With margin debt soaring and many investors actively taking on consumer debt to buy stocks, we can conclude that there’s a lot of borrowed money in the market today. If so many others are doing it, does that mean you should also borrow to invest?
Consider the Risks
You can borrow money to buy stocks, but you’ll be taking significant risks, and some of the risks may not be obvious. Let’s take a look at some of those risks.
Systemic Debt Risk
This risk is not specific to you. It applies to anyone using borrowed money to invest in a highly leveraged market. High debt levels mean high risk levels: if you look at the margin debt chart above, you’ll see that margin debt peaked before both the 2001 and 2008 recessions.
If stock values turn down, people who are borrowing to buy stocks don’t just have to sell the stock they borrowed to buy. They may have to sell other stocks to cover a margin call or pay back a loan. That selling pushes prices down further and pushes other investors into the same situation. That makes a highly leveraged market vulnerable to rapid price drops.
You should assess the impact of leverage on the market before making any investment, but it’s particularly critical when you’re investing borrowed money.
Risk of Loan Default Due to Investment Loss
This is the most obvious risk of using borrowed money to buy stock. If your selected investments don’t perform as expected you may lose money. You may then be unable to pay your loans. That could force you to liquidate other investments.
Your credit may suffer and you could be forced into default and even bankruptcy, depending on the amount and type of loans you’ve used to buy stock.
Risk of Leverage Addiction
This is perhaps the most insidious risk of borrowing money to buy stock. If you succeed and make money you’ll get a huge emotional high. You’ll feel smart and accomplished like you beat the system. There’s a very good chance that you’ll do it again. The more you succeed, the more likely you are to borrow more and take more risks. That can leave you in an extremely risky situation, and sooner or later markets do turn down.
When leverage works, it magnifies your gains… but leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices.
Warren Buffet
The Experts Advise Against It… But Aren’t They Doing it Too?
Very few investment professionals would advise using borrowed money to buy stocks. Most would advise against it, and those who would approve would probably qualify their approval heavily.
That reluctance to endorse buying stock with borrowed money is often seen as hypocritical. Many of the fund managers and investment professionals that discourage individual investors from buying stock with borrowed money are managing highly leveraged portfolios. Warren Buffet, who has warned about the risks of leverage, used borrowed money to invest early in his career.
The difference, of course, is that individual investors simply can’t borrow on the same terms as large investment institutions. That may not be fair, but it’s still true. If you could borrow on the same terms as Berkshire Hathaway or a major hedge fund, and if you have professional-level risk assessment expertise, borrowing to buy stocks might be a good idea. Very few individual investors are in that position.
Investing with borrowed money could be a reasonable move if the loan terms are good and you’re very sure that you’ve predicted the stock’s movement accurately.
It’s very tempting to use low-interest loans to invest in a rapidly expanding market. It’s also very risky. You may choose to take that risk, but you’ll want to assess it very carefully and avoid getting carried away if you do succeed. Leverage has made some investors rich. It has also made some rich investors poor.
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