For those paying a close eye on the stock markets, prices of many stocks that we may be tracking may look attractive right now. In fact, Singapore’s benchmark Straits Times Index (STI) is down close to 19% in the year-to-date, while, in the US, the S&P500 is down about 11%.
To take full advantage of the current market slump, we have the option of leverage investing or margin financing – where we borrow money to invest in high quality or high dividend-paying stocks. Moreover, interest rates are at a really low point currently and may go even lower as global economies try to combat the economic fall-out from COVID-19.
At the end of the day, we have to realise that with higher returns, come higher risk – the leverage or margin facilities that our brokerage provides us earns them a fixed return, while returns in the stock markets are never fixed and we are bearing that risk.
While the notion of profiting on funds we don’t actually have can be appealing, we have to go in with our eyes open to the potential risks that lies ahead. We can think of many ways this is a good idea, but here are 10 possible pitfalls we may also encounter.
#1 You Pay Interest On Money You’re Borrowing
When we borrow money for our leverage investing strategy, we have to pay an interest. This can range from about 3% to over 6% per annum, depending on the brokerage we use and how risky our investments is going to be. Often, brokerages will have a separate list for blue-chip investments and offer a lower interest for these companies.
If our investments do not yield a return equal to or higher than the interest we have to pay, it will end up being unprofitable. In the current highly volatile market environment, even professionals will find it is hard to predict winners, let alone retail investors like us.
We also have to pay the interest on a regular basis, while our investments may not increase uniformly or distribute dividends for some time.
#2 Your Losses Are Magnified When Markets Move Against You
When markets go up, we stand to gain by earning a return on funds we don’t have. Similarly, when markets go down, we have to withstand larger losses as well.
While this sounds straightforward, when such an event occurs, it may take the wind out of our sails. With a $100,000 portfolio, a 10% decline will mean our $100,000 becomes $90,000.
Using leverage, the same $100,000 in cash will give us a portfolio worth about $350,000. A 10% decline will mean our $100,000 becomes $65,000.
Many will say it’s just maths, but we need to do the maths and be willing to take on that risk.
#3 Potentially Face Margin Call, And Need To Cough Up Even More Cash
Once our $100,000 crashes down to $65,000, we will face a margin call.
Let’s say we are able to leverage 3.5 times our cash value. That’s how our $100,000 buys us a portfolio worth $350,000. When the markets crash 10%, our portfolio will only be worth $315,000.
3.5 times of $65,000 is $227,500 – that means we need to stump up $25,000 more in cash to maintain our current portfolio at 3.5 times leverage, or we need to sell down our portfolio to that level.
Read Also: What Past Market Crashes Can Teach Investors About The 2020 Crash That We’re Currently In
#4 You Might Not Profit Even If The Market Recovers
There is consensus that the markets will eventually recover. It’s just the “when” that no one can be sure of.
Worryingly, we face the possibility of getting margin called at any point and not being able to continue stumping up cash or having to pare down our portfolio. And, given the volatile nature of the markets currently, the chance of it happening may not be that low.
So, while we may be right in the long-term, there’s no guarantee we can actually hang on to our leveraged portfolio to realise the gain.
#5 Markets May Trend Sideways For Some Time Before Rising
Even in a good case scenario that markets stop being so volatile or dip, it may trend sideways for an extended period of time. All the while we have to continue paying interest on our borrowed funds.
With no returns to speak of, we may let go of it to avoid having to keep paying a hefty interest.
#6 You’re Unlikely To Hold The Shares All The Way Up
In the best case scenario that markets spike upwards, there’s a really good chance we will not hang on to the shares for a long period of time.
Psychologically, if we use leverage, it’s hard to imagine daring to ride it all the way up. Once we see some decent returns, we will likely sell off the position prematurely. If our portfolio climbs 5%, our $100,000 becomes $117,500. Selling gives us a cool 17.5% return. We may miss out on long term gains over the next few years on the stock if we held on to our leveraged position or even just invested our cash into it.
Worst still, after prematurely selling and losing out on potential long-term gains, we may also be tempted to repeat this strategy multiple times. After a while, it only takes one or two crashes to wipe out our gains and even decline into steep losses.
#7 Stocks May Get Taken Out Of Margin List
During a downturn, individual companies can become affected due to poorer business or cash flow, especially if they are operating within a particularly hard-hit industry. This can lead to certain stocks being taken off the “margin list”.
If we are invested in these companies, there is an uncertainty that we can suddenly get margin called have to pay the entirely portfolio in cash if we want to keep it.
#8 Stocks Could Be Reclassified Into A Higher Risk Category In The Margin List
Even if our stocks aren’t taken off the margin list, it may get moved from a safer list into a higher risk category for leverage investing. There is an interest rate risk here. Some brokerage may charge a rate as low as 2.9% per annum for their “blue chip” list, and a lot higher interest for more risky companies.
#9 Companies May Reduce Dividend Payouts
It’s not far-fetched to assume that companies will see their revenue and profit levels drop, especially if COVID-19 drags on. This will affect their ability to continue paying attractive dividends.
It may also be prudent for companies wanting to keep a stronger balance sheet with more cash rather than paying it out to shareholder in case they encounter difficulties during the downturn.
If we are intending to fund our interest payment or are putting other plans into place with expectations that we will receive dividends from the companies we are investing into, we may be in for a rude awakening when companies reduce dividends. We’ve already seen REITs slash their distribution by 80% in view of the coming difficulties.
Read Also: Income Investing: How To Select The Right Stocks To Build A Sustainable Dividend Income Stream
#10 You’ll Be Impacted By Fund Raising Actions Taken By Companies
The longer the current downturn drags on, the higher the probability that companies come under financial pressure. To mitigate this is not take on more debt or cut dividends, however, some companies may need to raise cash from shareholders in order to continue operations.
When companies have a rights issue to shareholders, investors need to participate, often at discounted prices, in order not to be diluted.
For investors who have invested in such companies with leverage, they may face a situation of not being able to participate in the rights issue, and may have to divest or have their stake in the company diluted.
Understand The Pros And The Cons Of Leverage Investing
Seeing only the potential upside, we may be lured into leverage investing. Detailed above, there are many ways we may end up worse off if we employ such a strategy.
That’s not to say we should not embark on leverage investing either. Done right, leverage investing can be really profitable and make a marked difference to our portfolio value. What we need to do is understand both the positives and the risks involved, not to over-leverage ourselves, and not to invest based on a hot tip or greed – we need to put in the hard work of researching the companies we are investing in.
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