You can get different results for supporting or against borrowing to invest, depending on the time period you choose. But if we go back to 1935, the average long-term prime rate in Canada was around 6.6%. Canadian equities represented by the TSX returned 9.5% per year. The S&P 500 in the US generated an annualized return of around 11%, including reinvested dividends.
At first glance, borrowing to invest in stocks seems logical. But most investors wouldn’t invest 100% in stocks. Adding bonds and other fixed income securities would reduce returns. The deduction of investment charges and transaction costs would reduce returns. Introducing potential bad behavior from investors or advisers, such as high-priced or low-priced, could also limit bottom line earnings.
Real estate is a much more difficult asset class for which to identify historical returns. This is largely explained by the fact that the return is based not only on price appreciation, but also on net rental income. Rents are not tracked the same way historical dividends are tracked for stocks.
Real estate may be a better investment in which to borrow to invest than stocks, bonds, mutual funds, and ETFs. There are several reasons for this. One of the biggest is that real estate is less liquid. If stocks fall, you can panic and sell with just the push of a button. Selling real estate takes a lot more work and it can deter gut feelings.
Real estate is also less volatile. Stocks fall about three out of ten years, while real estate typically goes up in value. As such, it is a more stable asset class.
Finally, rents generally reflect the cost of ownership plus a profit to the owner from supply and demand, and income appreciates over time, aligning fairly well with inflation. There can be significant differences in rent-to-market ratios in different cities, with some areas of Canada currently relying much more on capital appreciation than income. Low rents and high market values should be a red flag for local investors, but the economics of owning a rental property are generally well suited to the leverage of a leveraged buy, regional anomalies aside.
Borrowing to invest can help increase returns if you time things right, but market timing can be as much luck as it is skill. Leveraged investing, regardless of the investment purchased, is better in the long term rather than the short term. Market efficiency has a way of punishing the average short-term investor and rewarding long-term investors in the process.
Jason Heath is a Fee and Advisory Only Chartered Financial Planner (CFP) with Objective Financial Partners Inc. in Toronto. He does not sell any financial products.