If borrowing money is so cheap, and the returns from stocks are so good, why shouldn’t we borrow money to buy more stocks?
That’s at least the clear argument of CalPERS, America’s largest pension fund, which just announced it hopes to increase returns by taking on debt so that it can buy more investments on margin.
The amount so far is not much: CalPERS says it will borrow up to 5% of the value of its portfolio, Although it says it can increase it to 20% over time,
But it raises an intriguing question: Why don’t we all do it?
It’s not that borrowing is expensive. Federal funds rates are basically 0%. They are predicted by the money market (rightly or wrongly) to grow no more than 2% by 2025, even amidst the current flurry about inflation. BofA Securities points out that interest rates on 10-year Treasury bonds are now down about 5 percent. Current inflation, “a level over the past 200 years that has been linked to terror, inflation, war, and depression.”
No, you and I cannot borrow at the federal-funds rate. Middle-class Americans, on the other hand, often have access to multiple sources of very cheap debt, which we can use to make additional investments if we so desire. Some are obvious: a home equity line of credit, a margin loan at your broker, and those 0% credit cards on the fly in our letter boxes. like an invitation from hogwarts,
Some brokerage firms charge usury interest rates on margin but others do not. Interactive Brokers, for example, Fees as low as 1.58%,
And there are other options too. Stock options, financial instruments that are complex but less ‘dangerous’ than they sound, can effectively cost you $2 or $3 or even $10 worth of stock with $1 reasonably low. Lets buy. Closed-end mutual funds, a type of fund that is structured like a regular stock and trades in the market, often use cheap debt to boost their returns. And there are “leveraged” exchange-traded funds, usually with names like Ultra or 2X or 3X, that effectively try to get you more investment bang for your money. All come with massive warnings and risk warnings, but they aren’t always exploding cigars.
Oh, and if you delay paying your federal taxes by the April 15 due date of next year, you’ll have extra cash to invest throughout the year and Uncle Sam is currently charging you. only 3% for privilege.
Returns on the S&P 500 SPX since the 1920s, according to data from NYU’s Stern School of Business,
has outpaced the return on Treasury bills by an average of 6.5 percentage points per year.
Borrowing to invest is not as crazy as it sounds. After all, what do we all do when buying a home? We usually only put down 20% or 25% of the value and borrow the rest. Nobody thinks it’s crazy. And it is the main source of wealth for many middle class people. Think about how much money you made on the value of your home. Imagine how little you would earn if you hadn’t been able to take out a mortgage, and instead only be able to buy a house when you could afford 100% of the purchase price. You’ll still be renting, and poor for it.
Warren Buffett invests with leverage. few years ago, analysts found that the main source of Buffett’s astonishing investment success over many decades was neither superior stock selection, market timing or management skills: it was simply that he borrowed money cheaply through his insurance operations, and more by using the extra money. To buy the stock he could have done otherwise. They focused on cheap, high quality and low volatility stocks, they worked. Meanwhile his leverage, he calculated, averaged 1.7:1. In other words, he ran his portfolio the equivalent of 60% of the mortgage.
Alan Meacham, the guy who ran Arlington Value Investments for 20 years, took a step forward a few years ago: Through his own fund, he cheaply borrowed money to buy additional stock in Warren Buffett’s Berkshire Hathaway, increasing his investors’ returns. increased even more.
Some Financial experts argue That we should borrow money to invest when we’re young: otherwise we invest much less in our 20s and 30s, when we don’t have much money to invest in than we did in our 50s and 60s.
There is a clear downside to the concept of borrowing money to buy stocks. The first is that probably not the best time to do this is when scribblers like me are writing about it. The market is at record highs right now, and according to various calculations could be in a huge bubble that is ripe for a terrible drop. The late economist Hyman Minsky famously argued that when things are booming people become complacent, borrow too much and take too much risk, which creates the next crisis. You might consider articles like this – and actions like CalParse – as a minstrel warning.
Brokerage Firms Have Margin Loans already at record levels, and almost twice as much as a few years ago. The best time to borrow money to buy more stocks is going to be during a collapse, when stocks are cheap, fear hits the ground… and hardly anyone wants to take the risk.
The other problem with borrowing money to buy stocks is that you should only do it if you are absolutely sure you can get out of the extra volatility. In the last two major bear markets, 2000 to 2003 and 2007 to 2009, the value of the S&P 500 halved. Someone running the portfolio with 50% of the borrowed money would have been wiped out.
Too many people owning too many stocks with a lot of borrowed money is exactly what made the infamous 1929 stock market so dark and so bad.
By 1932, coincidentally, the stock had fallen 90% from its peak. Ouch.
In principle there is nothing wrong with borrowing a nominal amount to buy more stock, as we do to buy our homes. Even, say, borrowing an additional 10% or 20% can materially increase long-term returns. But only if you are sure that you can exit volatility. Otherwise you will lose the trade, not win.