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Financial Literacy Month: Borrowing to Invest

When asked about borrowing to invest, 53% of Canadians missed the basic math.  

Ian Tam, CFA 17 November, 2022 | 4:28AM
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The Ontario Securities Commission Investor Office recently commissioned a study to understand the financial literacy of Canadians. In a questionnaire to Canadians, a series of 27 multiple-choice questions were asked. On average, investors answered just over half (53%) of the questions correctly. In this weekly Series, we answer some of the questions and explain why they’re important.

Question: You invest $500 of cash and borrow an additional $500 to buy $1,000 worth of stock. If the value of the stock drops by 50% and you sell it, approximately how much of your $500 in cash are you left with?
Answer: $0
(47% of Canadian investors got this correct out of 2500 respondents)

The key concept that Canadians are missing here: when you borrow money for something, you owe that original amount back to the lender regardless of what you use those proceeds for. In the question posed by the OSC, the investor owed $500 to whomever they borrowed from. After a 50% decrease in the stock price, the investor’s original $1000 market position is only sold for $500. Meanwhile, the investor still owes $500 to the lender, leaving the investor with $0 after repaying the debt. If on the other hand, the stock had doubled in value, the investor’s position would have been worth $1500, which represents a much higher growth rate compared to not borrowing to invest.

This concept is called leverage. Borrowing to invest is a lever that in effect magnifies your returns and losses. Levered investments will grow faster but also fall harder.

What Should You Do?

For the above reasons, conservative investors need to think twice before investing using leverage. Leverage can be built into investment products. For example, some ETFs track a multiple of an index or commodity (ex. 2X S&P 500 Bull or 2X Crude Oil ETFs). These products use leverage via exposure to derivative instruments like futures contracts and are meant to be held for periods of less than one day. Leverage can also be used as an active strategy amongst liquid alternative funds, which prior to recent rule changes were generally sold to accredited investors. Finally, leverage can also be created by the investor by borrowing to invest.  

Re: Mortgages & HELOCs
Canadians who aspire to homeownership will likely need to borrow to make this a reality. Qualified borrowers might also be able to obtain a line of credit against their home (known as a Home Equity Line of Credit, or HELOC), allowing them to borrow against their own house for whatever purpose. Investing these proceeds is essentially the scenario described in the OSC’s skill testing question.

All this said, leverage can be a useful tool for certain skilled investors to magnify exposure. For most Canadians (or at least 53%, according to the survey results), leverage is likely not the answer.  

This article does not constitute financial advice. Investors are always urged to conduct their own research before buying/selling any security. 

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About Author

Ian Tam, CFA  Investment Specialist at Morningstar Canada. 

 

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