If borrowing is so cheap and stock returns are so good, why shouldn’t we borrow money to buy more shares?
The amount so far isn’t much: CalPERS says it will borrow up to 5% of its portfolio value, although it says it can promptly increase to 20%.
But it raises a compelling question: Why don’t we all do this?
It’s not like borrowing is expensive. the federal funds rate is essentially 0%. Even in light of current inflation, they are predicted by money markets (rightly or wrongly) to grow to no more than 2% by 2025. BofA Securities points out that yields on 10-year Treasury notes is currently nearly 5 percentage points lower. current inflation, “a level in the last 200 years that is associated with panic, inflation, war and recession.”
No, you and I cannot borrow at the federal funds rate. On the other hand, the middle class in America often has access to a lot of relatively cheap debt that if we want, we can use to invest more. Some of the obvious: Home equity lines of credit, your broker’s margin debt and those 0% credit card offers flying into our mailboxes like an invitation from Hogwarts.
Some brokers charge high interest on margin but others do not. Interactive brokers, for example, fee is at least 1.58%.
And there are other alternatives as well. Stock Options, financial instruments that are complex but less ‘dangerous’ than they sound, allow you to buy $2 or $3 or even $10 worth of stock at a $1 discount at a fraction of the cost. reasonably low fees. Closed-end mutual funds, a type of fund structured like a regular security and traded in the market, often use cheap debt to boost their returns. And there are “leveraged” exchange-traded funds, often with names like Ultra or 2X or 3X, that try to help you invest more of your money. They all come with big warnings and risk warnings, but they don’t always blow up cigars.
Oh, and if you delay filing your federal taxes until the due date, April 15 next year, you’ll have extra money all year to invest and Uncle Sam will now charge you only 3% for privileges.
According to data from NYU’s Stern School of Business, since the 1920s, returns on the S&P 500
beat returns on Treasury bills by an average of 6.5 percentage points a year.
Borrowing to invest is also not crazy. After all, what do we all have to do when buying a home? We usually just drop 20% or 25% of the value and borrow the rest. No one thinks this is crazy. And it is the main source of wealth for many middle-class people. Think about how much money you made based on the value of your house. Imagine how little money you would make if you couldn’t get a mortgage, and instead could only buy a home when you could afford 100% of the purchase price. You will still rent, and the poorer for it.
Warren Buffett invests with leverage. A few years ago, Analysts found that the main source of Buffett’s incredible investment success over the decades has not been his stock selection, market timing, or superior management skills: He simply borrowed money cheaply. , through its insurance operations, and use the excess to buy more shares than would otherwise be possible. He focused on, they focused on cheap, high-quality and low-volatility stocks. Meanwhile, his leverage, they calculate, averages 1.7:1. In other words, he runs his portfolio with a mortgage equivalent of 60%.
Allan Mecham, the wonder guy who’s been running Arlington Value investments for 20 years, has gone a step further a few years ago: Through his fund, he’s borrowed money cheaply to buy more shares in Warren Buffett’s Berkshire Hathaway, driving his investors’ returns even more.
Some Financial experts argue that we should borrow money to invest when we’re young: Otherwise, we invest too little in our 20s and 30s, when we don’t have a lot of money, compared to what we could invest at our age 50 and 60.
There are obvious downsides to the concept of borrowing money to buy stocks. First the best time to do this is probably not when scribblers like me are writing about it. The market is currently at record highs, and by various calculations could be in a massive bubble that is ripe for a nasty pullback. The late economist Hyman Minsky argued that when things are booming, people get complacent, take on too much debt and take on too much risk, which will create the next crisis. You can take articles like these – and actions like those of CalPERS – as a Minskyesque warning.
Margin debt at brokerage firms is was at a record level, and is almost double what it was a few years ago. The best time to borrow money to buy more stocks is during a recession, when stocks are cheap, fear of land lurking… and almost no one wants to take risks.
The second problem with borrowing money to buy stocks is that you should only do it if you are absolutely certain that you can avoid further volatility. During the last two major bear markets, from 2000 to 2003 and 2007 to 2009, the S&P 500 index halved in value. Someone running a portfolio with 50% borrowed money will be written off.
Too many people owning too many stocks with too much borrowed money is what caused the infamous stock market crash of 1929 so deep and so bad.
By 1932, by chance, stocks were down 90% from their peak. Noisy.
In theory, there’s nothing wrong with borrowing a modest amount to buy more stocks, just as we do to buy our own house. Even, for example, borrowing 10% or 20% more can yield material long-term returns. But only if you are sure that you can overcome the volatility. Otherwise, you will lose, not win, from the trade.
https://www.marketwatch.com/story/the-pros-and-cons-of-borrowing-to-buy-stocks-11637968685?rss=1&siteid=rss Opinion: Pros and cons of borrowing to buy stocks