Caution: Don’t do it without giving it a serious thought and knowing all the risks. For common investors, it is one of the riskiest things which they can do in stock markets.
Common investors are better off avoiding mistakes than looking for multibaggers. Avoiding mistakes means not doing anything stupid with their money. It means having reasonable expectations and behaving reasonably. I will give you an example of each.
Example of Unreasonable Behavior
If a person has no idea about the actual business behind a share he has just purchased, then that is unreasonable behavior. The person is playing blind. He might still end up making money. But that is not because of his skill or any other ability, but because of his good luck.
Example of Unreasonable Behavior
Now markets can give returns in excess of 50% in a year. Compare this with returns of 8.5% given by traditional products and you would want to immediately dump your FDs, PFs, NSCs, etc. But expecting 50% to happen, year after year for decades, is a case of having unreasonable expectations. Such expectations, and actions based on those expectations are bound to cause serious losses in stock markets.
The problem with common investors is that they neither have the time nor the energy to sit and understand businesses behind the stocks they own. So ideally, the best way for them to avoid mistakes is to stick with investing in mutual funds.
But lets be honest.
Direct stock investing is glamorous.
And at times, it gives the perception that making money is easy – where else can you make 10% or more in a day. But this perception is just a perception and not the truth.
It is not easy to get above average returns in stock markets. I know most of you won’t believe me. But you need to take my word for it. It is easy to be average in markets. Just buy index (funds). But being better-than-average is difficult. And being better-than-average for long periods of time, is exponentially difficult.
Now lets come back to the topic…
The title of this post puts up a question, which can be linked to the behavior of someone who I personally think will be an Ultra Aggressive Investor. It can be looked at as one extreme end of a hypothetical risk spectrum depicted below:
Think about it again. The title of this post asks you about what would happen if you took a loan and invested in something as risky as the stock markets. Sounds crazy. Isn’t it? And in most cases, it is crazy. In past, I have been regularly advising readers not to take loans to invest in stock markets.
But crazy might not be the right word to use here. It is actually all about the individual investor’s risk tolerance. To put it simply, it might be beyond the risk tolerance of a majority of people to invest in markets using borrowed money. Me included. But for many other, the risk may in fact be tolerable. I will come back to this discussion of risk in latter part of this post.
For now, I will tell you why this thought of doing a post on this topics came to my mind.
Few days back, I received a call from my credit card company, offering me a pre-approved personal loan of Rs 5 lacs at 10% for 5 years. I am sure many of you would be regularly getting similar unwanted calls. I politely refused the caller and told him that I didn’t need one. He tried convincing me but I managed to convince him against convincing me. 🙂
But today, I thought about it. What if I took this easily available credit (ofcourse at a cost – though not very high) and put it to better use?
In real life, I believe that there is no better use of money than to spend it on buying experiences that my family and I will remember for the rest of our lives. But the second best use that I could think off was to deploy funds in stock markets. But that is risky and against my personal philosophy of not using borrowed funds to invest, that too in an asset class which can give sleepless nights to many of us.
I also remembered a reader Krish’s comment on my post last year, that it was surprising that whole financial fraternity advocates equity investing with savings but not using borrowed funds. People about debt/equity ratios of companies, loans for start-ups but discourage if someone wants to invest in markets with loan.
Now my stand is still the same. I don’t intend to borrow and invest for sometime to come. Atleast not in next few years unless something like a PE10 event happens. 🙂
But the phone call from the credit card company and Krish’s comment had me thinking.
What – If ?
So instead of just thinking that investing using borrowed funds is wrong, I decided to see how this concept would have worked in past.
In rest of this post, what I will try to do is to use the past data to see what would have happened, if someone decided to invest Rs 5 Lacs in markets (after taking a loan). And to keep it simple, I will just stick with a scenario, where investment is made in the index. No direct stocks, futures or options. Just plain and simple index investments.
Sticking with the index is the easiest thing for a common investor. It might not be as profitable as active investing, but it still eliminates the risk of getting your stock picks or your fund picks wrong. By investing in index, one is not trying to beat the averages. One is trying to be the average. And that is not bad considering that averages in past have been in excess of 12% per year.
Now I am not sure what exactly was the interest rate or EMI, which the caller told me. But I used a simple loan amortization schedule to arrive at the required figures.
A loan of Rs 5 lacs at 10% for 5 years, can be serviced by an EMI of Rs 10,624.
This would mean that the borrower ends up paying Rs 6.37 lacs over a period of 5 years on this loan of Rs 5 lacs.
For the analysis, I got hold of Nifty data since 01-January-1999.
Now for each day, I assumed that an investment of Rs 5 lac is made in the Nifty. As already mentioned, this Rs 5 lac is funded by a loan for 5 years.
Then I calculated the returns on this investment after 5 years.
Now for analysis, ignoring other details like transaction costs, real value of money, mental stress, sleepless nights, etc., a return in excess of Rs 6.37 lacs for an investment of Rs 5 lac in index would mean that break-even point has been reached.
Anything above Rs 6.37 lac means that the entire transaction (Taking Loan –> Investing –> Repaying Loan –> Selling Investments) will be in green.
Again for simplicity, I am ignoring the debate whether it makes sense to take a loan just to break even after 5 years of risk-taking or not.
So here is the result set of more than 2900 data points:
The blue line depicts the value of investments (of Rs 5 lacs) after 5 years.
The red line depicts the actual loan repayment amount which includes principal repayment as well as interest payments = Rs 6.37 lacs.
Now surprisingly, the blue graph hovers above the red line for most of the last 10-15 years! And at times, it even crosses Rs 30 lac! Yes… on an investment of just Rs 5 lac!
In fact, it’s below Rs 6.37 lac threshold for only 15% of the time.
Once again, this result points at the benefits of risky behaviour in stock markets. But it does nothing to show the risks involved. You might think that this behaviour is normal for stock markets. But that is not correct. India witnessed one of the greatest bull markets ever (in short term) between 2003 and 2007. The returns were so spectacular, that one cannot consider them to be normal. Its best to moderate the returns during the 2003-2007 Bull run to see a more realistic picture.
Now don’t draw any conclusions here. I am sure many of you would be having thoughts similar to the one below:
“That’s interesting. Even if I take a loan of say Rs 5 lacs, I only end up paying about Rs 10,000 a month as EMI. In return what I get is a chance to increase my investment from Rs 5 lacs to upto Rs 30 lacs!! Doesn’t that sound great? Also the chances of things going totally wrong are just 15%. Can’t I take this bet? Not much to loose here.”
Now I will tell you a real life fact here. If you take a loan, you would be using your available credit limit. And it’s also possible that you might not be able to avail any other personal loan till you clear off this existing loan. Now what will you do if you need that money for some emergency? You don’t want to sell your investments and exit at a price, which might be not acceptable to you. What if that emergency is such that you need to sell out irrespective of your losses. It’s not that easy. I hope you can realize the gravity of such a situation.
Now lets do one thing. Lets evaluate these returns, on the basis of P/E multiples of the Nifty. I have done some detailed analysis of PE in past. You can check it here.
In below graph, I am just breaking down the numbers obtained for Rs 5 lac investment on basis of Nifty P/E data.
I am sure you would have observed a trend here. Lets focus on the first column:
The very first thing to notice here is that a market below PE12 is extremely rare in Indian context. In the analysis, there were just 58 instances out of 2900+, where this actually happened. That is just about 2%. So if you want to time the markets and then take a loan, then please remember that it’s tough.
Also a real life fact is that when markets are available at levels where PE is close to or below 12, it would mean that economy is in doldrums. This would mean that credit would not be available easily. So you won’t get any cheap and easy loans to invest in PE12 markets. This is a very important point to remember.
But lets suppose that you do find money to invest. Now the chances of turning profitable (investment value more than Rs 6.37 lac) are much higher at lower PEs than they would be in say during high PE zones of 20+ (below):
As you can see above, most of the instances in encircled box are towards the top, i.e. lower returns on investment of Rs 5 lacs (which eventually costs Rs 6.37 lacs).
Now I have told you that personally, I don’t intend to take such a risk. But I know people who have done this successfully. A good friend of mine is one of the most aggressive investors I have ever known. He did what I can never do. He borrowed about Rs 25 lacs from various sources like banks, family, and friends and invested in around 10 stocks in 2013. Now his portfolio value exceeds Rs 50 lacs and he is still paying regular EMIs. I am trying to convince him to prepay atleast a part of the big loan with his profits. But he is a perennial optimist. I just hope it works for him in the long run. 🙂
Let me now add a few concluding words about the risk-discussion I parked in the first half of the post.
Is it a good idea to borrow money to invest in stock markets, which are inherently risky?
Honestly speaking, there is no definitive answer to this question. I am biased by my own behaviour to say that it’s wrong to do. But data (above) shows that there may be some merit in it if the cost of borrowing the funds is not much.
Like all other investment choices, this choice is also linked primarily to an investor’s investment risk tolerance and has multiple dimensions of risk: the risk of taking loans and the risk of investing in the stock market.
The biggest risk with loans is that it’s a promise to pay back in future, which is based on the assumption that you will continue to earn enough to regularly service the EMIs. But future might bring in some unfortunate incidents that your ability to repay loans may be compromised. This makes loans risky.
Then there is the general risk associated with stock markets. Data analysis I did is fine. But past performance is never a guarantee of future returns. 🙂
Now when we combine these two risks, things can get really complex and unthinkable.
Just a situation for you to ponder about. You take a loan to invest. You end up investing when markets were not cheap. Markets crash. Your investments are down 30%. Economy itself turns bad. You are fired from your job. But you still need to pay EMIs and run your house. You end up selling your investments at a loss. Your entire data driven plan goes out of the window.
But on the upside, things can be beautiful – as shown in a data point to where an investment of Rs 5 lacs turned into something above Rs 30 lacs in just 5 years!
To put it very simply, the idea of borrowing to invest itself is not bad. It is just a very risky one. More so if you are a common investor under common circumstances.