The difference between good debt and bad debt
Even though debt is constantly frowned upon by most individuals, debt isn’t always as bad as many people make it out to be. Debt can do good things for governments, good things for corporations, and, more importantly, good things for you. The key is to use borrowed money to increase your wealth (good debt), not to squander it on financial freedom sucking maggots (bad debt).
What is leverage?
Leverage is borrowing money to invest. This strategy makes sense when you expect the returns from the investment to be greater than the cost of the borrowed money. Every successful corporation uses leverage. In fact, by the end of 2013, the value of the U.S. corporate bond market was close to $10 trillion. That’s $10 trillion being put to work to help corporations earn even more money. And if you want to achieve financial freedom, sooner rather than later, you need to consider borrowing to invest as well.
This is especially true if you are comfortable assuming more risk in order to go after larger returns. As discussed in the previous page on Investments, leverage has the effect of amplifying an investor’s return. As such, it can enable you to reach financial freedom many years earlier. Without using a strategy involving leverage there would have been no way for my wife and I to retire in our mid-thirties.
This being said, the truth is that any amount of leverage is more risky than no leverage at all. As previously discussed in Investments, not only does leverage have the effect of magnifying gains, it also has the effect of magnifying losses. The risk of larger losses means that leverage is not for the faint of heart. If you can’t sleep at night knowing you have increased your risk for larger losses, you think you may sell all your investments after a short-term loss, you refuse to diversify properly, or you risk more than you can afford to lose, then you should not leverage yourself at all.
Leverage, risk and reward
Most investors who are looking to earn higher returns don’t ever use leverage. Instead, they just buy riskier investments. This might be a mistake. Despite the possibility for higher returns, these investments often come with substantially higher risk. This means that investors who adopt this strategy might not be getting the best risk-adjusted return. Let’s examine why leveraging yourself with a diversified portfolio of less risky stocks might be a better way to go after a higher return. Before we do so, however, we will need to define the difference between high beta stocks and low beta stocks.
Stocks that experience price changes greater than the market as a whole are defined by academics and investment professionals as high beta stocks. These stocks, because of the higher variation in their returns, possess more risk than the market as a whole. Moreover, because of this risk, investors expect a higher return from these investments. In contrast, stocks whose prices are less sensitive to market ups and downs, when compared to the market as a whole, are said to be low beta stocks. As opposed to high beta stocks, investors are usually willing to accept a lower return for holding low beta stocks due to the fact that they are less risky.
Many investors that seek out higher returns often simply buy high beta stocks. If we were to ask Nobel Prize winner, Harry Markowitz, about this strategy, however, and examine his Nobel Prize winning work around Modern Portfolio Theory (MPT), we might come to a different conclusion.
MPT suggests that the best way to earn a high return for a low amount of risk is to buy a diversified portfolio of quality investments and then leverage yourself to buy even more of this diversified portfolio. Moreover, recent research has also confirmed that leveraging yourself to buy low beta stocks such as large, financially stable blue-chip companies that pay regular dividends, has historically offered higher risk-adjusted returns compared to simply buying high beta stocks.
The secret to Buffett’s success
A 2012 article in The Economist, titled “The Secret of Buffett’s Success,” written by Andrea Frazzini, David Kabiller, and Lasse Pedersen, makes the claim that borrowing money to invest in low beta stocks offers superior returns on a risk-adjusted basis than investing in higher beta stocks. The authors of this article claim that using leverage to buy high quality companies is the reason that Berkshire Hathaway has been so successful. The authors concluded that between 1989 and 2009 Berkshire Hathaway, on average, leveraged its capital by 60% and found that this leverage significantly boosted the company’s return. The authors also highlight the fact that Berkshire Hathaway was able to borrow money at fairly low costs, thanks to its AAA rated debt. The ability to borrow money at a low cost, as one can imagine, is one of the key success factors for using leverage.
I discuss leverage in detail in my book, Think Like a CEO and Get Rich. Borrowing to invest in both real estate and a portfolio of solid dividend paying stocks is one of the major reasons my wife and I were able to achieve financial freedom at a young age. We were able to borrow money at a relatively low rate and then we invested it for higher profits in proven long-term investments that generated steady monthly income. Moreover, much of that monthly income received favourable tax advantages.
Click on the link below to read more about taxes and how minimizing them will play a large role in achieving financial freedom at a young age.