It’s risky to borrow when investing
September 17, 2015
Should you borrow to invest? Leverage can have rewards; however, there is risk.
There have been a lot of discussions about borrowing. Mostly about how Canadians are overextended and there have been warnings from the federal government encouraging borrowers to pay down the debt.
This has been going for many years because since interest rates plummeted years ago, Canadians have been borrowing more than ever. Most often they borrow to consume goods or services that are often considered to be extras.
Very little of the borrowing conversation is related to borrowing to invest. That is not the case within the financial services industry.
There is a concern that some financial advisors encourage leverage so that investment products can be sold. As a result there are built-in guidelines to attempt to discourage borrowing to invest.
Leverage acts as a catalyst. It accentuates investment results.
If you borrow $100,000 and the market goes up by 10 percent, then you have just profited by $10,000. Sounds simple and very inviting.
Unfortunately, sometimes the markets decline in value and your $100,000 investment declines to $90,000, which means you are out of pocket $10,000.
Gains are fine but losses have to be repaid. That can be a big problem, particularly for an unsophisticated investor who is not fully prepared for the potential loss that comes with borrowing.
Many investors who have borrowed to invest will panic when the market declines. Quite often this means they will sell the investments and then be stuck with debt that has to be paid back.
Investors have a terrible track record when it comes to investing. History shows that many investors wait until the market appreciates in value before they have the confidence to invest.
Then at the first sign of a market downturn they sell at a loss. This happens all the time.
Studies in both Canada and the United States have shown how poorly investors do against the underlying market they invest in. The cause is market timing and most people get it wrong.
If the same people who panic when the market declines have increased their investment portfolio with leverage they are more likely to panic. They will likely sell their investments at a loss.
There have been articles about specific individuals who have borrowed to invest. Often they invest in specific stocks, which in my opinion is absolutely crazy.
There is greater certainty by investing in a very well-diversified investment portfolio. Over the long term, markets have historically always increased in value.
The sad reality of owning specific stocks is sometimes these stocks decline significantly in value and never regain those losses.
Borrowing to invest can be a useful strategy; however, it is not for everyone.
We strongly encourage all investors who have borrowed to invest to reconsider their actions and ensure that it is in their best interest.
RELATED ARTICLES