Debt makes the world go round. We need it to buy our homes, otherwise we’d be saving forever to have enough money to buy it outright. Business’s need debt to get started and to expand. But when it comes to investing, we are increasingly reading stories of investments where investors have the value of their investment wiped out completely. There are usually property related but not exclusively so. And the common denominator is debt, also known as leverage or gearing.
When there is a downturn (and there always is, we just don’t know when or what it will be) and you see your investment fall, you just need to give it time to recover. Leverage changes that dynamic.
Using leverage can supercharge your returns. You put in €100,000 but you get the returns of €200,000 or more, depending on how much you borrowed. Of course, this debt has to be paid for and the capital paid back in the end. If you get your timing right you can make super level of returns on your investment. How much? Let’s see how much using a number of different scenarios:
All of the investments are made for 10 years with an annualised return of 8% per annum (the brochures always promise an 8% return). The leveraged investment pays interest on the loan of 5% which is deducted from the investment each year. The capital sum is paid back at the end of the 10 years. As you can see, leveraging up can make you a lot of money…as long as returns stay positive.
We know that markets don’t go up in the straight line, there are ups and downs along the way. The higher the amount of debt you have, the more sensitive your investment is to falls in value and the higher the risk of you losing all of your money.
I looked at the fall of the average Irish property fund in the last property crash from April 2007 to March 2009, which 27.18% per annum or -46.13% overall. What would happen if that crash happened again to your money? We looked at the results if the crash happened 4 years into the 10 year investment term. Other than the two negative years, every other year returned 8%.
With no debt, your investment would have almost equaled the value of your initial investment. In fact, after the 11th year, it would be worth €106,002. If you had borrowed the same amount as you initial investment, you would have gotten back less than half of what you invested. And if your investment borrowed two or three times your investment, your money would be gone.
Leveraging your investments isn’t restricted to property deals. We saw people’s money wiped out in the ACC Bank Solid World Bond cases and Sean Quinn famously lost his fortune by using Contracts for Difference, with him having to borrow €2 billion to settle his position, which lead to his bankruptcy. More recently, Bill Hwang of Archegos Capital leveraged up $200 million to be worth $20 billion, which went to $0 in 2 days because he was over leveraged.
Growing wealth takes time. Leveraging up your investment can speed up that process…if things go well. If there is a bump in the road along the way, you can lose it all. Which would you prefer, to be told that you need to keep your money invested for longer or be told that it was all gone?
14 June 2021