Every month I buy stocks (index funds). Normally I buy stocks for aprox. 2500 – 3000 $ every month. But what if I use leverage to buy some extra stocks every month as well? Would I become faster financial independent then?
As I write this my index fund portfolio is worth 149.000 $ USD.
Out of these 149.000 $, 36500 $ is leveraged. Which means that 25 % of my portfolio is leveraged.
Leverage ratio: 1,25 : 1
In my country (Norway), I can leverage my stocks for 2,19 % interest rate. To qualify for 2,19 % there is some criterias that has to be met:
-The stock loan has to be lower than 40 % of my total loan value (the loan value is 80 % of total value). My current stock loan is 30,5 % of my total value.
-If I meet these criterias (which I do), I qualify for 2,19 % interest rate. If some of the criterias isn’t met anymore, I’ll head up to 4,44 % interest rate.
Comparison – invest 1,25 : 1 leverage vs. non-leverage in a 10 year period
To do this experiment we need to make some assumptions. I will use:
– 7 % annually growth of the stocks
– I buy stocks for 3000 $ every month in the non-leverage example
-I buy stocks for 3000 $ + 2500 $ (leverage) = 5500 $ every month in the 1,25 : 1 leverage example
-The interest rate is 2,19 % right now, but let’s use 3 % (since it probably will raise in coming years).
-Current stock portfolio: 149.000 $, which 36.500 $ is leveraged.
Table 1: Comparison of a 25 % leveraged portfolio vs. no use of leverage in a 10 year period.
As you can see, we end up with much more using leverage in a 10-year period. But we have to subtract the 3 % interest rate which also compounds over the period to see the real difference.
2500 $ / month for 10 years with 3 % interest rate = 349.000 $. This means that our leveraged investment is actually worth: 1.251.405 – 349.000 = 902.405 $.
The leveraged investment is worth 902.405 – 818.693 = 83.712 $ more than the non-leveraged portfolio after 10 years.
Comparision – 1,25 : 1 leverage vs. non-leverage in a 20 year period
I use the same assumptions for this example as the last one. Here’s the results:
Table 2: Comparison of a 25 % leveraged portfolio vs. no use of leverage in a 20 year period.
-Results after 15 years: 2500 $ / month for 15 years with 3 % interest rate = 567.000 $. This means that our leveraged investment is actually worth: 2.168.000 – 567.000 = 1.601.000 $.
The leveraged investment is worth 1.601.000 – 1.376.000 = 225.000 $ more than the non-leveraged portfolio after 15 years.
-Results after 20 years: 2500 $ / month for 20 years with 3 % interest rate = 821.000 $. This means that our leveraged investment is actually worth: 3.467.000 – 821.000 = 2.646.000 $.
The leveraged investment is worth 2.646.000 – 2.164.000 = 482.000 $ more than the non-leveraged portfolio after 20 years.
Comparison – 1,25 : 1 leverage vs. non-leverage in a 30 year period
I use the same assumptions for this example as the two previous examples. Here’s the results:
Table 3: Comparison of a 25 % leveraged portfolio vs. no use of leverage in a 30 year period.
-Results after 25 years: 2500 $ / month for 25 years with 3 % interest rate = 1.1115.000 $. This means that our leveraged investment is actually worth: 5.308.000 – 1.115.000 = 4.193.000 $.
The leveraged investment is worth 4.193.000 – 3.283.000 = 910.000 $ more than the non-leveraged portfolio after 25 years.
-Results after 30 years: 2500 $ / month for 30 years with 3 % interest rate = 1.456.000 $. This means that our leveraged investment is actually worth: 7.919.000 – 1.456.000 = 6.463.000 $.
The leveraged investment is worth 6.463.000 – 4.869.000 = 1.594.000 $ more than the non-leveraged portfolio after 30 years.
Thoughts about a leveraged portfolio
As my examples show, there is no doubt that leveraging your portfolio is a smart thing to do (in theory).
Most investors that got superrich in their life has used some kind of leverage.
But is it a smart to invest with leverage for “normal” persons like you and me? Let’s see on some important factors you have to consider before doing this.
A portfolio with 1,25 : 1 leverage will be wiped out if the market falls 80 %.
Example: Your portfolio is worth 125.000 $, which 25.000 $ is leveraged. If the market drops 80 %, you only got 25.000 $ left. And that is 25.000 $ you owe the broker. You either have to insert more money to your account (margin call), or admit that you lost your money.
And even if a 80 % drop is rare, I’m here to tell you that it actually happened before. In 1929 the Dow Jones dropped 90 % ! Can you see it on the figure under?
So if a 80 % drop would occur, you either have to say goodbye to your money, or put in more money in your account. Risky!
But let’s be realistic.
Would you manage to go down with the market all the way down to 80 % ?
Or would you sell off earlier? At a 30% drop? 40 % ? 50 % ? 60 / 70 % ?
Criterias that has to be met for having a stock loan
On top of that you have to follow a set of criterias / rules if you’re having a stock loan.
For example: My broker, Nordnet, gives me 2,19 % interest rate. But only if I meet the following criteria: The stock loan has to be lower than 40 % of my total loan value (the loan value is 80 % of total value).
Okay, that was though to understand. Let me give you an example from my own portfolio.
Explaination: My portfolio is worth 149.000 $ right now (this is my total value). But 80 % is the maximum loan value, this means that my current loan value is 119.200 $. The stock loan has to be maximum 40 % of the loan value: 119.200 $ x 0,40 = 47.680 $.
In other words, I can’t leverage my portfolio with more than 47.680 $ if I want 2,19 % interest rate. If I leverage more than 47.680 $ my interest rate will go up to 4,44 %.
My current stock loan is 30,5 % of my total loan value (36.500 / 119.200 $).
Here’s the point: I mentioned my stock portfolio could drop 80 % before I’m wiped out, but another risk is to get a higher interest rate from the broker if my portfolio drop as little as 25 %.
Example from my portfolio – Stock loan: 36.500 $, Total loan value: 119.200. The market suddenly drops 25%. My total loan value is now: 119.200 × (1 – 0,25) = 89.400 $. My stock loan is still 36.500 $, which means that my stock loan is 40,8% of my total loan value (36500 $ / 89.400 $). Then I have to pay 4,44 % interest rate. Which is a lot more than 2,19 %.
As you can see this can be the difference between sucess and failure for investment returns!
Your annual return may vary a lot more than the historical 7 % return everybod refer to
In my assumption I use 7 % interest rate every year. But we don’t know how much the market will return every year. If you’re really unlucky you could go a whole decade with negative or zero returns!
If this happens in the starting years of your journey, the probability of a margin call is high. And in a bad market your interest rate from the broker will be higher.
Since you don’t know how the market will look in the future, it is highly possible you will lose a lot of money by investing with leverage.
Figure 1: This could be you!
The stock loan interest rate copies the market interest rate
My interest rate for the stock loan is now 2,19 %. But we’ve all heard that the market interest rate will raise in the coming years.
What if the interest rate creep up to 7 % in 5 – 10 years? If my annual stock returns is still the same this will be a losing strategy.
What if I have 349.000 $ in stock loan after 10 years (as my example showed), and my portfolio tanks 30 % ? And maybe the stock loan interest rate is almost 7 % ?
The normal thing to do would be to sell off stocks to get rid of the 349.000 $ in leverage, because the strategy isn’t profitable anymore. But then I would have to accept a huge loss of money as well!
As I mentioned earlier, would you go down with the market all the way if it drops 80 % ? I know most people wouldn’t!
It is easy to write posts about how to handle the market in good times and bad times. But how you actually react when you see those red numbers month after month is a totally different story.
Before you even consider leveraging your portfolio you have to think through how much risk you can handle.
Let’s assume you got a portfolio with 150.000 $ in index funds. How would you feel if the market plunged? Is 10 % okey ? What about 40 – 50 % ? How would you feel if your portfolio suddenly only were worth 75.000 $ ?
Would you still relax and pretend as nothing happened? Maybe you would search around on the internet looking for “confirmation bias”-articles? Articles that tells you that market meltdowns are common and is a part of an healthy market economy.
See table 4 under and think about when you would pull out of the market. Would you go all the way down? Or would you sell off earlier? Be honest with your self. You really have to think through this if you consier using leverage.
How many of my readers would tolerate a 80 % market meltdown? It’s easy to say you will, but it’s a totally different aspect in practice.
For myself, I think I would second-guess my investments if the market tanks more than 50 %.
It doesn’t matter how many times I’ve read JLCollinsnh’s Stock Series and his line “The market always goes up, not every day, not every month, but in the long run”.
When the stock market drops much, I can’t help it, but I really doubt my investing skills. Even if it is totally normal that the market tanks now and then.
Using “confirmation bias” in bad times is a perfectly normal thing to do for every human being.
Table 4: Starting portfolio of 150 k $ and amount left if a market meltdown occurs.
“It should be impossible to lose money in the stock market, but because of our human psychology most people lose money in the stock market”
I showed you what my portfolio look like, and that I already am leveraged 1,25 : 1 in the stock market. This article considers the possibilities of using leverage as a way to reach FI faster.
And as my comparison examples show, you could earn a lot of money this way. You could be superrich.
After 10 years you could have 83.000 $ more in your index funds with using only 25 % leverage. After 20 years you could have 482.000 $ more, and if you pass 30 years doing this you would have insanely 1.594.000 $ more with using a small amount of leverage (25 %).
Will I follow this path and leverage 1,25 : 1 all the way? Probably not, because I think the risk is to high with my broker. If the market drops by only 25 %, my stock loan rate will increase from 2,19 % to 4,44 %.
The market interest rate may also increase in the coming years, and this means smaller profits using leverage. Maybe you will lose huge amounts as well because you have to sell off stocks to get rid of the leverage. Life happens, and suddenly you may need to liquidate your money.
In the stock market you’re exposed for risk. Using leverage you are increasing this risk. You have to ask yourself if you’re comfortable with that.
Using leverage as a strategy to reach FI faster is not for you if you:
-Don’t want extra risk
-Do not have extra cash in backhand in case of a margin call
-Don’t want to lose a (potentially) huge amount of money
-Do not know how to handle your emotions during a market meltdown
-Want a smoother ride to FI
In general I’m positive to a small amount of leverage ( 1,25 : 1 ) if it is used right and if you’re aware of the extra risk. I’m not afraid of debt, if the interest rate is relatively low, I will have debt as long as I can get higher interest rates in stocks, real estates etc.
In case you still wonder, I wil reach FI aprox. 1 year earlier with this strategy. If you’re route to FI is farer away you will shave off even more years!
I’m not done thinking through this strategy with leverage, and this article is meant as an experiment for my self and my progress to FI. I already know about a person that failed using 2 : 1 leverage, read more about his journey here as a warning for why you shouldn’t try this.
Let me end this article in the words of Morgan Housel: “One study I remember showed that young investors should use 2x leverage in the stock market, because – statistically – even if you get wiped out you’re still likely to earn superior returns over time, as long as you dust yourself off and keep investing after a wipeout. Which, in the real world, no one would actually do. They’d swear off investing for life. What works on a spreadsheet and what works at the kitchen table are ten miles apart.“
What do you think about this article?
I would love to get in contact with readers that is leveraging their stock portfolio. Please share your experiences in the comments section or contact me at post@route2FI.com !
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