Today another guest post by reader Sander. He already reached FIRE and is currently enjoying his newly found time. We met a short while ago for lunch. Yes, this was one of those “let’s meet complete internet strangers for coffee” kind of thing. Sander is a smart guy, and so is his investment strategy. I like it and asked if he could write a post (or two?!) about it. He didn’t disappoint! Today we are going to look at “Getting Rich by Using Other People’s Money!”
We already featured some other interesting guest posts too, including:
- The pension shuffle
- Where are the weird FIRE folks
- Why you company is not a great place for financial growth
- Hacking the 4% rule
Don’t be shy with your feedback!
Getting Rich by using other People’s Money
You gotta love this title, don’t you? It’s what we do when we focus on real estate investments. We lend money for let’s say 3%, charge a rent of 5% and keep the difference as a reward. I we lend half the amount needed, this raises our ROI from the original 5% to 7%, which is a considerable raise.
When you are in real estate, this is normal. In fact, most real estate investors I know try to raise their leverage as high as possible in order to maximize their return on capital.
I’ve been investing for years, and I always found this leveraging very appealing, since it can really raise your return on investment. But, alas, I am not a real estate kinda person. The hustle of fixing things, renters not paying me, looking for new tenants, I don’t know. The returns are appealing, but the hassle sure isn’t for me.
But a very big advantage of real estate investing is the leverage. Now I’m a former banker, so I know a few things about leverage and the risks associated with it. On top of that, I am an active investor in bonds, stocks and options.
I came up with an answer how I could make use of leverage, without having to turn to real estate. It’s a bit of a long story, but the essence of what I do is easy. I will try to shed some light on it.
My goal is a portfolio which yields income, just like a real estate portfolio. I need a steady yearly income, so I can use that for living expenses.
Step 1: create a portfolio which yields income
I analyze the stock market and pick three categories for this income.
Of course, many hours of researching, analyzing, reading etc. have gone into selecting the individual stocks within each category. I am willing to share insights with people interested, but for the sake of simplicity I will only give a hint of flavor:
- High dividend stocks: think ING, Aegon, Amsterdam Commodities, Ahold, Royal Dutch Shell, Ishares Stoxx small 200, Ishares Euro Dividend.
- Real estate: think Eurocommercial Properties, Vastned, Wereldhave, Realty Income, Simon Property group, Think Global Real estate.
- High Yield: think Rabo ledencertificaten, Achmea 6% 2006 perp, ASR 5% 2014, Ishares $ high yield corp bond, Ishares JP Morgan EM local gov bond.
Choosing carefully leads to a portfolio yielding around 5%. This is nice, but I don’t think real estate lovers are excited yet about this ROI…
Step 2: Creating leverage
This is where the magic happens!
Where real estate works with very cheap mortgages, I found a way to even cheaper leverage stock market investments. In fact, the average interest I currently pay on my leverage is 0,22%. I could elaborate on the way I create this leverage, but I will also leave that for now. I will just say it’s not for everybody: you need some assets in your broker account. Let’s say around 50k. If you’re interested, leave a remark, perhaps I could write a second article about the ‘how to-part’. (Editorial Mr CF: yeah, you should! I hate cliffhangers).
If I use 100% leverage against my initial investment, I take out a loan of €500.000. The costs are €1.100 euro per year (0,22%).
With this €500k, I just double my portfolio:
The net result is €50.000 minus €1.100 funding costs is €48.900, which is a net result of 9,8%. Now this sound attractive, doesn’t it? This sounds like an income you could live from…
Have in mind that this takes not into account the fact that the stocks in portfolio might rise, which they most probably do over time. Of course, there is also a risk of lower assets prices, which makes a good bridge to the risks associated.
Yes, of course. No pain, no gain. No risk, no return. Risks are not bad per se, but they need to be carefully analyzed and managed as good as possible. So what are the risks?
- Stock market risk
- Margin risk
- Interest risk
- Other risk
Stock market risk is the biggest risk
A bear market could really hurt, so bear in mind to pick stock with a low beta and a low drawdown to minimize the risk. Since I’m a banker, I tend to overallocated in financial institutions, because I understand them. This would, however, not be my advice to others. Boring is good. Pick Unilever, Royal Dutch Shell, Ahold.
The more leverage you use, the smaller the stock part should be. The risk of a real bear market is just too big.
Margin risk is related to stock market risk
The leverage I take out makes use of margin in my stock broker account. This means they keep an eye on the risks of my portfolio versus the value of the assets. It’s a complicated calculation which they use to calculate the risk. In fact, I also use their values to manage my risks! However, their margin calculation can indicate I need to sell stocks when the markets are down. This is of course something I want to avoid at all costs, so I keep a buffer to keep me from harm.
Keep in mind that there is also a liquidity risk here, which also effects the margin risk. In bad times, it could be difficult to sell your stuff.
Interest risk: Like I said, I was a banker…
When you take out a loan, the interest is floating or fixed for a certain period of time. This is called the duration. When you invest in bonds, they also have a duration. The more those two durations differ, the more you are open to interest risk.
For example, the duration of the Rabo Ledencertificaten is even infinite, so beware of a short loan to cover them. If the interest rises, the cost of your loan rises, while the yield of the asset is fixed, hurting your income real bad…
Other risk could be whatever
For example a policy change at your broker, changing the margin policy. This could mean you need more cover. There could also be some kind of fraud in one of the companies you are investing in, or even your broker.
Smart use of leverage could really boost your income. This is a common practice in real estate investing, but I would also recommend this for other ways of investing for income.
There are risks associated with it, and therefore it should only be used by people who know what they are doing. In my opinion, every investor should know the ins and outs of his investments, and even more so if there is leverage used. This goes for stocks, bonds but also for real estate investing.
I feel the reward outweighs the risks, but be aware of what you’re doing. Debts can be harmful, for all kinds of investing, also for real estate!
For those who are interested in the follow up, please check this post!