Is it risky borrowing money to invest?
Today’s question comes from Jeremiah. He asks:
Hey Chris…obsessed with your website and advice…keep up the great work! I had a question I wanted to run by you.
I was looking online at smaller loans and came across some pretty decent terms and had an idea I wanted to see what you thought about. I can borrow $15,000 (or possibly more) for around 3% interest for 3-5 years (my choice) and was considering doing this and investing that cash into ETFs, Index Funds, Mutual Funds, etc. Now, I know the first reaction is probably “why would you borrow money to invest?”
Fair question. My thought process is I can borrow this money at 3% interest and (more likely than not) be able to get a much greater return than 3% over the 3-5 year term. Maybe I am just being really naive here (please tell me if that’s your honest opinion) but I’m really wondering if you think this would be a good idea? Can you help me see where my faults are if you don’t agree?
Since 1871 the stock market has returned about 9%.
People will say the market won’t have those same returns going forward. That’s fine. People have been saying lots of things for a long time.
Still, what you’re talking about doing is a bad idea, and I’ll tell you why.
No one on this planet — economists, analysts, strategists — know where the market is headed in the short term.
On average, the market falls 10% once a year, about 20% every four or five years, about 30% every decade.
So can you tell me what happens when you borrow $15,000, your investments rise 9% the next two years, but then fall say, 20%?
Here’s the math: the first year your $15,000 rises to $16,350; the second year $17,822; and the third year falls to $14,258. Now your loan’s due.
In reality that’s not how this would work. A loan requires you to make monthly payments. You’re constantly selling investments, investments that need to be in a taxable brokerage account, so you’re also paying short-term capital gains tax.
The way investors typically borrow money to invest is with margin. You apply for margin in your brokerage account, borrowing money from your broker.
Let me tell you a story about margin.
There was this 20-something investor who bought a small amount of this biotech stock called Celera. The stock started doing well so he continued buying more, but this time using margin.
All of a sudden the stock started falling from a high of $276.
He’s thinking, “What idiots!” and uses margin to buy more shares.
He can’t believe it when it falls to $170. He buys more.
Stunned as it falls to $150 he buys even more.
And when it finally hits $130 he sells every other stock he owns, raising all the cash he can, and margins himself to the gills.
He’s convinced the stock is going to rebound, and when it does he’s going to make a massive profit.
It then falls to $85.
At this point his broker is forced to sell his entire position in order to cover his margined debt. Yeah, his $60,000 brokerage account which took three years to build is wiped out in just two weeks. Worse, he now owes his broker $1,500.
(As for Celera? It was eventually acquired at $8.)
You see, investing really has nothing to do with money. It’s mostly about avoiding bad decisions, and I started using decision trees to help with this.
After all, I’m human and make emotional and psychological mistakes just like everyone else.
Here’s a personal example. I like keeping three to five years of living expenses in cash. Should that be sitting in cash, in a money market fund, or invested.
What’s the best decision.
Decision #1: Cash earning 0%
$1,000 x 1.0 = $1,000
Decision #2: Money market fund earning 2%
$1,000 x 1.02 = $1,020
Decision #3: Invested earning 9%
$1,000 x 1.09 = $1,090
Investing is the best decision, but also the only decision that involves risk. Remember, on average the market falls 10% every year, about 20% every four or five years, about 30% every decade.
And because there’s no way to predict if you’re going to get caught in a decline you need to incorporate uncertainty into the decision.
Here’s how you do that. Let’s say you think there’s a 40% chance the market falls 10% leaving you with $900, and a 60% chance the market goes up 9% and you’d have $1,090.
To evaluate this decision you need to work backwards:
($900 x 0.40) + ($1,090 x 0.60) = $1,014
This means you’ll probably get worse returns from investments earning 9% ($1,014) than from a money market fund earning 2% ($1,020). Decision trees aren’t perfect, but they’re a useful tool to think through options. To make the best decision.
Make sense?
We’ve been in a bull market since March 2009. The market has returned over 300%, so anyone invested in this timeframe has made money.
And if you’ve been borrowing money to make money, using margin, it’s magnified those gains.
Your spouse thinks you’re smart, your friends are jealous, and you’re sitting there thinking borrowing money to invest was a good decision.
Okay, but what happens when the market falls?
Like Warren Buffett famously said, “Only when the tide goes out do you discover who’s been swimming naked.”