A retirement reality check

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NEW YORK (Money) -- Question: My husband and I work for a high-tech company, but we don't have much in savings. My husband has been borrowing money to put into the stock market, but he has lost money for the past two years. I don't think we should be doing this, but he says we need to take risks. What do you think? - Joan, Phoenix, AZ

Answer: First of all I think your husband needs to listen to you more. He's right in saying that you have to take some risks if want to build wealth. But we're talking about prudent risks. Risks that are very likely to pay off, like saving money on a regular basis, investing it in a diversified portfolio that includes both stocks and bonds and then riding out short-term drops in the markets so you can enjoy the long-term upside that the financial markets can offer.

But what your husband is doing is really more like speculation in my opinion. He's gambling that he'll be able to create wealth out of thin air by earning more on the money he borrows than he pays in interest to get that money.

I can understand why that may seem like a sure bet. After all, stocks have historically generated higher long-term returns than debt instruments. So your hubby probably figures that as long as he's investing for the long haul, he's assured of coming out ahead. The interest he'll pay on his debt will be lower than the returns he'll earn on the stocks.

But there are several flaws with his strategy. Aside from the fact that stocks' higher returns aren't guaranteed, the main pitfall is that we don't live in the long term. We live day to day.

And as we've seen lately, the stock market can take some pretty frightening dives that may lead to losses in the short-term. And those losses can wreak havoc with your husband's strategy.

Let's say, for example, that your husband borrows $10,000 at an interest rate of 7 percent. If he invests that ten grand and earns 10 percent over the next year, he'll have $11,000.

His loan balance at the end of the year will be $10,700. (In reality, he'll probably have to make monthly payments, but let's keep things simple.) So he could pay off the loan and come out ahead by $300. Hurray! Free money.

But what if stock prices decline by 10 percent? In that case, his investment account is worth $9,000 and he has a loan for $10,700. He's now in the hole for $1,700.

Maybe he can just wait it out until the market rebounds and puts him ahead. But in the meantime, his loan is going to continue racking up interest and he's going to have to make payments on that loan.

If he makes the loan payments from his investment account, he'll have less capital left to participate in the market's eventual rebound - which means it may take him quite a while to break even. If he makes the loan payments out of his pocket, that will put strain on the household budget.

In a worst-case scenario - one or both of you lose your jobs while the investment account's value is well below the loan balance - you could be faced with having to pay off the loan by selling off other assets or, barring that, go into default on the loan.

Essentially, you could end up in similar situation that hedge funds that invest using "leverage," or borrowed money, sometimes find themselves in when their "can't lose" strategies backfire.

Of course, it may not come to that. Your husband's plan could work out. But is it really worth embarking on this strategy for a gain that amounts to the difference between the loan rate and the potential investment return?

I don't think so. It seems to me the payoff is rather small for the risk you're taking. I suggest that you and your husband have a sit-down to discuss your finances.

Your hubby seems to have a pretty active imagination, so I'd ask him to put that high-tech brain of his to work to come up with some ways to save rather hatching harebrained schemes to turn borrowed money into wealth. (For some suggestions on how to bulk up your savings, I suggest you check out a column I wrote earlier this year titled, "Easy Ways to (Really) Save $400,000."

The first thing you want to do is accumulate about three months' worth of living expenses in a secure account, say, a money-market fund, short-term CDs or a savings account.

Once you've done that, you can start investing your savings. If you're not already participating in a workplace plan like a 401(k), you should do so immediately, and contribute at least enough to get whatever matching funds, if any, your employer kicks in.

If you don't have access to such a plan, you can contribute to IRAs or even just invest in taxable accounts. (For more on your options outside a workplace plan, click here.)

But the most important thing you've got to convey in this conversation is that if you want a real shot at creating financial security and building wealth, you've got to save.

Since your husband has lost money on his investments over the past two years, he may be resorting to magical thinking there too rather than simply following some basic investing techniques that balance risk and reward. So you and your husband might want to brush up on the fundamentals by checking out our Money 101 lessons on the basics of investing, as well as the ones that specifically deal with investing in stocks, mutual funds, bonds and asset allocation.

If you're successful in getting the savings message across and convincing your husband to follow a few tried-and-true investing techniques, then at least you and he will know that you're building your financial futures on a solid foundation, not smoke and mirrors.