By Tom Bradley

Over the last couple of weeks we’ve met with two prospective clients who were dealing with unpleasant situations related to investment loans. In one case, the loan proceeds were used to purchase mutual funds with deferred sales charges. (I haven’t quite got my mind around this. What do you think? Should this be allowed?)

These situations prompted me to address the broader topic of borrowing to invest. I’ll get right to the point. It should only be done in two circumstances:

1. By individual investors who are short the money to make an RRSP contribution, but can pay back the loan or line of credit within six months.

2. By sophisticated, well-healed investors who understand the worst case scenarios and will not abandon the strategy when hit by a severe market blow.

I know Investors Group and some of the banks are active in promoting this activity and I think it’s totally inappropriate. These institutions are preying on human nature (greed) and playing to investors’ greatest weakness (short-termism).

Investing is tough enough as it is. Most investors don’t deal with negative returns and hysterical headlines very well. Indeed, there’s overwhelming evidence that investors (in aggregate) behave badly at extreme points of the market cycle. There’s no doubt in my mind, the pressure of an underwater loan lowers the chances of a successful outcome and makes the consequences of an unsuccessful outcome more damaging.

To make matters worse, a bulk of these loans are issued after stocks have done well and go primarily to investors who have the least wherewithal, financially and psychologically, to manage a leveraged portfolio.

We borrow to buy everything these days, but using credit to buy investments is different. It’s waaaaaaaaaaaaaaaaaay harder.

Postscript: Subsequent to meeting the investors mentioned above, I read an article in the Investment Executive magazine. It pointed out that compliance officers at the Investment Industry Regulatory Organization of Canada (IIROC) are now focusing on ‘borrowing to invest’ programs and finding an increasing number of inappropriate strategies.

In the same article, there was a chart showing the growth of margin debt. The level of client debt outstanding at IIROC dealers is now back to its pre-2008 peak of $16 billion (this doesn’t include bank loans). Interestingly, the chart tracks the stock market very closely – i.e. less debt at market lows and more at market highs.