Buying stocks on borrowed money
Now is a great time to buy stocks, but you don't have to bet the farm to do it.
NEW YORK (Money) -- Question: I read your article on the idea of buying stocks in today's economy, I agree 100%. I currently have a HELOC (home equity line of credit) in the amount of $50,000 and we have been discussing borrowing to put it into the stock market. What do you think?
The Mole's Answer: Well, what I think is that one should never, and allow me to capitalize for emphasis, EVER borrow to invest in the stock market. In my view, doing so is nothing more than gambling.
There are a few ways to borrow and invest in the stock market such as taking out a loan, using home equity, buying on margin or purchasing a leveraged exchange traded fund. Some are better than others but none are good.
The stock market is down about 40% so far this year and that's pretty bad, if you ask me. But someone who, let's say, borrowed to double their investment, has seen more than an 80% loss. It's a bit more than double, in fact, because they also had to pay interest on the money they borrowed.
While I believe that most of the stock market disaster this year was due to all of the era of subprime easy lending catching up to us, I also think part of it was caused by too much leverage in the stock market.
Many institutions had leverage and stock market positions. When the market declined, they were forced to liquidate some stocks to raise cash. This, of course, caused the market to fall more and the vicious cycle continued. Now we are all paying the price.
You may be confusing my advice to buy stocks now in a recent column with a suggestion to buy at any cost. What I'm suggesting is not to pull equity out of your home and throw it into the stock market, but rather that you take a good look at your asset allocation, and have the guts to rebalance, even in a tough time like this. That means selling some of your safer assets and buying more stocks.
Most people know that we underperform the stock market because of the high expenses we pay, but not many realize we pay an additional cost because of performance chasing. We act in a predictably irrational way by following the herd and buying near the top of the market and selling near the bottom. Studies have shown that this irrational behavior costs us an extra 1.5% annually on average.
Truth be told, I wish I knew whether we were at the bottom right now because I'd be one very rich mole. And though I don't know that, I do know that rebalancing tends to work quite well over longer periods of time.
If we set an overall asset allocation, say 60% stocks and 40% fixed income and just stuck to it, what would we have done over the past several years?
- Between 2003 - 2007, when the U.S. stock market nearly doubled and the international market nearly tripled, we would have had to sell some of our equities. While the herd was stampeding toward buying, we would have been selling.
- Now that the market is having a 40% off sale, we should be buying, even though everyone else seems to be selling.
All of this seems quite simple but simple investing is never easy. Hard as it is to sell some of our equities in good times, it's much harder to buy them in bad times. Yet that's exactly what I believe we should all be doing now.
Only time will tell but I think the odds are that an investor with cash and courage will do quite well by rebalancing and moving toward their target allocation that they had during the good times. With that said, no one should have a target allocation of more than 100% in stocks. Borrowing to get over that 100% allocation may work, but I highly discourage it. You'd be speculating when you should be investing.