Should You Borrow Money to Buy Stocks? Income Investors 2018-05-03 14:19:09 Investors have borrowed a record amout of money to invest in the stock market. But is that a good idea? Let take break down this issue point by point. Dividend Stocks,News

Should You Borrow Money to Buy Stocks?

One of the most common questions I get from family and friends nowadays concerns leverage.

“Rob, my financial advisor suggested taking the equity out of my house to buy stocks. Do you think that’s a good idea?”

Apparently, they’re not the only ones. Investors have borrowed a record $600.0 billion against their portfolios, according to the Financial Industry Regulatory Authority. With stocks hitting record highs, leveraged traders have made money hand over fist. (Source: “Updated: Investing with Borrowed Funds: No ‘Margin’ for Error,” Financial Industry Regulatory Authority, last accessed March 28, 2018.)

I can’t provide personal financial advice. That said, around this research office, we treat conservatism like a religion (Old Testament-style) and our first commandment would go something like, “Thou shall not borrow money to invest.” Despite the booming stock market, we have stuck to that approach for a couple of reasons:

Possible Disaster: I live by the philosophy, “don’t wait to buy stocks, buy stocks and wait.” But over the past century, though, stocks have suffered some gut-wrenching declines: -70% in 1932, -42% in 1973, -31% in 1987, -43% in 2002, and -51% in 2008. If you had borrowed to invest during these periods, you would have gotten wiped out. The bank would have called in your loans and liquidated your positions at exactly the wrong time. We’ll see more crashes like these in the future, there’s no doubt about it. But for a levelheaded investor who’s not handicapped by debt, these routine events provide extraordinary opportunities.

Poor Strategy: In my meetings with numerous millionaires over the years, I’ve found that they have a tendency over the scope of their lives to make conservative decisions. They work hard, move slowly, and bide their time, and that’s how they ended up with a multi-million-dollar net worth. When you study these individuals as a group, you find that most of their money came from their businesses or professions. Only rarely does someone make a large fortune through speculation or leverage.

Going Broke: Warren Buffett once explained the three ways smart people go broke: liquor, ladies, and leverage. When someone goes bust, it’s almost always because they borrowed money to invest. All too often, the individual was already wealthy but wanted to pyramid his fortune through leverage. I agree with this view; it doesn’t make sense to bet what you have and need in order to get what you don’t need. If you make all of your investments on a cash basis, however, it’s almost impossible to lose everything.

Expensive Products: Financial advisors make a boatload of money leveraging up their clients’ portfolios. First, they collect a commission on the issue of a mortgage, investment loan, or line of credit, then they earn huge fees on the sale of expensive mutual funds (through front loads, back loads, and trailing fees). And because their client borrowed money to invest, they get to sell even more of their product. It makes you wonder who makes the most money on this deal: the financial advisor, or the client?

Bad Omen: I don’t claim to be a good market timer (quite the opposite, in fact), but when regular people start borrowing money to invest, that tends to suggest that equity prices have gotten “frothy.” We saw huge spikes in margin debt just before the stock market crashes of 1987, 2000, and 2007. The same thing has played out over the past year. I don’t mean to scare you out of equities (I continue to buy stocks myself month in and month out), but such rampant optimism should make you uncomfortable. It should also scare the heck out of anyone who’s leveraged up to the hilt.

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