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You can’t bank on an expected return

We’ve previously looked at how interest payments, other costs and taxes will reduce your expected return if you borrow to invest.

But banking on the stock market to deliver an expected return is risky, even over 20 years — and here ‘expected return’ includes simply “more money than I put in, taking into account interest and charges”.

When we began this series on borrowing to invest, I said that you might see 10% a year from investing your borrowed money into the stock market, before costs.

And it’s true, you might. That’s the long run average return here in the UK and the US, give or take a bit.

But you might easily invest your borrowed money just before a bad spell for shares, and only get 5% a year.

According to my copy of the latest Barclays Capital Equity Gilt Study that I last dusted off when we looked at corporate bond returns, there have been several times over the past 110 years when UK equities have failed to deliver a positive real return on investment over 20 years, let alone their expected return.

At such times, you’ll not break even after costs and charges.

Worse, you might invest at a truly terrible time, and lose a lot of money.
Just look at Japan for a worst-case scenario.

Anyone who borrowed to invest when Japan’s Nikkei stock market index hit 38,957 in 1989 is sitting on a 75% loss over the past 20 years. A terrible loss, but even worse if you spent those 20 years paying double because of interest.

Do I think awful Japanese-style returns from shares are likely if you invest today?

No, I think the fact that corporate and government bonds having beaten equities over 20 years suggests we might see a decade of double digit gains for shares.

But I’d be very cautious about borrowing any money to bet on it, beyond perhaps trickling money into tax-sheltered investments instead of paying down a mortgage (which is effectively the same thing as borrowing to invest).

An expected return is not a smooth return

Remember also that the stock market is volatile. You might see average returns of 10% or more for 19 years, only to suffer from a stock market crash the year before your repayment becomes due.

Perhaps in the 21st year the market bounces back, just to rub it in.

Too late — you repayment date has passed!

I can’t think of much worse than borrowing £100,000 on an interest only basis, paying interest on it for 20 years, and then not having enough to repay the capital outstanding at the end.

Sure, you could try to cleverly lock in gains over the decades and so on. Remember though that this will wrack up more costs, and that the usual drawbacks of market timing and over-trading still apply. You’re actually likely to reduce your expected returns this way, according to academics.

Short-term borrowing is madness

Most of this series is about borrowing to take advantage of long-term returns from the stock market.

As we’ve seen, it might be marginally profitable, but there are plenty of risks, and you can’t expect to make more than a couple of percent extra a year, even if it all works out.

That’s worth having – but much less than the rough-and-ready initial calculations would imply.

In contrast I’ve barely looked at borrowing to invest over the short-term, because I think there’s no case for it.

Anyone who has lived through the past decade and seen two bear markets where stock markets fell 50% should know exactly why borrowing over five to ten years is simply gambling.

If you invest your own money over the long-term, you can afford to ride out the ups and downs.

But if you’re investing other people’s money over the short-term, you’re at the mercy of the whims of the market — and you could easily end up owing money to your lender after selling (or being forced to sell) your investments.

I’ll go into more detail on this problem of market volatility when gearing up in the next part in the series, so please do subscribe to keep in the loop.

In the meantime, the mathematically inclined amongst you could check out this link that was kindly sent in by a reader from Australia.

In his country, borrowing to invest (gearing) is apparently sold quite hard to private investors. But:

Once you start to borrow, there is a sharp increase in the volatility of the portfolio. For example, a 50% loan to value ratio sees returns increase by 1.7% to 14.78%, with portfolio volatility increasing to 40.35%.

In other words, for enduring a doubling of volatility, you get just 1.7% in extra returns.

The figures would be pretty similar for the UK and the US, and underline why mixing short-term investing and borrowing is like mixing alcoholic drinks – exciting at the time, but dangerous and likely to end in tears.

They also underline how the extra returns are hardly worth the risk.

Concluding thoughts on expected returns

The takeaway as I see it here is that expected returns from the stock market are fine for long-term investment planning, but not a rock solid basis for planning how you’ll repay debts, further undermining the case for borrowing.

With a cheap enough loan you’ve got a good chance of doing okay over 20 years if you borrow to invest in the stock market and keep costs low, but there are definitely no guarantees.

Over the short-term, it’s madness.

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{ 8 comments… add one }
  • 1 Neal @ WealthPilgrim.com September 10, 2009, 1:52 pm

    This is the most important subject in terms of understanding investing.

    A given investment may have a 93% chance of returning between -10 and +15 – so folks kind of expect to fall in that range.

    What they don’t expect is to have a -35% return – even though it is certainly in the range of possibilities. Because they internally dismiss the possibility, they react emotionally and this is where the investor really gets into trouble.

    Thanks for writing this important piece.

  • 2 Tony September 10, 2009, 4:45 pm

    It’s unpopular advice, but in the same vein, people shouldn’t really invest unless cedit cards and personal loans have been repaid first (with the possible exclusions of interest-free and low interest student loan debt). Otherwise, this must also be the equivalent of borrowing to invest at 17% pa or so in the UK: even worse than your example of paying the mortgage early.

    However, from a practical point of view, one of the reasons the UK is in a mess, is that households have built up large non-mortgage debts, but still need to make provision for retirement etc. So most of us have to compromise and repay debts as a priority AND make a start on investing for the long term.

  • 3 The Investor September 10, 2009, 9:09 pm

    @Tony – Yep, absolutely agree. Perhaps I’ve skipped over other forms of debt too lightly in these pieces — as you say if borrowing to invest doesn’t really make sense when you’re borrowing via a cheap mortgage it certainly doesn’t work for anything else!

    @Neal – I think it was Peter Lynch who said when he started in the fund management business he was told markets went up 10% a year and once out of the classroom he never saw an exactly 10% year again! 😉

  • 4 Mike September 11, 2009, 6:16 am

    I have heard some argument about long run periods having negative returns for equities.

    The classic period that is cited is the post depression period but these sort of arguments often fail to factor in stuff like:

    dividends
    index selection (for instance the Dow in the 30s was rubbish)
    in the case of the 30s deflation
    drip-feeding (yeah sure if you bought in 1929 just before the crash it would have hurt but most people don’t buy all at once and never buy again)

  • 5 The Investor September 17, 2009, 6:24 pm

    Drip feeding is the most powerful counter-argument — and another reason to avoid trying to time in and out of markets. Some of the stats you’ll see (such as the Barclays Capital Equity Gilt ones I tend to quote on Monevator) do take into account dividends though — they’re total return stats.

  • 6 The Investor September 17, 2009, 6:30 pm

    Actually, I’m just thinking I don’t agree with my own point above about drip feeding being an argument against the utility of considering long-run bad periods for stocks.

    If you have a paper worth of X invested in the market and it delivers a disappointing Y over the next 20 years, does it matter whether you happened to have built that fund up over decades previously or invested the day before the crash?

    Really it’s a strong argument for rebalancing:
    http://monevator.com/series/how-to-rebalance-your-portfolio/

  • 7 Mike September 18, 2009, 1:03 am

    If you’re going to disagree with yourself at least it’s better to plump for one side of the argument or the other! (-; [not including the people that can hold two completely contradictory views at the same time and not be concerned by this.]

    On this last point it doesn’t bear thinking too closely about rebalancing as a strategy if you are an index fund fan …. e.g. “I buy index funds because I believe the market is efficient, and then I rebalance because I believe it isn’t …” …. (-:

    PS (and yep I’m an index fund fan and try not to think about it … )

  • 8 The Investor September 18, 2009, 7:47 am

    I think it was George Soros who said he can buy the pound in the morning and sell it in the afternoon… 😉

    Regarding index funds, isn’t there a distinction between agreeing the market is an efficient clearing system for finding out the best price for stock A or B (or at least that you or I can’t consistently exploit any of its failings for profit), as opposed to saying that the valuation of the stock market against other asset classes is always right?

    I’m not sure even strong efficient market theory implies the latter, though I’m ready to learn otherwise.

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