One very interesting comment that was posted last week following my post about leverage was a question about using leverage/debt to increase the size of a dividend portfolio. The question surprised me quite a bit. Not because the idea of using debt was so unique but simply because I thought this subject should be discussed much more and I’m surprised to not have read more about it. So not only did I decide to answer with a complete blog post but I also asked Mike to give out his thoughts on The Dividend Guy Blog, which you can also read (after reading here of course, ha ha).

The Concept

The idea behind this is very simple. If you are able to get access to credit at 1.5% to 2% for example, would it be smart to use that in order to invest in a dividend portfolio that could generate 4% of dividends? In this low interest rate environment, it’s certainly a question worth asking. There are many different points to consider but here are my thoughts on the idea.

Pros

–Using “other people’s money” in order to make more money is not a new concept but it never gets old. Why? Because using leverage can significantly accelerate how much passive income you will be able to generate.

–Dividend stocks are very liquid and while it’s not ideal to have to sell them, especially if you can’t control the timing, knowing that you can do it makes a big difference compared to leveraging yourself

–More monthly cash flows: As I discussed in last week’s newsletter (sign up here if you’ve not already done so!), even in this difficult environment, dividends are still increasing at a very healthy pace so it’s fair to say that by investing into a well diversified dividend portfolio, you should get a very accurate idea of the dividends you will be making. From the perspective of cash flows, you will know from the start if you are making more through this leverage.

–Often Fiscally Advantageous: Depending on how you get the money, it is very possible that you could end up paying less taxes by doing this if for example you end up getting deductions on the interest that you pay on that loan (take the case of a tax deductible mortgage).

Cons

-Last week I wrote about the dangers of leverage and how it is taking down the whole system these days with some governments or companies having put themselves in critical situations where they

–Net Asset Fluctuations: One downside is that owning assets, even fairly stable dividend stocks will expose you to market fluctuations. While the impact on your dividend payments will be fairly limited, the value of your assets will go up and down. So yes, if you leverage yourself, those fluctuations will be more important.

Are You Already Doing This?

I always find it very interesting when some friends say they would never borrow in order to invest, it is just too risky. Really? If you have some debt and are putting money aside for investments, that is exactly what you are doing. If you did not want to use any leverage for investing, you would not invest a single dollar before paying back that debt. I am simplifying things a bit because there are fiscal impacts involved in both having debt (mortgage for example) and certain types of investments. I do hope you agree on the general concept though. If you taking a portion of your money to invest rather than pay back debts, you are choosing to live with more leverage than you would need.

Managing Finances

In my opinion, it’s all about managing your personal finances. How I do it? Let’s imagine that I currently have:

500K of assets
350K of debts

The question becomes, a few months from now, what do I want my situation to look like? Of course ideally, I’d have a few millions of assets and no debt but let’s be real here. Would I prefer having:

600K of assets
350K of debts

or

500K of assets
250K of debts

Both can work out fine but you will obviously build your assets much more quickly in the first case. It all depends on how comfortable you are with the amount of debt vs. assets that you own. I guess we each have our own zones of comfort but personally I would probably go somewhere near the middle of those 2 scenarios.

Ways To Do It

There are obviously three critical parts to doing this operation:

1-Determine Amount Of Debt: Once you are able to determine that amount, you will be able to see how much of the money that you earn should go into building your assets or if you should even take a new loan.

2-Find The Cheapest Source Of Money: I think it’s important to be creative about this. Taking a loan of 3% might be your cheapest method but if you are paying less than that on your mortgage, student loans or others, simply diminishing the amount that you are paying back to invest in your dividend portfolio might be a more efficient way to pull this off.

3-Invest In A Solid/Diversified Dividend Portfolio: Regular readers will not be surprised to hear that the type of portfolio I would use a portfolio built like the Ultimate Sustainable Dividend Portfolio. One major reason is that I prefer investing in a portfolio that is yielding 2.9% but is increasing that payout very quickly with stable, growing companies rather than using debt to buy some higher paying, less stable dividend stocks.  Just think of the idea of borrowing money at 2-3% to buy shares of FTR, which do pay a great yield, but one that is likely to decline in the short to medium term.

Do You Borrow To Invest In Dividend Stocks?

Have you done it? If so, under which circumstances and how is it done? Don’t forget to check out Mike’s take on the subject at TheDividendGuyBlog

I’ve read a few times about Bitcoin, and have certainly found the concept to be very interesting. Then, yesterday, I read more about it in Wired, thanks to a nice post by Fred Wilson. The idea of a virtual currency controlled by a non-government entity is interesting and maybe even fascinating on so many levels. I highly recommend that you read the post by Wired. It’s unclear if this currency will end up succeeding or not, there are many questions regarding how it works, who holds the power and authority, etc. There have also been other “virtual currencies” such as the one used in Second Life, discussions about Facebook credits, etc.

It Will Happen Eventually

I think the concept of having a currency that is more stable, that is able to avoid being used for political or other motives is incredibly attractive. The problem of course is that like any other currency, the concept can only work if enough people are willing to have faith. Most virtual currencies have tried doing that by making it possible to do exchanges for US dollars or other currencies. That is certainly one step, a necessary one. However, I think much more is necessary in order for this concept to work. Maybe we would need an international organisation such as the UN or the IMF to be involved. Or maybe simply having a company big enough to be believed in. But even then, if big banks such as Citibank have shown their vulnerability in the past, how can someone trust that the backing by a large corporation would be able to make the currency stable? I think that would be a big challenge under any circumstances even though as we are seeing these days, even Sovereign nations are from from risk free.

Is Bitcoin the one?

It will be difficult for any currency to prevail in this race. There have been worries about malware stealing the virtual currency, many other unanswered questions. I think there are still a lot of questions regarding the rules for this currency and how it can be used. While Facebook credits or currencies developed by Zynga or Second Life have a clear use, the rules and how those currencies could evolve over time are certainly not as clear.

Would You Invest Right Now?

What if I told you that you get a significantly return by putting part of your assets in an alternative currency such as Bitcoin for 1 year or so? For example, getting a 10% return on a 1 year investment made in Bitcoins. Would you do it? If not, why? I would say that I’m not at that point quite yet but it’s very intriguing to see if virtual or independent currencies will survive the test of time and gain influence as viable alternatives.

Have you seen the photo on the right before? Sometimes I find pictures very inspiring and oddly enough, I found this one very relevant to this blog. You must think I’m crazy. Maybe I am but please hear me out a bit longer. If you have not seen this picture before, it was taken during riots in Vancouver following a hockey game (yes, Canadians do take hockey seriously).

This couple made the news because despite that everything that was going around them, they were able to focus on what seemed important to them, their couple. They were clearly not too worried about stealing from shops or engaging the police like so many others were. That is one thing. The more important thing is that they “remained on task” (I’m sure at the time the task seemed very important) when all hell was breaking loose.

I sometimes feel like so many of us can get carried away when circumstances change. Just try watching financial news these days and you’ll hear all of these world ending scenarios that seem so dramatic. Don’t get me wrong, I think the current issues are critical and could have a big impact on the world economy and financial markets. I do however have a question:

“Did you think that big recessions or market crashes/downturns would not occur?”

I would assume that we all know that investing in the markets means going through a ride that has its fair shares of ups and downs. If it didn’t, the game would be too easy don’t you think? When I think of my dividend investing approach, my tech long & short stock picks and also the long term speculative stocks, all of these approaches are based on using a fairly strict methodology and I know very well that it’s not in my interest to start modifying it to account for market ups and downs.

We all know what happens to those that panic, they usually end up selling near the bottom and then miss the rally that follows. I’m not saying that you should try to determine the bottom and try buying everything you can put your hands on either. I’m saying that it’s important to keep focus and stay on course when it seems like the world is going to end.

How Do I Remain On Course?

–Only invest what I can afford to lose: Investing is great but when you start feeling anxiety about the value of your holdings, it becomes a lot more stressful. I was once told to invest in a way that I can “sleep well at night” and I stick to that.

–Avoid Timing The Market: Trying to invest all of my assets at specific times or taking everything out because I fear a crash is coming would almost always be a recipe for disaster, the odds are much better if I stay on course with my investments.

–Try To See The Brighter Side: In very volatile markets, many investors panic and that creates a lot of confusion in the markets. One of the great benefits is that certain discrepancies start appearing providing great opportunities for those that are still putting money in the market. Also, if you are putting a fixed amount every month or so, you are likely able to buy at depressed prices which will turn out to be a good thing in the long run.

–Diversify My Assets: I’ve said this before but those that stick to only sector in their retirement accounts are crazy. The financial market looked rock solid up until 2008 and then out of the blue, things turned into a real nightmare for investors of companies such as Lehman Brothers, Bear Sterns and many other big firms.

–Not Acting Too Spontaneously: The crisis in Europe certainly has big impacts on should change how I personally invest as well but I think it’s very rare that watching a news broadcast will be enough to start shorting specific sectors or companies, etc. I try to be rational about it all and while I do take decisions based on those news, it’s rarely done right away. Having a few days or nights to think things through is rarely a great idea. It’s not a race.

How About Yourself? Any Thoughts On Trying To Stay Focused In Periods Like These?

I think it’s fair to say that a million dollars is nowhere near what it used to be. Inflation and time have transformed an amount that not too long ago seemed astronomical, impressive and enough to live off of for decades into an amount that many consider merely a beginning to their retirement. Chances are that your “number”, the amount of money you need to save up in order to live at the level that you hope and expect to be is likely significantly higher than $1 million.

Feels Like Such A Difficult Challenge

I know, I know, to many of you, including myself up until a few years ago, reaching the 7 numbers seemed extremely challenging if not impossible. As years go by, it is becoming a lot less of an illusion and feels much more like a milestone that I will reach at some point in the next 2 decades if all goes well.

What Changed?

As someone that writes about dividend investing, technology stock picks, the importance of earning money, I’d certainly love to tell you that the secret behind most millionaires is their incredibly ability to trade and to generate solid and consistent returns. I’d love to tell you that it’s the most important thing in the world. In reality though, it simply would not be true.

It’s So Much More Simple Than That

Becoming rich can certainly be helped by getting a promotion, finding a new job, starting a business, making some great investments in the markets, real estate or any other asset. The reality however is that becoming a millionaire isn’t so much about that as it is about something else. Spending less than you make every year and consistently increase the amount that you are saving.

It’s not complicated, not pretty, but that’s the reality. When you say athletes or business people that are making millions of dollars every year and still manage to go bankrupt years later, it’s simply because they were overspending. And you probably know tons of people around you, some that make a lot more but also spend that entire extra amount.

Be Careful Of Shortcuts

Yesterday I discussed leverage and how dangerous it is. Using some leverage or taking some risks on certain investments or moves can be a good idea but it’s important to only risk what you can actually afford to lose and to avoid “over leveraging yourself”. It’s easy to push further and further once the process has stated but rarely a good idea.

How I’m Going About This

Every year, I do my best, through investing, my job and additional cash flows, to increase my income. Then, I take a portion of that amount to increase the amount I save every month/year. It’s that simple. Obviously, I then do my best using my bucket system to increase my investments in dividend stocks, technology long & short picks and longer term speculative picks.

Simplicity Is So Easy To Forget

I know, this post is nothing unique.. Sometimes however, I feel like we try to make things so much more complicated than they should be. The basics are things that we know but we often need reminders.

What Is Your Plan To Reach Your First Million Dollars?

Reading the news headlines these days can turn out to be a scary exercise. Just take a look around and you’ll see news about Man Financial, European and US banks, comparisons with Lehman Brothers and Bear Sterns, and the domino effect if a few countries do end up going bankrupt. Why is this all happening? It just seems like leverage is killing the entire system. It’s happening both for large multinationals but also for the now called “99%”.

We often hear things such as leverage ratios. But what do those actually mean? Let’s try a very simplified example:

Imagine that a French bank had a value of $10. Over time, that bank might accumulate large amounts of deposits, debts and other elements on that balance sheet but imagine that the bank is still worth $10 but has $400 worth of assets and $390 of debts. If for some reason, someone at that bank believed that buying Greek bonds was a great opportunity and bet 5% of the bank’s assets or $20 on those bonds. The crazy thing is that these bonds were not forced to be “marked-to-market” in Europe. What do I mean? Even though the bonds started losing value in recent months, the bank still did not recognize any losses on that position and accounts for them as if they were worth the price that had been paid. That is not the case of course.

Now back to reality.. Talks are that these bonds could end up being worth less than half of their value when Greece does eventually default. In the example of the European bank, that would mean a loss of $10-15 on that investment. You probably see the problem by now… the bank, because of significant losses in a fairly small investment is now worthless and will also be forced to go bankrupt.

Because the whole system is now so connected, there is probably a similar US bank that has $20 of its own assets invested in that French bank… overnight, that position becomes worth a fraction of what it once was and the US bank is now in trouble.

It’s a very dangerous domino effect that can go on for a long time.

You’d Think We’d Have Learned

Over and over, the main cause of economic and financial trouble has been tied to leverage and the inability to sustain losses. That is also what happened in the housing sector. Buyers were stressed so thin buying multiple houses that the only way it could work was to have prices going up at all times. As soon as a small decline would occur, the whole system would (and did) go down as mortgages turned underwater and sellers became increasingly desperate.

The Never Ending Temptation

The problem of course is that leverage ends up being a profitable bet for so many. I did look at compensation structures for hedge funds recently and how that encouraged going for more risk (which often means leverage). As for individuals, the main issue is greed. It becomes so tempting to try always reaching for better returns, especially when certain assets keep rising year after year.

Tricky Issue To Tackle

The problem of course is that deleveraging is a complex and tricky thing to pull off. It usually takes a lot of time and it’s a very difficult thing to do in markets and economic environments such as the current ones. Many financial institutions, especially US based ones have diminished their leverage ratios significantly since 2008 but those levels are still too high to sustain big losses such as the ones that might occur if Europe can’t get itself back together.

A few weeks ago, we did a reader’s survey asking all of you what you liked and would like to see more of on this blog, it’s not too late to answer if you have not done so yet! One of the requests that has been coming up over and over is for more speculative investment posts. Given the name of this blog, it would be hard for me to argue that:)

Back In Context

I like to use a bucket system when managing money. What does that mean and how does it work? It does mean having several bank accounts. All money that I receive will be used to pay for my expenses, etc. There is also money that is set aside for investments in 3 types of accounts:

-Long term retirement account (ETF’s and dividend investing)

-Long term horizon
-Low risk
-Very diversified

-Speculative investing (long and short trades that you can see here)

-Medium term horizon
-“Average” level of risk

-Long term speculative plays (long term speculation)

-Long term horizon
-High risk
-No diversification

Split Between The Buckets

It’s actually quite simple how I do it. I determine an amount of money that I want to set aside in each. For example, every month, the first $1000 that I can save would go into the long term term retirement, the next $500 into the long and short trades and any surplus would go into longer term speculation.

Why Are Speculative Investments Last In Line?

As interesting as these types of investments are, I do understand that they are very risky so any amount invested might end up  being lost. Most of you know how I would be investing the first and second bucket but the third one is not as clear.

Long Term Speculative Plays

We are all different but personally because of my interest and knowledge of technology stocks, I tend to concentrate on those and try to determine stocks that could possibly become the next Microsoft (MSFT). The companies can be newly turned public but I don’t think it’s an actual requirement! Keep in mind that I consider these investments to be high risk and could certainly imagine losing on many of those bets. The goal is to hit one or two home runs.

How I Determine Those Picks

In that third bucket, I am not looking for 10 or 20 companies, this is about choosing at most 5 stocks that I truly believe in:

-Stocks that have a lot of upside
-Stocks that have an edge on competition
-Metrics that are easy to quantify (I don’t necessarily care about profits or even revenues but metrics such as traffic or others must be easy to access
–Companies that I understand well: As much as I’m convinced that mining and biotech companies out there are destined for greatness, I could probably never differentiate between those that will and those that don’t.

Some of the companies that I follow fit into this type of investment even though I’d have a difficult time picking them (right now) in long and short trades because they are such long term plays.

What’s Next

Over the next few months, I will discuss some of the long term speculative plays that I have considered or invested in myself.  As always, I’d be thrilled to get feedback or ideas!