Leveraged Money is just an Illusion

Now that the situation in Greece is put back on the oxygen mask for a while, I’ve been reading a lot about the potential contamination problems we could face with regards to Chinese market situation.

If you have been following global economic news, you definitely noticed how bad the Chinese market crashed (30% within 2 weeks) after cranking up by 150%. It is fascinating how China manages its finance over the past 10 years. I mean; the country is growing at lightning speed (mind you, its growth speed has seriously slowed down recently) and it seems to find the answer to any economic problem along the way. At one point in time, we even thought China could give some money management lesson to the Americans when they were stuck in the middle of the 2008 credit crisis.

 

The problem is that the Chinese answer has always been “more credit”

The country borrowed to build ghost cities in order to help the country get out of the 2008 global recession. It worked.

The country created a “shadow banking system” to help individuals and institutions finance their projects.

Lately, they have boosted their own stock market by letting brokers open a record level of margin accounts. This is how many investors started their quest to financial freedom by a nice amount due to their broker. They thought that since the market is always up (haha!), they could invest in an overheated market (+150%) without suffering any losses. Even better than that; they will probably make even more money since they were fully leveraged in an *ever* growing market. And this is why we see so many Chinese crying in the news about their losses recently…

 

Leveraged Money is always an Illusion

I’ve been a big fan of leveraged money for many years. I even bought my first house with the profit generated from a leveraged operation in my brokerage account. However, I also learned over the years that while borrowing money to invest can make you rich, it can also drag you down and you may lose more than what you can support.

Leveraged money is not yours and this is what people tend to forget… or tend to fully understand it as they don’t manage this money like it was theirs. This is how excesses in the stock markets are created and bubbles are built.

The concept of a margin account works perfectly as long as the stock market goes up. However, we all know it’s never going to be that way. People start investing, borrow more money and see how big their portfolio can grow. They keep their margin open with a good balance of their holdings due to the broker. Dividend payment can even pay for the margin interest in order to help the investor sleep well at night as he doesn’t even realize he previously borrowed money to invest. Then, one day the market drops and the profit evaporates faster than water in a desert. The investors receive a margin call (meaning he doesn’t have the value to support his loan) and he is forced to sell everything since he never thought it was a good idea to keep money aside to pay off his margin loan. The whole illusion breaks and the investor is left with nothing but losses.

I have a feeling this is what is happening in China at the moment as the phenomenon hits the whole stock market as it is heavily relies on margin accounts for additional liquidity.

 

Doesn’t it mean leveraging is always bad?

I don’t think counting on leverage to support stock market growth is a good idea at all. It definitely creates the illusion that everything is perfect and that the growth is justified when it’s not.

However, it doesn’t mean that individual investors should never leverage money. I think it could be a great tool to create real wealth as long as you have a plan to pay off your margin account before you borrow a dollar. I’ve successfully used leverage in the past using these simple but crucial rules of success:

Borrow what you can pay back. I’ve never borrowed money I couldn’t pay back through a personal loan over 5 years. I was well aware I could lose money while leveraging and this is why I’ve always make sure I was able to reimburse what was owed in a short period of 5 years. This was my way to protect my other assets from bankruptcy.

Borrow only if you have time to invest. Using others’ money to make money is a great idea… as long as you manage this money as if it was your own! Too many investors want to invest borrowed money as fast as possible in order to make money rapidly on the market. It doesn’t work that way. You must remain a patient investor, even though you invest on margin.

Know when you will pay back your investment loan. Paying interest only for the time you borrow works perfectly fine. This is the right way to use the margin as you use the capital to invest and make it grow bigger while the cost of borrowing in terms of cash flow is set to a minimum. However, if you plan on keeping your loan forever, you will eventually hit a bear market and lose a big part of it. I’ve always set a psychological payment date when I borrowed money to invest. My goal was to recover my money and make an additional profit in a specific timeframe. This is how you can finally cash out your profit and walk away with a smile.

Don’t borrow if you have less than 10 years in front of you. This is the last, but probably the most important rule to follow if you want to leverage. Since an economic cycle last between 5 and 8 years, you can’t enter in a leverage strategy if you have less than 10 years before you need this money. If an investor borrowed money in 2005 with a 4-5 years time frame, his results were catastrophic. However, the same investor with a ten year time frame will have a positive outcome from his portfolio. Mind you, in both cases, this wasn’t the perfect time to leverage!

 

Final Thoughts – What is Going to Happen in China?

While I wasn’t much concerned about what was happening with Greece, I’m more concerned about the Chinese stock market. We saw how leveraging busted our own stock market back in 2008 and the same thing could happen in China now. While our systems have flaws, we can say that Chinese stock market is cloudy and it’s very hard to determine what is owned at the moment and how bad the situation is.

For the time being, I will stick with Canadian and US stocks and will definitely not consider emerging markets!

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