Borrow to own stocks?
Question: Facts: I have a stable job. My only debt is school debt that costs me approximately $200 per month. After expenses each month I am able to put away money into savings and contribute to my IRA. Additionally, I have enough savings that my family could get by for at least 7-10 months if I were to lose work today.
What I lack is discretionary capital to invest with an eye towards long term growth. Even assuming increases in pay over time, it will be a while before I have a sizable enough amount of money to put into an index tracking fund, or the like.
Is it a good idea to take out a 10K loan at 7.41% with the goal of investing that money for the long term 10-15 years? I can afford the ~150 per month payment on the loan right now. The life of the loan would be six years.
Or is it wiser to just keep the $150 per month accumulating in savings? ($1800 per year). Any thoughts or considerations are greatly appreciated! Andres, Helena, MT
Answer: I would keep accumulating savings, despite fractional yields. The tactic of borrowing to buy stock is extremely risky and likely to backfire. Betting on stocks with borrowed money is extremely risky.
At first glance, it might seem like a sensible strategy. Since 1926 stocks have shown an average annual return of almost 10%. You should come out ahead with an interest cost of 7.41%, right?
Yet on average Lake Eerie never freezes. For example, stocks returned a mere 2.39% over the past 5 years (ending July 31, 2011), much less than your 6 year loan would cost. Stocks returned an annualized 2.61% over the past 10 years. Going out 20 years the annualized return on stocks was 8.37%, not much above the cost of borrowing. Stocks are risky, short-and long-term
Even a casual glance at the history books shows investors struggling to cope with traumatic events, cataclysms like World War I, World War II, September 11, and the Great Recession--and the current market breakdown.
The surprises aren't all negative. We've also lived through radical new technologies that have changed the way we live and work, such as the railroads, the radio, the Internet, and social media.
We have to manage our money through the tumult. Time doesn't eliminate the uncertainty. It's inherent in owning stocks. I would keep adding to your savings.
At the same time, I would get more familiar with investing. A good book is The Random Walk Guide To Investing by Burton Malkiel. It's short, covers the basics of investing, and full of wise advice. You don't need a lot of money to expose yourself to the stock. Mostly what you need is a strategy, an approach that helps you live through the tough market times.