Like red braces, boasting about money, and TV programmes about share trading, borrowing to invest is one of those activities that becomes popular when the stock markets have been going up for a while.
And just like bragging about your shares picks on telly while you’re wearing red braces, borrowing to invest is generally a bad idea.
At the moment, borrowing to buy shares is not so popular; the level of margin debt reported to the New York Stock Exchange touched a low in February this year, and has only risen a little since.
But trading on margin will come back into vogue if this rally continues.
Indeed, I’ve already received a couple of emails from readers suggesting I give my personal views about it.
My personal view can be summed up as Don’t Do It.
But as you may know I never use three words when 3,000 are available here on Monevator, so let’s look into the whole subject in more detail.
Borrowing to invest for the short term
Generally, people borrow to invest on short term trades.
In the US, for example, many brokers allow you to trade on margin — you put down 25% deposit and borrow the rest to fund your investment.
Obviously borrowing greatly increases your gains when you win, and amplifies your losses if you lose, as this article on margin trading from the Motley Fool explains:
The broker, or regulatory authorities stipulate that the investor has to maintain a personal stake, of say 25% in the investment. This is known is the ‘maintenance margin’.
Using these assumptions it would be possible to invest £10,000 by paying £5,000 and borrowing £5,000.
If prices rises 40% (to £14,000), our lucky (skilful?) investor makes £4,000, less any interest payments. Based on his investment of £5,000 he has made a 80% return, twice the non-borrowing investor’s 40%. […]
If the value of the portfolio decreased by 40% (from £10,000 to £6,000) the trader’s personal stake is now only £1,000 (£6,000 – £5,000).
But to maintain his stake at the agreed 25% of value (£1,500) the broker will issue a ‘margin call’. Either the investor has to deposit another £500, or the broker starts selling shares to that value.
Day trading loses most investors money. Doing it on margin does it even quicker.
Naturally I don’t use a margin account myself.
What about borrowing to invest for the long term?
We have discussed before how short-term trading is generally bad for your wealth, but over the long term it’s fairly clear that investing is a good thing.
So does that mean borrowing to invest for the long term is okay?
After all, stock markets rise 10% a year over the long-term, right?
Why not borrow at 5%, invest the money at 10%, and then in 20 years you can pocket the difference and sail off into the sunset on your yacht, waving me and my scaredy-cat blog goodbye?
Borrowing to invest increases risk for little reward
The short reason not to do it: borrowing to invest even over the long term is riskier than it looks, and it’s less rewarding, too.
At first glance, I’ll grant you it looks attractive. Who wouldn’t want to take £100,000 of other people’s money, compound it at 10% for 20 years, and end up with over £650,000?
Exactly — who wouldn’t? There’s your first clue life isn’t so simple.
- The money you will borrow is expensive
- Tax and other costs will eat up your returns
- Market returns are unpredictable, even over 20 years
- Your investment will probably be marked to market
- If you want to borrow to invest, it’s most likely a bad time to do so
All of these deserve more detail, so over the course of a week long special series, I’ll give five good reasons why I think you don’t want to borrow to invest, especially when it seems like a good idea. (Cryptic, eh? Read the whole series to learn what I mean.)
Remember as ever I’m not a financial adviser — just a private investor.
Having said that, if your adviser suggests you take out a huge loan to buy into the stock market, I’d suggest you get another adviser!
To ensure you see the whole series, please do subscribe to Monevator for free!