Should You Borrow to Invest?

 

Borrowing to Invest Has Made Me a Millionaire:

It all started after the 2008 financial crisis – stock prices were beaten down, dividend yields were high, and interest rates were low. In fact, if there was ever a good time to borrow money to invest in the stock market (known as leverage in financial jargon), it was after the 2008 financial crisis. There is little doubt, however, that their will be other opportunities to do the same thing.

In the years that followed the financial crisis, my wife and I borrowed hundreds of thousands of dollars and put it to work for us in a number of solid dividend paying stocks. We picked stocks that had a history of rising dividend payments, held on to these stocks for the long-term, and collected the dividend payments. In the process we became millionaires. We still own many of these stocks today.

It wasn’t just the stock market. My wife and I also borrowed money to invest in real estate as well. We bought a rental property and we bought a property to live in that came with a rental suite. In the process we made over a thousand dollars a month in extra income. Moreover, both properties have dramatically increased in value since we bought them.

With all these investments we made sure we bought stocks and real estate that provided income above and beyond our cost of borrowing, we bought when we thought these investments were undervalued, we diversified our investments, and we stayed invested for the long-term. Adopting these strategies paid off for us, and we ended up retiring in our thirties and now live off the income these investments provide.

 

Think Like the Rich and Think Like a CEO

leverage 300You are never going to get rich without taking a little bit of risk. As far as my wife and I were concerned, we could either keep on doing the same things we were doing and retire much later in life, or we could think like the rich think and think like a CEO thinks and try to grow our wealth much faster. To borrow a quote from the famous financier Robert G. Allen, “How many millionaires do you know who have become wealthy by investing in savings accounts?”

A wealthy property investor has no doubt borrowed money to invest in real estate. And wealthy corporations absolutely borrow to invest when they think they can earn a higher return on their investments than the cost of their borrowing. Corporate America has trillions of dollars in borrowed money working to earn it even more money. If you want to get wealthy quicker than most, you need to consider doing the same.

The key when you borrow to invest is to invest using proven wealth building strategies, manage your risk properly, and control your emotions. Would a successful CEO borrow more than the company could afford to lose and invest it all in one risky business that wasn’t earning the company any money? Of course not. Equally important, would a respectable CEO borrow a whack of money and gamble it on some sort of short-term strategy. No, the most successful companies invest in projects that offer sustainable long-term growth. Finally, would a good CEO purchase a business that was way overvalued or panic and withdraw all the company’s money during a temporary down-turn? No and No.

 

The Secret of Warren Buffett’s Success

It isn’t just real estate investors and successful corporations that borrow to invest, successful investors in the stock market also employ the same strategy. Warren Buffett is one of the richest men in the world and arguably one of the most successful investors of our time. At least part of the reason that Mr. Buffett has been so successful, however, is because of the fact that he borrows to invest.

In fact, an article in The Economist makes the claim that without the use of leverage, Mr. Buffett’s returns would have been “unspectacular.” The article reveals that Berkshire (Mr. Buffett’s company) has leveraged its capital, on average, by 60% in the past, significantly boosting the company’s total return.   http://www.economist.com/node/21563735

As mentioned above, one of the keys to being successful when you borrow money to invest is using proven wealth building strategies and properly managing your risk. Warren Buffett epitomizes this types of behaviour. Mr. Buffett is an adamant value investor and student of the father of value investing, Benjamin Graham. In fact, Mr. Buffett has said that the best investment he has ever made has not been a stock or a bond, it has been Mr. Graham’s book The Intelligent Investor (the definitive book on value investing).

Mr. Buffett tries to buy companies that are trading below their intrinsic value and have a history of good returns. He then holds on to these companies for the long-term. He does not speculate on risky companies with no history of earnings and he does not day trade.

 

Modern Portfolio Theory

For those academics out there that want further evidence that borrowing to invest can be a viable strategy, look no further than Modern Portfolio Theory (MPT). MPT is the Nobel price winning work of American economist Harry Markowitz. MPT was developed in 1952 and is still widely used in the finance industry today.

MPT advises us that the best risk-adjusted return (the best ratio of return vs. risk) can be achieved by diversifying and buying many investments. One of the main concepts of MPT, however, is that diversifying into investments whose investment returns are not correlated provides a better risk-adjusted return than naïve diversification and helps creates what Markowitz termed is the optimal portfolio (a portfolio that has the best risk-adjusted return).

Another main idea of MPT, however, is that if investors want to go after a higher return, they should borrow money at what is called the risk-free rate (the interest rate charged on an investment that offers no risk, such as a US T-bill) and invest this money in their optimal portfolio. In other words, borrowing to invest at a low interest rate and investing it in a properly diversified portfolio that can be expected to earn higher returns than the risk-free rate should provide a better risk-adjusted return compared to going after a higher return by ploughing all your money into very risky investments.

Judging from the article in The Economist mentioned above, this appears to be a strategy that Mr. Buffett has used. What’s more, this same article also reveals that, historically speaking, a better risk-adjusted return has been achieved by low beta stocks (less risky stocks) than by high beta stocks (more risky stocks) and that it should be possible to exploit this fact by borrowing to invest in a portfolio of well diversified less risky stocks.

 

When Does it Make Sense to Borrow to Invest?

If you want to borrow to invest, it makes sense to pay attention to the lessons provided by Mr. Buffett and by MPT. Here are the rules I’ve come up with whenever I borrow to invest:

  1. I try and buy undervalued investments. My rule is to try and buy investments that are trading at least 20% beneath their value. This is what most value investors would refer to as a buffer. I usually achieve this by only borrowing to invest after large market selloffs have dragged everything down – good stocks and bad stocks.
  2. I’ll only buy an investment if the dividend payout is at least large enough to cover my borrowing cost. Furthermore, I only buy stocks that have a history of steady rising dividends. I don’t buy risky stocks with an unsustainable dividend that is at risk of being cut. This might sound difficult, but after the financial crisis I was able to borrow money at an unbelievably low 2.5% from a HELOC and invest it in solid dividend paying stocks that were yielding close to 6%.
  3. I hold on to my investments for the long-term. I don’t day-trade.
  4. I make sure I am properly diversified into many good companies
  5. I pay attention to taxes. Investors are often eligible to claim the interest expense on money borrowed to invest as a tax-deduction. Assuming you are in a 30% tax bracket, this means your cost of borrowing is reduced by 30%.

 

Know the Risks of Borrowing to Invest

While it is true that leveraging yourself and borrowing money to invest can lead to higher returns, it is also true that borrowing to invest can lead to greater losses. Consider the following example:

If you invest $20,000 to buy a $100,000 investment, effectively borrowing $80,000, and that investment increases in value to $105,000, then you haven’t just gained 5% of your investment ($5,000 of $100,000), you have gained 25% ($5,000 of $20,000). Conversely, however, if you invest $20,000 to buy a $100,000 investment and that investment falls to $95,000, then you haven’t only lost 5% of your investment ($5,000 of $100,000), you have lost 25% ($5,000 of $20,000). It is this wide variation of returns that means leverage is always more risky than no leverage at all.

If you are going to adopt a strategy involving leverage, then you should make sure that – (1) you don’t borrow more than you can afford to lose; (2) you can comfortably cover the interest expenses on your debt, and (3) you are able to control your emotions and not panic and go running for the hills at the first sign of trouble.

In this regard, it pays to get a little investing experience before you adopt a strategy using leverage. It also pays for you to start a strategy involving leverage with just a little bit of borrowed money and to go slow. You want to make sure you are confident in your investing strategy and that you can control your emotions. If you can’t be sure you will follow the three points mentioned above, or you can’t sleep at night knowing you’ve increased your risk, then it probably makes sense to stay away from a strategy involving the use of leverage.

Moreover, if the time is not right to leverage yourself in the stock market, consider if the time is right to use some leverage and invest in real estate. Just make sure you try and follow the same rules for real estate as you did for the stock market. Try to buy undervalued real estate, try to be cash flow positive, and invest for the long-term. If the time is not right for the stock market or for real estate, then you will need to be patient. The best investors out there have both patience and discipline.

Eventually an opportunity will present itself, and if you are prepared, you’ll be able to take advantage of it.

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