Leveraging investments

Leveraging existing assets or borrowing to invest is an advanced strategy that can substantially enhance wealth accumulation and provide diversification and tax optimization. For high-net-worth (HNW) investors, the disciplined application of leverage can potentially convert opportunities into notable gains, provided the associated risks are meticulously managed. 

This article examines the primary advantages of borrowing to invest and leveraging existing assets, with a particular focus on how these strategies can be effectively integrated into a well-diversified portfolio.

Maximizing Returns

The potential to amplify returns is one of the most compelling motivations for leveraging investments. Typically, an investor might borrow capital at a relatively low interest rate to invest in asset classes expected to yield higher returns. The difference between the cost of borrowing and the return on investment—commonly called the spread—can lead to enhanced profitability.

For instance, if an investor borrows at a 4% interest rate and allocates the funds to a portfolio of high-quality stocks or real estate expected to generate 8-10% annually, the resulting 4-6% spread can produce marked gains, especially when applied to a considerable amount of capital. Over time, these gains compound, further accelerating wealth accumulation.  

This spread may be larger than it appears, once you take into account the tax effect of leveraged investing. When an investor borrows funds and uses them for the purpose of earning income, the interest may be deductible for tax purposes, provided that the borrowing is arranged properly. This tax effect means that the out-of-pocket cost of interest may be lower than it appears. 

Returning to our investor from above, imagine they borrowed $100,000 at that 4% interest rate, arranging with their advisors to ensure it is tax-deductible. They would pay $4,000 of annual interest to their lender, but their income for tax purposes would be reduced by that same amount. This would reduce the investor’s bill by the amount of tax they otherwise would have paid on that $4,000. For an investor in Alberta in 2024 at the top tax bracket of 48%, this deductible interest may reduce their tax bill by up to $1,920. After considering these tax savings, the investor in this example would have an out-of-pocket cost of borrowing as low as 2.08%. Of course, the investor will also owe tax on the income generated from those investments.

Enhanced Portfolio Diversification

Diversification is a fundamental principle of risk management in investment portfolios. Borrowing to invest offers a method for achieving diversification without necessitating the sale of existing assets, which could otherwise trigger capital gains taxes or disrupt a carefully balanced portfolio.

Let’s say an investor with a significant concentration in a particular sector seeks to diversify into other sectors or asset classes. Borrowing provides the capital required for this diversification without the need to liquidate the original position. This approach enables the investor to maintain exposure to preferred assets while spreading risk across a broader range of investments. This strategy is particularly advantageous for investors with concentrated wealth in categories such as stock options or real estate.

Strategic Use of Margin Accounts

Margin accounts offer a flexible solution for investors to borrow against the value of their existing investments. For HNW individuals, this can be an effective tool for managing liquidity without selling assets and incurring capital gains taxes. With the new capital gains inclusion rate that took effect June 25, 2024, the benefit of deferring capital gains taxes may be higher than before, especially for corporate investors or individuals who regularly realize large amounts of capital gains.

As an example, an investor might use a margin account to borrow against a diversified stock portfolio to finance a new investment or meet a personal financial obligation. The borrowed funds are readily accessible, providing immediate liquidity and allowing the investor to retain their original investment positions. This strategic use of leverage enhances financial flexibility and supports more dynamic portfolio management.

Not all investment firms are able to offer margin accounts to their clients, so investors should check with their advisors as regulatory constraints will vary.

Maintaining Liquidity While Expanding Investment Opportunities

Borrowing to invest allows investors to broaden their portfolios without compromising liquidity.

To illustrate, an investor may want to engage in a private equity transaction or acquire a significant real estate asset without liquidating other investments. By leveraging existing assets, the investor can maintain their liquidity position while capitalizing on new opportunities. This approach ensures that the investor has access to cash for unforeseen needs or additional investment opportunities while continuing to build wealth.

Risk and Return are Related

While leveraging investments can significantly amplify returns and enhance diversification, it’s important to acknowledge the associated risks. These risks, though manageable, include the potential for magnified losses if the investments underperform, particularly in volatile markets. Moreover, securities are often used in consideration of the leverage, and oftentimes, a creditor can call a loan or ask for margin when investments fall—this is usually an inopportune time to be selling and raising cash. However, for HNW investors with a well-diversified portfolio and a strong risk tolerance, the strategic use of leverage can still be a powerful tool for wealth creation, provided it is applied with caution and under the guidance of experienced advisors.

Conclusion

For investors with a strong risk tolerance and a well-diversified portfolio, leveraging can be a highly effective tool for wealth creation. However, it is critical to collaborate with experienced financial advisors who comprehend the complexities of leverage and can tailor strategies to align with your financial goals and risk profile.

Ultimately, leveraging investments is not merely about boosting returns; it’s about making informed, strategic decisions that strengthen your overall financial position. When implemented with precision and discipline, leverage can be a powerful instrument in the pursuit of sustained wealth and financial security.