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Why it’s almost always a bad time to borrow to invest

Very few people wanted to borrow to invest in March 2009, after the FTSE 100 had halved in two years and the US markets had been in meltdown.

The sad fact is gearing up1 only becomes popular in optimistic times.

Unfortunately, when the economy is doing well, shares and other investments have usually been rising in price for years. They are then typically very expensive, and so less likely to deliver good returns in the future.

This makes borrowing to invest in happier times much riskier than if you did so in a bear market.

When you should borrow, you won’t want to

In a bear market when prices are cheap, fewer people are willing or able to borrow to invest.

The thought of your borrowed money getting eaten up double quick by falling share prices is a terrifying one — and quite rightly, too, given the risks of borrowing to invest in mark to market assets like stocks.

I was fully invested by the end of March 2009, but I would never have been able to stomach gearing up to take on even more risk in those emotionally draining times. Just staying in a bear market takes willpower — borrowing could easily push you mentally as well as financially over the edge.

Tip 1: We’re all only human, so here’s a good rule of thumb: When you feel it’s safe to borrow to invest, it’s not actually safe to do so.

Money’s too tight to lend on

Ironically, it’s harder too to get anyone to lend you money when times are tough, cash is king, and assets are truly cheap.

Just ask a first-time house buyer after several years of falling prices. To get a mortgage they’ll need a perfect credit record and a deposit of 20% or more, to buy a house that’s maybe 25% cheaper than at the peak.

Buying the house after a crash is actually less risky for both them and the lender because it’s not so over-priced. Yet many won’t get financing.

Of course, such caution doesn’t last. In a decade or so the easy money will be back, and lenders will be doling out mortgages to all-comers. A few years ago you could get a 100% mortgage without even proving your income. It’ll happen again.

Similarly, in bullish times for shares, lending money to investors seems like a win-win for everyone.

Gearing up for the worst market ever

An example of lending to investors gone bad was the Wall Street Crash of 1929.

The speculators you see in those famous old black-and-white photos selling their cars or leaping out of windows weren’t just upset because they’d lost their money. They’d also lost lots of borrowed money, faced huge margin2 calls, and knew there was no way they would make the money back to repay their debts.

How did it happen? Well, the years leading up to 1929 were the definition of a go-go era for stocks. As a result, lots of brokers allowed their clients to invest on margin. This meant they could get, say, twice the exposure to a stock for the same money, which was great while prices were rising.

And prices did keep rising for longer than expected, helped in no small part by all the borrowed money entering the market. But then prices started falling, everyone tried to take their borrowed money out at once — which drove down prices even faster — and to cut a long story short, the world had the Great Depression on its hands.

Tip 2: Again, if people are only too happy to lend you money to borrow to invest in stocks, it’s almost certainly a bad time to do so!

Another way to gear up (if you must)

If you really want to borrow to invest — for example if you’re reading this article in bear market, and you think now is the time to be contrarian — then you might want to research covered warrants (aka options) or subscription shares.

Some of these offer a way to increase your gearing as with borrowing, but they limit the downside to you losing the maximum amount you invested in them.

Obviously losing all your money isn’t ideal, but it’s better than losing more money than you’ve got.

What’s the catch? Well, derivatives like these expire after a given time. This means if your investment doesn’t come good before a certain pre-determined date, you’ll lose your money when they expire.

Introducing a deadline into an investing horizon when dealing with volatile assets like stocks is a whole new kind of investing risk. You get nothing for free in the stock market.

Please remember, I am not responsible for your actions. Borrowing to invest and using derivatives is a game for specialist investors. You are very likely to lose money, as I hope I’ve made clear in this article.

Series NavigationThe risks of buying mark to market investments on margin
  1. Gearing is another word for borrowing — like a gear on a bicycle debt it can increase your output for the same input, but with shares it can also work the other way if prices fall. []
  2. Margin is jargon for using borrowed money from your stockbroker or dealer to buy shares []

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{ 2 comments… add one }
  • 1 Brad Castro November 19, 2010, 9:36 am

    I agree with what you’re saying, and there’s definitely a huge element of investor psychology at play when it comes to the decision to borrow to invest. When you’re feeling confident, that’s probably when you should be most worried.

    I would also add (and I don’t mean this in an arrogant way) that if you were a savvy enough investor, you wouldn’t need to borrow to invest in the first place.
    .-= Brad Castro on: Bear Put Spread- Bear Put Spread Explained =-.

  • 2 pkora94 November 20, 2010, 8:27 am

    Brad puts in an interesting point on ways of enhancing returns without having to remortgage. I understand there are products out there that you can buy that can multiply profits depending on which way you bet. In the worst case scenario you only lose that amount of money that you have bet with.
    The only problem is that my brain refuses to understand how they work so i have never dabbled. Would appreciate an easy to understand book or article.

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