Borrow to invest, not to buy on tips: prudent use of structural leverage offers many advantages

Money Digest, June, 2000 by David Karas

Is margin investing bad? In itself, absolutely not. Virtually any large purchase most consumers make involves borrowing money from someone. The problem is situational leverage as opposed to structural leverage.

Situational leverage is when you invest in an asset or product because it has momentum, you heard a hot tip, it went up, you have a hunch, or it appears that everyone else is getting rich off of this turkey so why not you!

Structural leverage is completely different. Structural leverage employs four concepts: tax reduction, capital gains, deferred future gains and full asset utilization.

A case in point: If you are at a 50% tax level, and you borrow money at 8% to invest (much higher than you would have to pay), the net cost to you is 4%. This means that you only have to make 4% to break even, the point of neutrality. Breaking even in the bad times is what it is all about.

If you borrow for an investment such as a mutual fund, the taxes on the gains of the fund are deferred until you sell the fund (bring it back into income). Yet, you get a current deduction from your income tax for a deferred gain until you chose to move the money back into your income. As you get to choose, you can ensure you do not bring it back into income until it is advantageous to do so.

When you use structural leverage investing, follow these principles:

1. Never borrow for individual stocks; always instead borrow for pooled funds.

2. Always diversify your holdings by 10. Ten different funds, 10 different managers, 10 different asset classes, and 10 different management styles.

3. Routinely take profits on your borrowed funds and reallocate the money back into alternative investment classes and managers.

4. Live in fear of your own prophetic wisdom. Do not trust the newspapers; trust your managers.

5. Be a slight contrarian. Always believe this is not going to last which will force you to realize profit, and not get married to a holding.

6. Do not be afraid to increase your leverage in a market decline, as long as you invest in the area that is different from where you are currently.

Prudent use of borrowed funds can add to your investment success. I can prove mathematically why most investors should employ some sort of leveraging during their life. Actually, most do, as leverage is employed if you have a mortgage on a house.

If you choose to use leverage in your wealth accumulation plans, ensure you get the full advantages that leverage provides, including tax deferrals, tax deductions, and full asset allocation.

Much of the advantages from structural investing do not require you to take significant risk in the type or style of investment to make a substantial improvement in your financial life over a long period of time.

A final piece of advice: get help from a competent financial planner who does this type of work regularly over a long period of time. Ask for referrals; do not just take their word with respect to their competency in this area.