Saturday, December 8, 2012

Cheapest Leverage

You know why buy & hold investing is more profitable for most investors? 
·         you don’t try to time the markets;
·         you don’t sell and buy during crashes and booms;
·         you collect and reinvest your dividends;
·         and you’re a natural value investor. 

But there is one other reason that most of us forget. You have the cheapest and most efficient leverage anyone can dream of!
“Excuse me?  , but I don’t borrow money when investing in stocks.” you may say.  My response: “Bullocks!” First of all,  a true “Buy & Holder” has the cheapest leverage an investor can get except maybe for insurance companies such as Berkshire Hathaway. But why not use borrowed money just like in real estate? More about that in a future post.

"Godfried, how can you claim that a Buy & Hold investment implies the use of leverage?"   The answer is that you borrow from the government interest free!  Let me explain… but first I need a coffee. Oh and you better take some time off this morning so you can soak this incredible idea in! Because it will take some explaining… at least 3 or 4 paragraphs J – but make sure that you will never forget this again!  Beat it into your skull with a baseball bat – but not too hard otherwise it may be the last thing you’ll ever remember.
When your investment appreciates and you sell it to lock in your profits, you also lock in profits for someone else. Yep, for the government! Because when you sell you pay capital gains taxes both to the provincial and federal governments. In Alberta you will pay 0.5 x 39% or 19.5%; in other provinces you’ll pay more. Furthermore, you’ll pay close to 19.29% (on Canadian dividends in Alberta).  So let’s do a spreadsheet calculation.
Case I: you’re a high flying trader and every deal you do is profitable and you make not just 1% but you make on average 12% per year. You are one of those guys that always brags about "Buy & Hold" being dead and you're the best thing since the invention of apple pie!
Case II: you’re an average investor who invests for dividends (3.5% per year) plus appreciation (6.5%)  or a total return of 10% by investing in underperforming Canadian Banks (yeah, right!). But you NEVER sell. Let’s do this for 15 years.
Here are the results for a $10,000 initial investment:
Click on image the magnify

So there you have it. On an after tax basis, the “Buy & Hold” investor can invest much more conservatively than an active trader and still get the same results.  It is as if the government provides you limitless credit for free and for as long as you hold the stock!  This allows you to increase your effective ROI to 12%.  Oh, buy the way; did you notice the effects of dividends on total profits?
The “Buy & Hold” pre-tax profits totaled $27,559 of which $10,523 or 28% came from dividends!

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