Important information about the risks of leveraged investing and costs of investing

January 23, 2012 With the arrival of the RRSP season, the Ontario Securities Commission (OSC) reminds investors to pay close attention to the risks of leveraged investing and the costs of investing. When making investment decisions, it is important to know that using borrowed money to purchase investments increases your investment risk. You should also ensure that you fully understand the costs associated with your investments.

The risks of leveraged investing

Borrowing money to invest in mutual funds and other securities is a common investing practice that can lead to increased investment risk. This practice is called leveraged investing. Investors need to understand that using borrowed money to purchase investments involves greater risk than a purchase using cash.

If you’re thinking about borrowing to invest, it’s important to understand why this strategy is risky. If you borrow money to purchase investments, you are responsible for repaying the loan and paying interest, even if the value of the investments declines. Your losses will also be magnified if your investments go down in value. As a result, leveraged investing could result in much greater losses than investing with your own cash.

Here is a simple example of leveraged investing and how it compares to traditional investing. It does not take into account any tax implications.

Here are some things to consider if you’re thinking about using leverage to invest:
  • The risk of leverage declines as the time horizon grows, so you should be investing for the long term;
  • You should reduce your risk by making loan repayments (i.e. repay the principal as well as paying interest);
  • Develop a disciplined investing strategy – don’t chase the latest fad or hot tip and don’t be put off by short-term market fluctuations.
For more information on leveraged investing, please refer to the OSC brochure Borrowing to Invest, or see the Investor Education Fund article on the subject.

Pay attention to costs

The OSC also reminds investors to always pay close attention to the costs of their investments. It is important that you understand the costs of the products you purchase and that you are comfortable with them, so ask your representative to explain all the costs related to your investments.

Costs are an important part of your investment strategy because the costs you pay will reduce your investment return. This does not mean that the investment with the lowest costs is automatically the best, just that you need to be aware of the costs before you invest.

For some investments, the costs are clear and easy to understand. If you buy common shares or sell common shares, you pay a fee to carry out that transaction. Other costs are not as easily seen. Research shows that investors are not aware that they are often charged to simply own an investment.

For example, when you buy mutual funds, some costs are paid by you and others are paid by the fund, which affects you because these costs reduce the fund’s returns. For example, you may pay a sales charge when purchasing mutual funds or, for funds with no sales charge on purchase, there may be a charge when you eventually sell the investment. Most mutual funds also pay your representative’s investment firm a fee during each year that you own the fund. This is called a trailing commission and it is not well understood by most investors. The trailing commission is how representatives are paid for providing ongoing services and advice to their clients. For more information, please refer to the Understanding Mutual Funds article on this topic.

You can obtain detailed information about your mutual fund investments, including costs, through public filings of the mutual fund company, such as prospectuses and annual and quarterly reports. In addition, you can find key information about each mutual fund in a summary document called Fund Facts, which is available on the website of each mutual fund company.

All investments involve costs to the investor and mutual fund trailing commissions are just one example. If you plan to buy investments from financial institutions such as banks and insurance companies, you should be diligent in asking about the costs of investing from those sources.