Reprinted courtesy of the National Post
by Tom Bradley
“Should I borrow to invest?”
This question comes and goes, depending on what markets are doing and how available credit is. Today, with stock prices rising and financial institutions throwing money at customers (“do you want fries with your credit line?”), we’re getting asked the question more. Indeed, with rates so low, there’s almost an urgency for people to take advantage.
So, does it make sense to borrow money and invest it? What factors should you consider? And, are there alternatives?
Do the math
Theoretically, borrowing to invest in financial securities is no different than borrowing for a house. In both cases, the value of the asset rises over time, but can go through periods when prices are volatile, jumping up or down.
Borrowing to invest, however, has nothing to do with locating near a good school. It’s all about making money, so the math must be compelling. If you can borrow around 4 per cent (the prime lending rate is 3.2 per cent) and earn a return in excess of that, it’s a beautiful thing. It’s even more beautiful if you’re in a high tax bracket because interest on an investment loan is tax deductible.
So yes, 5 and 5 will work. If you and your banker commit to doing this for 5 years and your portfolio earns at least 5 per cent after fees and commissions, you’re in the money. But before you run to the bank, there are things to consider.
Eyes wide open
First, debt strategies are often sold using current borrowing costs (low) and past investment returns (high). As you’d expect, the numbers really work on this basis. But keep in mind that the starting point for those past returns was higher interest rates and lower price to earnings multiples. Today’s rates likely portend more modest future returns.
Second, for all of us, the psychological part of investing is the most difficult. When debt is added, the challenge gets a whole lot tougher. For instance, doing the right thing when stocks are in steep decline is hard enough, but when you add the fact that your portfolio is worth less than the loan value, the degree of difficulty skyrockets.
Before you borrow to invest, you must have a history of successfully weathering ugly markets such as the tech wreck, 2008 financial crisis or even the declines of early 2016. Did you hang in, do some buying, or did you sell?
And finally, if you want help to stay on plan, don’t expect it to come from your lender. The bank has different interests than you do and is more likely to pile on than lend a hand. Their protocols lead them to offer you more love and money when things are good, and ask you to reduce the loan or increase the collateral when markets are challenging. Buy high and sell low.
A few years ago, a discussion with a client prompted us to run some numbers. We wanted to assess whether it was better to borrow and invest in a balanced portfolio, or hold all stocks with no leverage. After assessing the level and volatility of returns across a myriad of scenarios, we couldn’t discern a meaningful advantage for either strategy.
This work suggests that if you want to take more risk and reach for higher returns, you should first increase your portfolio’s equity content. Don’t get your banker involved until you’ve gone through good and bad markets with an all-equity portfolio.
Cheap debt is intoxicating, but using it to invest is not child’s play. It requires that you have experience and a history of success.
Make sure you look at both sides of the reward and risk equation. The promotional materials cover the upside, but you also need to get comfortable with less favourable outcomes, namely rising interest rates and/or negative returns in the early years before you’ve built up a cushion.
And if you’re going to borrow to invest, make sure you have a plan for when the markets go down and the bank calls. Know what other assets you can pledge against the loan, or where you can get additional cash, because for the strategy to work, you absolutely can’t bail out when the going gets tough.
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