I read a rather controversial article recently in the Wall Street Journal aptly entitled “Leverage Baby!” outlining the case for taking on debt to invest it at a higher rate. The main premise of the article was that now may be an optimal time to actually take out loans at extremely low interest rates, use that money for higher yielding investments and keep the proceeds. While this concept sounds plausible and this practice is actually being employed en force by the country’s largest banks (borrowing Fed Funds at 0% and investing it and loaning it out at higher rates), you’re not Goldman Sachs and neither am I. I think this is a risky proposition, especially for routine retail investors.
- Stocks May Have Seen Their Best Days – With markets rocketing 70% off their lows in March 2009, what would make you think they’re going to continue to proceed at the “historical” long-term return rates of 8-9% annually? The S&P500 went basically nowhere from 2000-2010 in what will forever be dubbed the “Lost Decade”. There’s no reason to believe the next decade will be any different. In light of the fact that income producing instruments are delivering virtually zero returns, then yes, I do choose to have my investable assets in stocks. But I’m not leveraging up to do so. I just view stocks as the most aggressive asset most likely to exceed inflation, not necessarily that I’d mortgage my house to throw more money at the next BP.
- You’re Not a Sophisticated Investor – Even investors who do qualify under the conventional “sophisticated investor” are virtually never sophisticated enough to protect themselves from themselves. Thousands of investors were taken for a ride by the various Ponzi schemes the collapsed in the past 2 years (Madoff was just one of dozens) and many more lost millions in exotic CDOs, MBS and other acronyms they probably didn’t understand. While many of us think we’re smart investors, what the data tells us is that most of us (professional money managers included) aren’t any better at picking stocks than a monkey throwing darts at the stock section of a newspaper. Making the presumption that by leveraging up and investing with any particular assumed return in mind is ludicrous. Stocks could be up, down or flat over the next decade in aggregate. And individual equities? It’s anyone’s guess.
- Leverage Can Kill If You’re Called Early – What about if it’s the harmless borrowing from a 401K or a home equity line of credit? That can’t hurt, right? Well, it can, especially if the market implodes again and you have to pay back those funds immediately. For instance, if you took out a 401K loan with your employer and you leave the company or are separated, in most cases, that money is due back immediately or it counts as a distribution subject to a painful penalty with taxes to boot. Also, many borrowers were shocked during the financial meltdown to learn that their lines of credit were being called in. This could very well happen again in 2011. The economy isn’t exactly firing on all cylinders and the Euro zone could well have ripple effects elsewhere in the world.
This kind of reminds me of when I used to engage in peer lending on Prosper.com (subject of a whole other post someday). I used to come across some borrowers who would state that they were looking to borrow on Prosper and use that money to invest at higher returns. I couldn’t help but laugh. This 20 year old guys is going to borrow money at 9% and make a positive return? What is he investing in? And who are the fools willing to lend him the money in an unsecured loan assuming they’ll ever see that money back? Well, the ideas proposed in the WSJ article aren’t that much more far-fetched. Borrow at 4-5%, make 8-10% in stocks and keep the rest. If only it were that simple…
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I had a brief stint contemplating on doing just this earlier this year. And, I had also read that WSJ article and scrutinized the delay of its publishing. We wouldn’t deem it utterly ridiculous during the middle of 2009.
And I definitely agree with you that stocks have run their course for the time being. There is too much economic uncertainty now to even ponder leveraging.
On the other hand, as one of those 20-somethings that tend carry more risk than other, I’d consider taking on some debt to invest – should the stock markets return to its bargain prices.
Many professional money managers fail to spot massive problems like the financial meltdown of the last few years (as you say). Given this fact it is total folly to think that we can consistently better their performance in our spare time. Leverage magnifies profits but obviously also magnifies losses . The knowledge of this can distort your normal investment judegments and make you more likely to fail.
I played around with the idea of taking a loan against my 401k and house to invest. But then chickened out knowing that such actions would be pretty reckless to do so.
It was a good thing too, because shortly there after, we went into the “Great Recession”!!!
What is you invested in your short strategy of leveraged ETFs with the borrowed money??
Darwin Reply:
June 25th, 2010 at 9:31 pm
@M&M, Hah, I bet you thought you had me there! Actually, perhaps I didn’t make it clear enough in the article, but when you’re going to short something, you do need a margin account, but that doesn’t mean I’m “borrowing on margin”. It just means that it has to be enabled in the event they need it, or if you’re going “into margin”, then you pay. Here’s the example where I would have been borrowing on margin and probably at say, 7% or something:
– If I had 50K cash to fund an account and went long 70K in stock. I would have had to borrow 20K on margin.
Here’s why my account history shows no margin costs (I’m not borrowing any money):
– Go long ~50K stock and ~30K leveraged ETFs. It’s a net 20K long position and would only trigger margin costs if one particular ETF went parabolic, which doesn’t concern my since I have opposing pairs.
So, in summary, it was a good thought, and many investors DO use margin to invest, but I’m not borrowing on margin to invest. It’s only “enabled” in order to allow me to do what I’m doing.
never borrow money to invest it. bad idea
The thought of leveraging your line of credit to purchase stock is an interesting idea. Could BP be an option if you’re speculating on a 2 year trend? What about Potash and the global need for increased food production?
This strategy requires a lot of discipline and a solid understanding of your accounts payable. Being over leveraged could work against you if you’re in a life change position such as wanting to buy a new home or even if you’re expected to start paying for secondary school expenses.
Do your homework and don’t just start blindly investing your ‘borrowed’ money.
What about taking on debt to invest in hard assets like precious metals?
With the world’s governments taking on more debt, it seems like precious metals can be seen as a currency/inflation/defense play that could pay off easily and stay ahead of loan interest rates.
I am not thinking about putting nest egg at risk but investment money.
I recall reading this WSJ article also and shaking my head. From a pure mathematical perspective one might be able to make a mental case for borrowing on your home or from your 401(k) to invest. In reality, as you pointed out, much can go wrong especially for the casual investor. Not the least of which is being right with your investment choices but wrong on the timing. I’m not against leverage but this is not where I would recommend using it.
I agree with the general consensus that this can probably work in theory, however most of us do not have enough stashed away that we can quit our day jobs and monitor the markets all day.
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