Below, a link to an article from the Canadian Investment Review archives (Winter 2003). It examines the impact of leverage in a diversified portfolio over the long-term. If you’re thinking of introducing leverage into your portfolio, the long-term perspective could be interesting. If not, you might enjoy a bit of nostalgia in the Nortel discussion up front:
Introduction
Margin loans to Canadian investors totalled approximately $8 billion in the first half of 2002, and exceeded $10 billion at the start of 2001. This enthusiasm for leveraged investing is due to potential magnification of bull market profits. However, there is considerable risk from greater losses when stock prices fall. The technology sector has provided painful lessons to investors in recent years.
One prominent example is Nortel, which quadrupled in value from fall 1999 to its record highs above $120 in summer 2000. Investors buying on 50% margin approximately doubled their profits before interest charges. But, in the two years following its peak, Nortel plummeted to less than $2 per share by summer 2002. Buying Nortel on 50% margin in 2001 produced losses of almost 200% for investors who held the stock throughout the decline.
While this example highlights the risk inherent in buying a single stock on margin, it does not shed any light on how leverage affects diversified portfolios in the long run. If the stock market continues to have a long-term upward trend, as in the 20th century, leverage may increase investors’ profits.
Our research examines the risks and returns on diversified Canadian equity portfolios when margin is used throughout long periods, such as 10 or 20 years. How much leverage is prudent to use? What are the chances of underperforming a more conservative strat- egy? Should the asset allocations vary across different long-term horizons? This study provides answers to these questions. Read the full article.