SHOULD YOU BORROW MONEY TO INVEST?
As stock markets have fallen sharply, many investment professionals believe that now may be a good time to start investing. Historically, when markets have taken such a pounding, it has proven wise to “buy the dip” and invest. At the same time, it is important to remember that whatever happened in the past is not always an indication of what will happen in the future. However, if we can use history as a learning tool, then it may be prudent to think about investing.
Yesterday a client wanted to know if it would be a good idea to take a loan in order to invest even more money? First of all, she thought that due to the recent falls on the stock market, she may possibly make a lot of money in the future. Another reason was that within the next two years it was very likely that she would be marrying off 3 children. She had little savings, and while she made ends meet every month she wasn’t able to save consistently. The client explained that as she would need to borrow money to make a wedding, she thought it might be prudent to take a loan now and invest the funds. Once those funds had made a profit, she would sell the investment and use the money to pay for her daughter’s wedding.
At first glance, this client’s assumptions appear to make a lot of sense. If she borrows money and invests it well, her returns will be much higher. For example, if she were to borrow $50,000 and make a 25% profit, she would pay back the $50,000 loan and pocket the $12,500 profit. This profit, which would be used for the wedding, would have been made easily – and without a penny of her own money!
Risk Versus Reward
At the same time, it is very important to remember that when an investor decides to make an investment she needs not only to take into account the potential profits, but also the possible risks involved. For example, what would you do if you invested $10,000 in a stock today, and tomorrow it drops by 10%?
Risk also has to do with time. The more time you’ve got to make up for short-term losses, the more aggressive you can be with your investments. Conversely, if you need funds next week, you shouldn’t put all of your money into some kind of speculative stock, or into any stock. This is because an investor cannot afford to lose her money, and in the short term, there is no way of knowing what will happen to a stock.
What if Something Goes Wrong?
In the case mentioned above, the client is working on the assumption that the market will go up, which is a definite possibility. However, what would happen if the market goes down another 20%? What would this client do then? Not only would she have to borrow more money to pay for the wedding, but she would also have to pay back a loan with 20% less money than she had in the first place.
Under her current circumstances, she would be setting herself up for a possible financial collapse that could have devastating results. She can’t afford the consequences if her market prediction is proven wrong. The time element mentioned earlier is an additional disadvantage because she may well have to start making weddings within the next year or two.
An important principle to remember in investing is that if you are in a situation where you cannot afford to lose money, you should not invest at all. And if you have no money in the first place, do not borrow in order to invest.
Conversely, there are certain situations when it actually pays to borrow money in order to invest. The most common example is when a person buys an apartment. In this situation, the buyer takes out a mortgage. Yet even here, it is still important to remember that a person should only take out a mortgage that he can handle. In fact, in most cases the bank won’t allow you to borrow more than you are able to pay back. While borrowing money is not in itself problematic, it should only be done if you have the ability to repay the loan without taking out another one in the eventuality that the money is lost.
The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc. or its affiliates.
