to plan and interest rates are not too high at the time of selling then this shouldn’t be a problem.However if interest rates are high and someone can earn 9% on a GIC then it’s hard imagine a stock that only pays 3% being worth a whole lot.All I can do with this one is to be flexible on when I’m going to sell.If I have a five or even ten year period in which to wind the plan down then that should help avoid high interest rate periods.

Equity risk:All equities are risky investments.The Canadian banks and other large successful companies are probably less risky than most but there is still risk involved.I believe the Canadian banks in particular are pretty safe but there is no guarantee that they will still be around in 25 years.Things that could change are the laws about Canadian bank ownership – if foreign banks are allowed to come in to Canada and compete then that will negatively impact the big five.Another thing that could happen is a one time event like a trading scandal that sinks a bank.It happened to Barings (subject of another post) and it could happen to any of the Canadian banks.

Other factors:This plan requires negative cash flow for the first several years so what happens if I end up unemployed for a long time or have to take a lower paying job?I might be regretting this plan if it’s hard to make the payments.Sure you can always sell the equities but what happens if the stocks are underwater at the time you want to sell?Also, the tax rebate won’t be as high if you are in a lower tax bracket – or are in no tax bracket at all which will change the economics of the plan.

Policy change:What happens if the interest deductibility rules change?What if dividend taxation rules change?These would have a huge impact on my plan.

Another point – if you are thinking of buying another house (upgrading) in the next decade or so and will be borrowing a significant amount to do so, then this plan might work against you because of the debt involved. I don’t know how banks treat investment loans but I would assume it would reduce the amount you could borrow for a mortgage although I guess it would depend on the value of the equities as well. In my case we’ve already moved out of our “starter” homes and won’t be upgrading for the forseeable future so it’s not really an issue for me.

Some of these risks are not all that likely and are hard to manage other than to keep the investment loan amount to a level which will allow me to be able to handle unforeseen situations.

Obviously there are a lot of potential risks to this plan but for most of them it’s hard to say how likely they are, which is why in my mind the big two (dividend increases & interest rates) are the ones to watch most closely.

Tomorrow’s post will deal with calculating how much I can comfortably borrow.