Portfolio Ideas. Should you borrow to invest?

It is perhaps common to borrow money to buy a house for self-occupation. But will you borrow to invest in stocks and bonds? Is it appropriate to do so? What are the issues? Here's more.

You may be already aware of the popular wisdom — use other people’s money to create wealth.

Professionals who offer this advice are essentially asking you to invest some of your own money and a lot of borrowed money to buy assets. Rather than argue otherwise, we urge you to consider the following issues before you decide to follow the popular wisdom. First, if you are borrowing money to invest in risky assets, you run the risk of earning less than your borrowing cost (negative spread).

Let’s say you borrow money to buy equity mutual funds. The interest cost on your loan is a fixed obligation; you have to incur the cost whether your mutual fund returns are positive or negative.

Is it worth taking such a risk when your investment objective is to meet important goals, such as your child’s college education costs? Second, if you are borrowing money to invest in stable-income products, you will more often than not earn negative spread. Stable-income products are those that generate income such as interest, and not capital appreciation.

It’s hard to earn interest in excess of the loan cost. Take fixed deposits. The interest earned on these is less than the interest cost on the loan. So why borrow money to invest in such products? Third, if your monthly income is unstable, you will unnecessarily stress your cash flow if you borrow money to buy assets. Your income could be unstable due to the nature of the industry in which you work for or the large variable component of your salary. Finally, borrowing can add to anxiety.

But why then do you borrow to buy a house? The reason is that you do not perceivably suffer losses on your real estate ‘investment’ for two reasons. One, there are no visible real-time prices for real estate, as there are for stocks.

You cannot easily compute the negative spread. And two, most individuals buy real estate for self-occupation. So, the pain of losing money on the ‘investment’ using borrowed money is not very high. Any potential loss is compensated by the happiness that you derive from living in your own house, and the fact that you save on rent. Further, many individuals view borrowing to buy a house as forced savings — you repay your loan every month and thus build your equity in the house. Borrowing money to buy an asset may not be worthwhile unless you have an assured positive spread. That is, the return on your investment must be higher than the cost of borrowing. But such investment opportunity is available only to rich individuals and institutional investors through exotic financial products.

So, your best opportunity to leverage is through exchange-traded derivatives, such as index futures and single-stock futures on the NSE. But if you do feel the urge to borrow money to invest, first create investment accounts, which are not from borrowed money, to meet your life goals. That way, borrowing to invest is less likely to hurt your chances of achieving your goals.

The writer is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in

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