Open Book #2: On Borrowed Time
Can leverage turn £5k a year into £150k -- safely?
It is the ultimate irony that the best way to get rich is to already be rich, and use that unfair advantage to get richer.
But the only other way I know is to take advantage of the growth available from compound interest.
Investors tend to want to optimise over time. And so the question becomes: can I use leverage — borrowed money — to amplify my gains?
It was the tool that wrecked my early investing prowess. As I discussed in Open Book #1, borrowing money from a broker to trade with leverage got me into a terrible mess.
I had to scrape for years just to get back to zero. But ignoring risky options, or intraday1 trading using ‘margin’ — another word for borrowing money to juice gains and losses — is there another lower-risk option? I want to take a small proportion of my overall six-figure investing portfolio and see what the results could be.
In the wake of the the 2008 stock market crash, Warren Buffett did an interview with CNBC.
“Let me give you a figure that will blow your mind,” he said. “I bought my first stock when I was 11 years old. It cost me $114.75. It was the first quarter of 1942. If I had put that $114.75 into the S&P 500 at that time and reinvested the dividends, what would it be worth today? $400,000 — in one person’s lifetime.”
In that multi-decade period, the market has fallen many times, the headlines have been uniformly terrible, suggesting we should all panic and sell everything we own.
The Pitch (and The Data)
Most investing professionals tend to suggest that the best way to make money work for you, rather than the other way around, is to dump as much cash as you can into an index fund tracking the biggest market in the world. This is the S&P 500 ETF2, a product that tracks the performance of the 500 largest companies in the United States. It is often considered the cornerstone of most successful long-term investment portfolios.
ETF is the shorthand for Exchange Traded Fund, a product that gathers together lots of companies into one tradeable asset (a thing you can buy and sell on a stock exchange or in an investment app).
An ETF that is categorised as ‘Accumulation’ — as opposed to its opposite type ‘Distribution’ — means that any income from dividend yields on these stocks is not handed straight back to you but is instead reinvested in more shares of this ETF. This way, we can achieve compound gains.
The 2x Leveraged Version
If I am looking at a long-term investment for compound growth, with no intention to sell, does it make sense to use a leveraged version of the S&P 500 ETF? After all — it is not me borrowing money to trade. It is the asset manager operating the ETF. These products can be held in tax-free ISAs, like Stocks and Shares ISAs or Lifetime ISAs.
If the S&P 500 goes up by 9% in a year, an S&P 500 ETF should rise 9%. A 2x Leveraged S&P 500 ETF would rise by 18% while a 3x Leveraged S&P 500 ETF would rise by 27%.
If the S&P 500 instead falls by 12.5% in one year, an 2x Leveraged S&P 500 ETF would fall by 25%, while a 3x Leveraged S&P 500 ETF would fall by 37.5%.
For a sense of perspective, we’ll look at Sir John Templeton3, who is often lauded as the iconic example of the contrarian investor: a man with clear sight (and balls of steel) who bought the entire market when the world was ending.
For a more down to earth comparison I also spoke to my friend, the trader Michael Taylor. Michael runs Shifting Shares and Buy The Bull Market and is one of the sharpest people I’ve ever met.
The Lifetime Bet
Say, for example, you are like me, and you have a Lifetime ISA, and about 10 years to play with.
The annual allowance for this UK tax-free investment product is £4k per year4. There are three really wonderful things about it.
1. No tax on income or capital gains
When I come to sell I won’t pay any tax on dividend income or capital gains (how much the value of an investment increases over time)5.
2. 25% instant gain every year guaranteed
By depositing the maximum £4k per year the UK government adds £1k. This is simple interest, not compounded. But it’s still free money, available to everyone to open when they turn 18. For me, only starting at 38, there’s £20k of free cash I’ve turned down without even knowing about it.
3. No withdrawals before 55 without significant penalty
This doesn’t seem like a major benefit at first glance. But because cash in my Stocks and Shares ISA (another type of UK tax-free investment pot) is fairly easily accessible, I am more inclined to access it. Without being rich already, the only other benefit I have on my side is the time to let an investment sit, undisturbed.
The Legend
John Templeton was only 29, one year into his Wall Street career, when he made the the bet that would define his life. A July 2008 obituary in The Economist noted: “Sir John revered thrift and had a horror of debt.” Less often reported is that his ‘horror of debt’ did not extend to trading with borrowed money.
On the eve of war in 1939, Templeton borrowed $10,000 — about $500,000 in today’s money — to buy 100 shares each in 104 companies selling at $1 per share or less. Only four turned out to be worthless, and he turned large profits on the others.
He was knighted in 1987 for his philanthropic efforts6. That honour requires serious money. And to me, Sir John’s bet sounds a lot like a leveraged ETF, about 70 years before leveraged ETFs were made available to the average investor.
The Trader
I first met Michael Taylor when I was writing for ValueTheMarkets, a stock-picking website based in London. He’s a tall, funny bloke with a strong Northumbrian accent, and he likes a pint, so he can’t be all bad. Aside from that, it was rapidly apparent he was the most successful trader I would likely ever meet.
On crappy pay at the start of his career, he took a big gamble, borrowing £25k from a bank to kickstart his trading.
Where did his skill come from? He said: “When I was 15 to 18 I played a lot of Age of Empires7. I got pretty good at it — into the top 50 in the world at one point. I think it helped when it comes to trading, as there are exactly the same kinds of pattern recognition needed for success, looking for advantages to exploit.”
And he is just one of those uncommon people who is emotionally well-suited to the extreme uncertainty that comes with trading.
“I think as a trader you need to be comfortable doing things that are uncomfortable. If you’re a people-pleaser or lack self-confidence it’s a difficult business. Most people blow up with leverage. Since 2018 brokers have had to publish the stats: it’s usually 70% of people or more.”
Does it make a difference if it is the fund manager taking out leverage, and not the individual investor? “I don’t use ETFs myself. But in any event, I prefer to manage my own leverage,” he says.
The Experiment
So, with the UK government’s extra £1k per year added on to my £4k, my new investment pot comes to £5k per year.
And the results are in. £5k per year over the last 10 years would have produced:
£103k in an S&P 500 ETF (a compound gain of 8.32% per year)
£145k in a 2x Leveraged S&P 500 ETF (a compound gain of 12.46% per year).
One thing which stands out, aside from the extra returns, is the massive shift in standard deviation: how much an investment value tends to swing up and down around its average price.
For the standard S&P 500 ETF, the figure is 13%. But for the 2x Leveraged ETF, it’s more than twice as much, at 28%.
The Problem
Logically, the 2x Leveraged S&P 500 ETF makes the most sense. When presented with the choice between £145,000 in 10 years, or £103,000 in 10 years, who would choose the lower number? But I have to manage my own wealth-destroying urges.
I explained in Open Book #1 that I have pretty awful impulse control.
This expresses itself in late-night Amazon shopping binges; wolfing down industrial quantities of Haribo; and over-optimistically setting work schedules which are functionally impossible.
I am, unlike Michael, a pretty useless trader. And the real questions I have to answer are not only:
a) How likely is this trade to end in profit, and
b) Do I have the available capital to pull it off, but also
c) Do I have the mental toughness to deal with the ups and downs of the market? Can I actually adhere to a long-term plan if my brain is screaming SELL SELL SELL?
With any long-term investment you are not only battling the market, you are battling your own instincts. In the 2020 Covid stock market crash, the value of my investment in a 2x Leveraged S&P 500 ETF would have dropped 38%. If I’d have invested in a 3x Leveraged S&P 500 ETF — which are available in almost every ISA provider’s app — that loss would be over 70%.
Would you be able to keep ploughing your five grand a year into a massive loss-maker? Into an investment that was worth £35,000 in January but only £10,500 a few months later?
The problem with leverage is not what it is but what it leads to. What Sir John Templeton and Michael Taylor both share (as Michael freely admits) is that they both got lucky. But both seem to have an internal steel I don’t possess, and unless I suffer some kind of unexpected head injury, I never will.
The Solution (for me)
The leveraged approach may suit some readers, but for others, may be the worst financial decision they ever make.
Much as I would love to be able to juice my gains, it probably won’t work for me. I know that. At one point I’d be down 60-70% and The Fear would strike and I’d just sell right at the bottom. This is the hidden cost of volatility.
I’ll leave leverage to those that can handle the emotional strain. I’d love to hear your thoughts on this too.
Intraday trading means buying stocks and selling them within the course of a single day.
This does mean betting heavily on the US, rather than all the other markets in the world. But the S&P 500 has returned around 9% a year on average, compared to 6.5% a year for global stock markets.
It was drummed into me as a young journalist to respect titles (for accuracy) but there are plenty of people with KBEs or peerages I consider to be dickheads, frauds or flat-out criminals. See, for reference, Sir Jimmy Savile. Still, when Queen Elizabeth II died in 2022 I remember being surprisingly upset. She conferred as much dignity and humour as one can onto that admittedly arbitrary title.
Putting £4k into a Lifetime ISA reduces your overall £20k yearly allowance to £16k for any other ISAs you may have, like a Stocks and Shares ISA, or Cash ISA.
Outside of an ISA, the capital gains limit in the UK is £6k a year. If I did go over that amount, I’d have to pay tax on anything extra, and would lose about 20% of my overall total when I came to sell.
Of course, history does not record the results of every other investor who also borrowed half a million to make a trade, and blew up their account. Those bankrupt traders don’t make the Royal Garden Party guestlist.
This is a video game popular with extremely nerdy people like Michael and myself.
This is very interesting and, as ever, clearly expressed, making a complicated subject very accessible. As a 73 year old pensioner it is just a spectator sport for me, but as always with relatively risky investing, there is always 20:20 hindsight and "if only.." is a regularly used phrase. Although generally, a bit like dating, people are happier to talk about their successes than their failures!