I’ve always been under the impression that leverage will likely be profitable over the long run — say a period of 10 or 20 years (you can find past posts on leverage here, here and here). Stocks beat bonds and cash handily over the long term, right? But is it really the case? What does market history tell us? To find the answer, we’ll turn to Triumph of the Optimists, in which authors Elroy Dimson, Paul Marsh and Mike Staunton present market returns for stocks, bonds and bills from 1900 to 2000 for 16 different countries including Canada and look at excess returns of stocks over bills. As an investor borrowing at 3% and earning 7% in the stock market, only gets to keep the difference, it makes sense to look at the equity risk premium versus bills. Assuming, investors can borrow at the T-bill rate, the sequence of excess returns available from stocks for every 10-year period starting in 1900 is:
3.5%, 2.4%, 8.8%, -0.5%, 8.4%, 12.9%, 5.2%, 2.5%, 0.0%, 3.5%
Unfortunately, investors are not in the lucky position of the Government of Canada and are unlikely to be able to borrow at the current T-bill rate of 0.25%. The best they can usually do is borrow at Prime, which is currently 2.25% or a 2% premium over the T-bill rate. Let’s deduct a premium of 2% from the equity premium sequence above to find out how successful leverage would have been in past 10-year periods:
1.5%, 0.4%, 6.8%, -2.5%, 6.4%, 10.9%, 3.2%, 0.5%, -2.0%, 1.5%
In other words, in 2 out of 10 10-year periods, leverage would have been unprofitable and barely profitable in 2 more. It is only in 4 out of 10 periods that leverage would have yielded substantial profits.
How about 20-year periods? Here’s the sequence of excess returns from stocks over bills after deducting a 2% premium:
0.9%, 3.6%, 2.1%, 1.9%, 8.6%, 7.0%, 1.9%, -0.8%, -0.2%
Again, the record is clear. Leveraging would have provided outsized returns in some periods and mediocre or quite poor results in others.
It is only over 30-year periods that all excess returns are positive:
2.9%, 1.5%, 3.5%, 4.8%, 6.8%, 4.8%, 0.5%, 0.1%
Leverage is typically advertised as a profitable strategy over the long term. But market history suggests that investors may sometimes have to wait a long time before the strategy turns profitable.
