Financial Risk in Leveraged Investing

It was really not that long ago when I reported my 1^st year return on investment for my HELOC portfolio which is funded with borrowed money from my Home Equity Line of Credit. ??Up until last month I had been sitting on double digit returns for the year which have melted since then thanks to the recent stampede out of stocks. Isnt that the best time to talk about risks in leveraged investing? I thought I should shed some light on the context of this investment in order to neutralize any??impression that this had been an easy endeavor to embark on. This post will basically discuss the risks that you need to be aware of if you ever decide to invest with borrowed money especially in times of turmoil. Many of us look back to these times??with a wouldve, couldve, shouldve after they have proved to have been great buying opportunities. While playing the armchair general is one thing it is a completely different experience to??personally??participate in a real battle.

Allow me to borrow a historical snippet for comparison purposes when it comes to taking such a step. In 1940, as part of the German campaign in Western Europe, a daring airborne assault was launched against the Belgian fort of Eben-Emael under the command of OberLeutnant Rudolf Witzig. The fort was heavily fortified, manned by a garrison of 1,000 soldiers and commanded the Albert Canal, Belgium’s principal barrier against attacks from the east. In order for the blitzkrieg to succeed, the fort had to be taken out and only 1 weakness was identified. With 85 paratroopers under his command, Witzig executed a brilliant operation by landing his gliders on top of the Fort, disabling its defenses and taking the fort’s 1,000 man garrison as prisoners at a cost of 6 killed and 19 wounded.

Investing with borrowed money is not for everyone; your odds are as good as those of Witzig’s since you will be landing on top of Mr. Market’s fort and you will face a much larger garrison in this case. If your 85 man assault party is neutralized, you still owe for them and potentially for much more.??Read??Fisher Investments news??and press releases to learn more about less risky ways to invest.

Risks ‘ the what ifs

Lets take a look at some of the questions that you should be asking and how I answered them at the time.

The first question to ask would be: What if we had another real estate, stock market or economic collapse? At the time, the odds were very low and it was a bearable risk in my opinion.

When I started my HELOC portfolio the recovery was underway. The European central bank had announced its $1 billion euro bailout fund putting debt worries temporarily to rest and the Fed followed with QE2 not long after. The risk trade was on and it was the perfect time for this venture since interest rates weren’t expected to move anytime soon.

The second question to ask would be: What if I lost my job? The chance of losing my job was expected to be very low until the end of 2011. In the event of a job loss, the odds of total loss were very low as I was slowly netting gains.

Even though investing almost exclusively in oil and gas stocks is viewed by many as suicidal. I kept my risks low ‘relatively speaking’ by sticking to what I understand best, by avoiding investing in drill punts (companies drilling in exotic places with a minor chance of striking oil i.e. lottery tickets) and international players for obvious reasons (Yemen, Tunisia anyone?). I focused and still do on the politically stable Canadian companies which own attractive land and production.

A Personal View

Many amongst you have the following thought and that’s fine:

‘I’d never pull money out of the house to play the stock market.’

But allow me to replace ‘play’ with ‘invest’ since I do not play the stock market. In fact I don’t even play the lottery except in very rare cases. I spend considerable time following up on my investments and would be disappointed if the return did not match the effort that was put into it.

I took a methodical approach to my investment and gradually waded into the market with little amounts at a time. My outstanding HELOC balance is currently $23,500 built up through the following transactions:

Depending on your financial health, $23,500 could sit anywhere between ‘peanuts and a load of money’. In my case it’s a significant amount but I never jeopardized the lifestyle of my family as losing the total amount constitutes a setback of 1 year’s worth on the mortgage; it hurts but it’s not the end of the world. In case the worst happens and I fail in the end losing 100% of my portfolio (possible but not probable), I will gladly look back to this experience because ‘I tried’ and that’s what this investment journal is for. In my opinion, every stock market crash is a rare buying opportunity. As it stands, I am ahead and my portfolio can absorb a significant drop before I get to owe any money to the bank.

Have a plan (what kind of portfolio do you have in mind?), take your time to deploy the money and always make sure you are investing what you can afford to lose. Most importantly, at the point of maximum??pessimism??in the markets, you still need to believe that the world economy as you know it is not going down in flames.

Remember Interest Rates & Taxes

I do not foresee interest rates moving in the short term so I am not worried about rates until the end of 2012. Since the interest paid is tax deductible, I don’t mind Mr. Market paying all of the margin/HELOC fees.

As for taxes, I have plenty of RRSP room because I privilege paying the mortgage with my cash flow. For 2010 I simply contributed an amount equivalent to my taxable capital gains to my RRSP so I did not get to pay any taxes. I still have room in my RRSP for up to 100% capital gains which is highly unlikely for this year. Remember, I need only contribute 50% of my capital gains in my RRSP to neutralize taxes since 50% of gains are taxable to start with. It’s a great way to fund my RRSP account if you ask me.

Consider Your Emotions

You are your own biggest enemy. What you believe is your risk tolerance and your actual risk tolerance are 2 separate things. If you are the type who will lose sleep over your portfolio then this strategy is not for you. If you are susceptible to selling/buying on emotions you might end up exiting the market at their lows and buying at their highs.

Finally, if you ever decide to invest by taking money out of your house, don’t take out an amount that will crush you if your house’s value declines substantially. Keep your expectations real and your greed subdued as there is no easy money in the market.

Please feel free to ask any questions or to share your opinion on the subject.