Using leverage to invest: How to think about it

Using a line of credit to borrow against, or leverage, a liquid securities portfolio may not have crossed your mind, especially if you’re a more conservative investor.

Why do some investors consider leverage, and some do not? Simply put, here is the math: If the expected return on a portfolio with leverage would be greater than the cost of borrowing against it with a line of credit, leverage could make sense as part of a long-term investment plan.

Despite that rates will fluctuate, they have come down in recent years and corresponding borrowing costs are relatively lower, making the use of leverage more inexpensive.

Why consider employing leverage? Conventionally, a portfolio-based line of credit may be used to stay invested while accessing cash to fund liquidity needs, such as tax payments. Another possible reason—as we explore—is to increase your overall investment exposure.

Using leverage is both a financial and a personal decision. Here are four fundamental principles to help guide the decision-making process. Leverage generally should: 

1. Align with and support an investor’s financial objectives, and be thoughtfully integrated with a wealth plan
2. Be applied in the appropriate wealth buckets, such as for long-term growth
3. Be implemented at a level designed to help achieve your broader ambitions
4. Result in a level of portfolio risk and potential return that closely matches the time frame of investor’s goals

Building on that foundation, let’s consider how a prudent degree of leverage would have made sense for investors with a range of risk appetites.

Could portfolio leverage be appropriate for some investors?

With an investor’s portfolio of stocks, bonds or other liquid assets, there may be the ability to borrow against those assets, typically up to 50% of their value (or more).¹

A wealth plan is typically built with short-term liquidity and long-term investment buckets. A liquidity bucket is designed to ensure enough cash is available to manage lifestyle requirements and near-term obligations.  A long-term bucket is meant to help grow or preserve wealth, to meet future goals.

For most clients, we don’t recommend using leverage on the liquidity portion of their portfolios. That should remain lower risk, since preserving these assets is usually a top priority. We suggest considering leverage for longer-term assets allocated to long-term purposes, like building a legacy or pursuing ongoing growth, because that part of a portfolio is typically better positioned to weather fluctuations. Those assets generally may have more time to recover from any drawdown.

How to think about implementing leverage

Employing leverage increases the volatility of a portfolio’s returns—on the up and downside. To illustrate how much, we’ve looked at how portfolios have performed historically, and the impact leverage would have had. Let’s take, for example, a 60% equity and 40% fixed income portfolio (a 60/40, or traditional, balanced indexed portfolio) and look at the results of using leverage to reinvest and increase exposure to the portfolio.²

Our historical analysis found that over the past 30 years, investors could have employed up to 60% leverage on a 60/40 portfolio,³ and it would have increased its return, at the cost of increased volatility. However, beyond 60% leverage, returns actually would have gone down. That’s because drawdowns in the portfolio’s value can become so drastic that recovering lost value is difficult.

Leverage beyond 60% on a portfolio over the past 30 years would also have risked margin calls⁴ along the way, requiring unplanned forced sales of portfolio assets. Forced sales would have disrupted the asset allocation strategy and might also have created taxable events.

So how much leverage, historically, could have been employed on a portfolio without any risk of a margin call? Our analysis looked back as far as the Great Depression. We found that if one had implemented 15% leverage on a 60/40 portfolio at any time the market was at a peak, at no point would a margin call have occurred, even during the worst peak-to-trough decline.

The same analysis found that an investor with a more aggressive 80/20 portfolio could have implemented 10% leverage, and one with a more conservative 40/60 portfolio could have employed 20% leverage, and neither would have had a margin call if they’d invested at a market peak, anytime since 1929.

The power of interest deductibility

An investor may ask, if the goal is higher expected returns, why not change a portfolio allocation from, for example, a 60/40 to an 80/20? It’s true, that could lift expected returns with a higher degree of equity exposure (and volatility). But changing allocations wouldn’t provide another aspect of leverage that we haven’t discussed yet: deducting interest.

When a taxable investor with non-tax exempt securities in their portfolio uses the proceeds of a line of credit to invest in taxable securities, the interest they would pay as a borrower may be deductible. That deductibility could have a meaningful impact—and often may be more advantageous than adjusting portfolio allocations. The interest expense they pay may offset the taxable income the investments generated (and possibly reduce other taxes that might need to be paid). Over time, tax savings may improve after-tax returns. Tax considerations vary based on each investor’s individual circumstances, and investors should consult their tax advisor.

Comparing leveraged versus unleveraged performance

Leverage does increase the volatility of a portfolio’s value, so at times a leveraged portfolio may produce better returns than an unleveraged portfolio, while at other times it may worsen them.

Over the last 30 years, our historical analysis found, a 60/40 portfolio with 15% leverage outperformed an unlevered portfolio 64% of the time, with a median outperformance of 0.4% annually. This result varied widely over time, however. Cyclicality is a feature of markets and the reason we suggest leveraging over a time horizon of five years or more: It helps mitigate the risks of volatile, disappointing  returns due to market timing.

Consider leverage size, aligned with your goals

Prudent levels of leverage may have a place on one’s balance sheet. When an investor carefully considers portfolio risk allocation, tax implications and risk tolerance, leverage can be a powerful tool to consider in how they plan for achieving long term portfolio goals.

We can help

Your J.P. Morgan team can help you think through whether thoughtful and disciplined use of leverage, grounded in clear understanding, could support you in achieving your financial ambitions.