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Brett Arends's ROI

Nov. 29, 2021, 12:29 p.m. EST

Buying stocks with borrowed money isn’t as crazy as it sounds

By Brett Arends

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 at least is the apparent reasoning of CalPERS, America’s biggest pension fund, which has just announced it hopes to goose up returns by taking on debt so it can buy more investments on margin .

The amount so far isn’t much: CalPERS says it will borrow up to 5% of the value of its portfolio, although it says it may in time raise that to 20% .

But it raises the intriguing question: Why don’t we all do this?

It’s not like borrowing is expensive. federal funds rates are basically 0%. Even amid the current flap about inflation, they are predicted by the money markets (rightly or wrongly) to rise to no more than 2% by 2025. BofA Securities points out that interest rates on 10 year Treasury bonds are now nearly 5 percentage points below current inflation, “a level in the past 200 years that has been associated with panics, inflation, wars & depression.”

No, you and I can’t borrow at the federal-funds rate. On the other hand, middle-class Americans often have access to multiple sources of pretty cheap debt which we could, if we wanted, use to take on extra investments. Some are obvious: Home equity lines of credit, margin debt at your broker, and those 0% credit card offers flying into our letter boxes like invitations from Hogwarts .

Some brokerage firms charge usurious interest rates on margin but others don’t. Interactive Brokers, for example, charges as little as 1.58% .

And there are other alternatives as well. Stock options, financial instruments that are complex but less ‘dangerous’ than they sound, effectively let you buy $2 or $3 or even $10 worth of stocks with $1 down at reasonably low cost. Closed-end mutual funds, a type of fund that is structured like a regular stock and which trades on 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 buck. All come with massive caveats and risk warnings, but they aren’t always exploding cigars.

Oh, and if you delay paying your federal taxes until the due date, April 15 of the following year, you will have the extra cash all year for investment and Uncle Sam will currently charge you just 3% for the privilege.

According to data from NYU’s Stern School of Business, since the 1920s the returns on the S&P 500 (S&P:SPX) have beaten the returns on Treasury bills by an average of 6.5 percentage points a year.

Borrowing to invest isn’t as crazy as it seems, either. After all, what do we all do when we buy a home? We typically put down just 20% or 25% of the value and borrow the rest. Nobody thinks this is insane. And it is the main source of wealth for many middle-class people. Think of how much money you’ve made on the value of your home. Imagine how little you would have made if you had not been able to take out a mortgage, and instead had only been able to buy a home when you could afford 100% of the purchase price. You’d still be renting, and the poorer for it.

Warren Buffett invests with leverage. Some years ago, analysts found that the main source of Buffett’s stunning investment success over many decades was neither superior stock selection, market timing or management skill: It was simply that he borrowed money cheaply, through his insurance operations, and using the extra money to buy more stocks than he could otherwise. He focused, they worked out, on stocks that were cheap, high quality, and had low volatility. Meanwhile his leverage, they calculated, averaged 1.7:1. In other words, he ran his portfolio with the equivalent of a 60% mortgage.

Allan Mecham, the boy wonder who ran Arlington Value investments for 20 years, went a step further some years ago: Through his fund he borrowed money cheaply to buy extra stock in Warren Buffett’s Berkshire Hathaway, boosting his investors’ returns even more.

Some financial experts argue that we should borrow money to invest when we’re young: Otherwise we invest too little in our 20s and 30s, when we don’t have much money, compared with what we can invest in our 50s and 60s.

There are obvious downsides to the concept of borrowing money to buy stocks. The first is that the best time to do this probably isn’t when scribblers like me are writing about it. The market right now is at record highs, and by various calculations may be in a massive bubble that is ripe for a nasty fall. The late economist Hyman Minsky famously argued that when things are booming people get complacent, borrow too much and take on too much risk, which creates the next crisis. You could consider articles like this — and actions like those of CalPERS — as a Minskyesque warning.

Margin debt at brokerage firms is already at record levels , and is nearly twice what it was just 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 stalks the land… and hardly anyone wants to take on risk.

The second problem with borrowing money to buy stocks is that you should only do it if you are absolutely sure that you can ride out the extra volatility. In the last two major bear markets, from 2000 to 2003 and 2007 to 2009, the S&P 500 halved in value. Someone running a portfolio with 50% borrowed money would have been wiped out.

Too many people owning too many stocks with too much borrowed money is precisely what made the infamous 1929 stock market crash so deep and so bad. 

By 1932, incidentally, stocks had fallen 90% from their peak. Ouch. 

In theory there is nothing wrong with borrowing a modest amount to buy more stocks, as we do to buy our homes. Even, say, borrowing an extra 10% or 20% could add materially to long term returns. But only if you are sure you can ride out the volatility. Otherwise you will end up losing, not winning, from the trade.

Link to MarketWatch's Slice.