I was listening to an episode of Joshua Sheat’s Radical Personal Finance podcast this week. He highlighted the story of someone who began investing in real estate in the late 1990’s and accumulated twenty rental houses over the course of a decade. However, they were unprepared when the housing bubble burst in 2008 and the Great Recession began. The end result was bankruptcy, divorce, and the loss of nearly 15 years of compounding. This story presents a great example of how leverage can destroy your life.
Debt is a pre-requisite to bankruptcy
The use of leverage in investing becomes a problem simply because it introduces debt into the equation. Debt is not necessary to be a successful investor. It is possible to save money regularly each year, invest it wisely, and end up a millionaire without ever incurring debt in the process. When you only purchase your investments with cash, you eliminate the ability for events outside of your control to ruin your investing journey. However, a black swan event can lead to ruin when debt is involved.
Leverage is one of the reasons that real estate investing in particular is so attractive to the average person. The ability to put down a 5% down-payment on a house, let’s you reap the benefits of rising housing prices well in excess of your actual cash investment. If the value of your house rises by 10%, and you put down a 5% down payment, you reap a 200% return on investment. Without leverage the gain would have been only 10%. However, leverage can also work against you on the downside. If your house value drops by 10%, then you face a 100% loss, and you owe more money on the house than it’s worth. This is very dangerous.
In the situation highlighted on the podcast, the guest repeatedly bought houses with low down payments. Then, used the gains of rising house prices to then buy additional houses. Instead of reducing risk over time, they maintained a high level of risk due to the leverage present. When they could no longer make debt payments, they had to declare bankruptcy. Had they instead owned rental houses without any debt, it wouldn’t have been possible to go bankrupt.
Avoid leverage use with investments
There are times where leverage is unavoidable. For most people, buying your first house will involve the use of a mortgage to pay for the property. This is normal, and you’ll benefit from leverage as long as you have a mortgage on the property. However, a personal residence is not an investment. Your investments should not be places to have or maintain leverage, because the value of investments can fluctuate wildly. A 50% drop in the value of your investments is a normal occurrence in the stock market. Someone who owns their shares completely in cash can continue to collect dividends and ignore the market price. However, use of leverage would lead to wipe out.
My recommendation is to never use margin under any circumstances in your stock investments. I wouldn’t even hold your investments in a margin eligible account, because you add additional risk to your investments. In real estate, using debt is mostly unavoidable when getting started. However, real estate leverage should be reduced in a focused manner to avoid the chance of bankruptcy. You should only have to get rich once. It’s hard enough as it is, so don’t make it any more difficult than it needs to be.
Do you have any thoughts or questions on the use of debt in investing? Share your thoughts in the comments below.