Gearing for growth?
Borrowing
money for investment purposes is a game as old as the hills –
but is it wise? Michael Wilson weighs the pros and cons
You can call
it ‘gearing up’, you can call it ‘leveraging
your assets’, you can call it ‘maximising your capital
potential’ – indeed, you can call it anything that
makes you feel more comfortable – but the chances are that
no matter how you label it, it amounts to the same thing. It has
become such a norm these days to borrow the money that you invest
in the equity markets that you probably don’t even notice
you’re doing it. Indeed, your family would probably think
you were being positively reckless if you didn’t.
Pause for
effect. But hang on, you might say, everybody knows you should
never invest with borrowed money. It’s the start of the
slippery slope that ends in the workhouse; it’s the dream
of riches that addles your brain and sends you down the road to
insanity. Above all, it’s risking your family’s happiness
and security, and maybe even the roof over their heads. Why would
anybody want to do such a thing?
Well, let’s
put the situation another way. If you’ve got money invested
in the stock market, but if you coincidentally happen to have
a mortgage or an overdraft or a credit card balance, then in principle
you’ve already sold your soul to the Dark Side. The money
that you invest today could just as well have gone toward reducing
your debts. So, it’s nearly the same thing as having more
debt than you need – isn’t it?
All this,
of course, is complete nonsense. If we applied the debt test as
rigorously as our logic seems to demand, then we couldn’t
even start investing for our pensions until our mortgages had
been paid off, and that would create all kinds of other problems.
Such as a poverty-stricken old age, and a lack of liquidity in
the global equity markets, and a complete lack of any sense of
achieving anything financially during the best years of our working
lives.
But we’re
getting into the realms of sophistry here, and that’s hardly
ever a good idea in the world of investments. So let’s get
real. Specifically, what we’re going to talk about in this
article is the age-old practice of borrowing money from your bank,
or perhaps your stockbroker, in order to punt it on the stock
market. Is that simple enough for you?
A
great time for risk-takers
It won’t
have escaped your notice that these last nine months have been
an excellent time to be short on cash and long on stocks. A 30
per cent rise in the world equity markets has coincided with a
50-year low on interest rates, making 2003 just about the finest
year on record for those people who were prepared to compromise
their principles.
Even a relatively
expensive loan at, say, 6 per cent interest would have cost you
only US$420 for every US$10,000 that you’d invested between
mid-March, when the markets first seemed to be turning back upward,
and mid-October, when they seemed to be getting a second bout
of indigestion.
Compare that
cost with the US$3,000 capital gains that you could reasonably
expect to have cleared in the same seven-month period, and the
cost of the loan appears insignificant. Your net gains would have
been around 26 per cent in absolute terms. Or 24.5 per cent in
real terms if the consumer price index had risen by 1.5 per cent
during those seven months – the equivalent of an annual
2.5 per cent rate.
That’s
all very well, of course, but we do need to remember that we’re
saying this with the blessed benefit of hindsight. Back in March
there were still plenty of people who reckoned that the bear still
had legs for at least another six months, that company valuations
were still too high in terms of their earnings, and that borrowing
any new money now would be sheer folly. What if they’d been
right?
Well, as we’ve
seen, the cost of your US$10,000 loan would have been US$420.
To which you’d have needed to add the total of any losses
you might have made during those seven months – US$1,000,
perhaps, plus the 1.5 per cent that inflation had taken out of
your wallet. Result: a US$1,570 hole in your bank account instead
of a US$2,450 profit.
Further losses
could easily have accrued if you’d got it really wrong.
Currency risk alone would have added another US$1,500 or so to
your net deficit if you’d been a US investor who borrowed
money in euros back in March, with the aim of investing them in
dollar-denominated assets like oil or gold. But conversely, European
or Asian investors are currently finding that it’s quite
advantageous to borrow such funds in dollars, because the burden
of paying them off has fallen by a similar 15 per cent since March.
And if the greenback keeps on sliding, that deal’s just
going to keep on getting better and better. Provided, of course,
that you earn your money in some other currency.
But
does it work?
The short
answer is, sometimes. At times like these, when equity markets
have been zooming up and borrowing costs are low, there’s
an argument to be made in favour of borrowing to fund your investing
itch. But how would borrowing work out as a long-term strategy?
Not so well,
it would seem. Over the last 30 years or so, the thousand-day
average for most developed-country stock markets has been growing
at somewhere between 5 per cent and 8 per cent a year. The crazy
growth spurts of 1975, 1988 and 1999 that we all remember so happily
need to be set in the wider context of all those years when nothing
much happened, or when markets fell sharply. Whether we like it
or not, we have to remind ourselves that every penny or cent we
borrow for our portfolios is going to be costing us the same old
variable rate of interest during the bad years as well as the
good ones.
Let’s
suppose, for the sake of argument, that you’ve borrowed
your money at an average variable rate of 5 per cent, without
any tax breaks to soften the blow (see below), and that you’re
getting a long-term average capital return of 7 per cent on your
investment. That implies a 2 per cent annual net return, which
doesn’t look too bad, especially when you consider that
you can reasonably hope to get a 2 per cent dividend yield from
your investments as well. Over a period of 30 years, a 4 per cent
total return every year would roughly treble your money. But that
attractive picture starts to look a little different if you add
in the probable effects of inflation. Even a 2 per cent rise in
the consumer price index would reduce your 200 per cent gain to
a real return of around 77 per cent over the full 30 years.
And that’s
without paying off any of the loan capital along the way. It would
be a rare kind of lender that allowed you to sit on its money
for 30 years without returning any of its capital at all. The
only likely exception would be an endowment lender, which would
insist on your taking out life assurance to cover the capital
sum if you were to fall under a bus. And we can confidently say
that the chances of your getting that life assurance for less
than 2 per cent a year would be minimal. Your long-term return
would rapidly drop towards zero.
The alternative,
and undoubtedly the better strategy, would be to grit your teeth
and pay off the borrowed capital in staged amounts, as you would
with a conventional repayment mortgage. In view of the substantial
sums involved, that would probably mean top-slicing your investment
at regular intervals – which would, of course, mean that
you wouldn’t see anything like the 77 per cent real return
we were just talking about. Paying off even 1 per cent a year
would reduce your gains to around 39 per cent over the 30-year
term.
So how will
it feel to have that debt hanging over your head during the bad
years when the capital value of your equity investment is falling,
as it inevitably will from time to time? It’ll probably
restrict your financial headroom the next time you go out to get
a mortgage, too. In short, if you haven’t factored in the
psychological and familial costs of borrowing for your portfolio,
then you haven’t done your sums properly.
But it’s
a different matter if you genuinely see an opportunity for substantial
one-off growth, and if you’re really prepared to regard
your borrowing as a short-term strategy with a precisely targeted
objective. If you’re utterly convinced that small caps or
oil or cyclicals like paper pulp are unreasonably and unsustainably
undervalued, then there’s a case to be made for taking the
pain. Provided, of course, that you have the strength of character
to sell up and repay the loan just as soon as 1) your objective
has been reached or 2) things start to go so pear-shaped with
your portfolio that there’s no point in continuing with
your strategy. Personal experience suggests that the latter is
much harder to achieve than the former!
Choose
your weapons
OK, you say,
I hear you, but I’m big enough to be able to cope. Tell
me how I can get into this leveraging business?
It tends
to vary according to the country you’re based in. US and
Canadian investors will normally want to turn to private-client
stockbrokers who’ll effectively lend you up to half of the
money with which to buy your portfolio – with the important
proviso that they’ll demand complete freedom to monitor
your investments, and to sell out without consulting you if things
start to look bad. Many of these stockbroker margin lenders have
taken a serious hammering since 2000, and you’re likely
to find that the credit rates they charge are quite a bit higher
than the 8 per cent that was typical during the late-90s boom.
Australian
investors spent a large part of the 1990s borrowing against their
homes, with the explicit purpose of getting stock market exposure.
That was fine by the Australian government at the time, because
it did the Oz stock market a power of good at a time of fast economic
growth. And there were often tax breaks to be wangled if the loans
could be presented as part of the borrower’s house purchase.
But now that house prices are stagnating and, in many cases falling,
there are a lot of investors who are perilously close to the waterline.
At least
the Ozzies had the benefit of fixed-rate lending, which is more
than can be said for the Brits. The favoured way in the UK over
the last few years has been to borrow using bank loans, variable-rate
mortgages and even (jeepers) credit cards, which have made something
of a habit of offering six-month deals at 0 per cent before their
standard rates of 11-18 per cent kick in. Even in those cases
where credit card lenders offer genuine “lifetime”
transfer rates of 3-5 per cent, the requirement to pay off at
least 2 per cent of the capital every month makes this a highly
inconvenient way to fund your portfolio. Unless, of course, you
have the discipline for the kinds of fast-in, fast-out strategies
we’ve just been looking at. In which case, the very best
of luck to you.
A
few commonsense guidelines
We could probably
say that you need to be a pretty special kind of investor to be
able to trade on margin with money that you’ve borrowed.
It isn’t recommended for anyone but the most experienced
investors, for the very simple reason that it can go horribly
wrong and land you with a bigger debt than the pot of cash you
started off with.
First, avoid
tracker funds at all costs. They take management charges, they
don’t usually pay dividends, and they’re designed
for the longer-term investor. Which is just what you don’t
want to be if you’re a borrower.
Secondly,
try to avoid taking on investment debts that are secured against
your principal home. Although they’ll normally come much
cheaper than bank loans if you dress them up in the shape of a
mortgage (you can get 2.95 per cent mortgages in continental Europe,
or 2 per cent in Japan), it makes little sense to risk anything
as important as your principal domicile in the event of your coming
unstuck. Unless, that is, you have some other form of security
that would come to your rescue in the worst-case scenario –
a rainy-day bank account, a priceless antique or two, a rich uncle,
or a small part of your pension fund whose loss wouldn’t
hurt you too badly..
Thirdly,
if you’re absolutely determined to go down the derivatives
road, then you’re better off sticking with options or spread
betting, because at least those won’t leave you with anything
worse than a 100 per cent loss if you should get it terribly wrong.
In most of these cases you’ll be limited to trading within
the limits of an account which you’ll have set up and fully
funded with cash before you start, so it’ll be up to the
people running your account to haul you in and limit your liabilities
(for example, with a margin call) if you should start getting
too big for your lucky boots.
And finally,
do everything you can to reduce your debt as soon as you feel
able to. If you’re making gains, consider top-slicing your
portfolio to repay the goddess of good fortune while you can.
It isn’t just the brave investor upon whom fortune smiles.
It’s the prudent one too.
