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Biblical Stewardship

Risk of Leverage

May 03, 2008

The recent crisis in world financial markets, which has had a negative impact on pension funds and mutual funds* that you own, is a great illustration of the potential risk of leverage. Leverage is defined as borrowing money to increase returns.

Recent crisis. A huge industry developed in the United States known as sub prime lending which included lending more than 100% of the value of a home often to individuals with less than stellar credit and job stability at low introductory mortgage rates. In the beginning of 2007, the US economy was slowing down and interest rates were increasing which resulted in more and more of these mortgages in default. These mortgages, packaged as financial instruments known as Asset Backed Commercial Paper, were bought and sold. Investors, many of them large financial institutions, who bought these financial instruments, are now realizing that they are only as good as the underlying mortgages they hold and are dependent on borrowers making their payments.

When is leverage a good thing? Many of us have used leverage to purchase a home or a car; others have used leverage to buy a business or rental property. Below are some guidelines in using leverage.

  • The Bible provides much advice about money. One of the key principles is to work towards being debt free.
  • There is no free lunch. The maximum risk free rate of return is around 4.5%. Any investment that promises a higher return carries with it some degree of risk.
  • Buyers beware. Understand the range of volatility of an investment and realize that using leverage increases the potential gain or loss. If an investment with a range of volatility of -10% to +20% in any given year loses 10% and if the cost to borrow the funds was 5%, the investor will be down 15%. In this scenario, an investor who invested $100,000 would be down $15,000.
  • Debt is still debt and needs to be paid off even if you can write off the interest.
  • Have a full understanding of the underlying investment...complicated is not always better. Warren Buffet, one of the world’s richest (financial) individuals is a proponent of not buying a business (investment) unless he fully understands it. Even full time money managers with large financial institutions have made mistakes as evidenced by the recent financial crises described above.
  • There are no shortcuts to saving and investing for retirement or any other goal. No investment strategy is likely to compensate for a client who is simply not saving enough in the first place. Good savers need thoughtful advice, patience and discipline to achieve their investment goals.
  • Finally, a cliché that is especially relevant: "If it sounds too good to be true it probably is."

 

*Mutual Funds are offered through Credential Asset Management Inc. Unless otherwise stated, mutual fund securities and cash balances are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer that insures deposits in credit unions.

®Credential is a registered mark owned by Credential Financial Inc. and is used under licence.


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