I was in my neighborhood bank the other day when I saw something that roiled my stomach and made me shudder. No, I hadn't crossed paths with Tom Cruise and Katie Holmes -- it was much worse. I stumbled upon a seemingly innocuous pamphlet beside the ATM titled "Borrowing to Invest."
With a trembling hand, I grabbed the brochure. It was even worse than I feared.
Empty promises
The pamphlet was chock-full of the usual suspects: "You should consult a financial, investment, and retirement planner to ... increase your investment returns and accelerate your capital growth." All well-turned phrases, carefully crafted to elicit a combination of doubt and greed.
But that's to be expected. Banks make money by implying that no one but them can understand finance -- especially not the small individual investor. No, what shocked me was how the pamphlet downplayed the risk of borrowing money to invest.
Recipe for disaster
The first bullet point: "Although some people are hesitant to borrow to invest, it can be a powerful wealth-building strategy." The bank is right, of course. It can build wealth -- for the bank. While investing borrowed money could leave you swimming in the red as a result of short-term volatility, the bank will earn its interest, commissions, fees, and possibly even the bid-ask spreads no matter what.
The brochure also promises that "you can reduce risk by adopting a strategy that reflects your personal risk tolerance," and that you can gain "improved investment discipline." Both are true, in a very obvious way. A leverage strategy that reflects your risk tolerance is less risky than one that greatly exceeds your risk tolerance. Of course, both strategies are significantly riskier than not borrowing money at all.
According to the bank, you could earn extraordinary returns by investing borrowed money. They supported this claim by cherry-picking a 20-year period from 1982 to 2001. That's a nice little slice of time to choose for evidence -- it begins with one of the greatest bull markets in history and concludes before the worst of a bear market. The artistry of such deceptions is breathtaking.
A Foolish perspective
I'm a Fool -- with the jester hat to prove it -- so I don't buy this story about small investors needing an institution to tell them what to do. Anyone with average intelligence, an interest in investing, and the patience to learn has a great chance of outperforming those uptight guys in ties.
I also don't think that borrowing money to invest is a great thing. It increases your risk while simultaneously reducing your flexibility. Suppose you invested in SPDRs (AMEX:SPY), an exchange-traded fund (ETF) that mirrors the S&P 500. As equity investing goes, that's conservative, because the index contains 500 of the strongest public companies. It also exposes the individual investor to a wide range of industries, from poorly performing tech companies like Applied Materials (NASDAQ:AMAT) and PMC-Sierra (NASDAQ:PMCS) to recently rising oil companies like ExxonMobil (NYSE:XOM) and Chevron (NYSE:CVX).
An investment in the index five years ago would be down today to the tune of about 1% per year (nothing you couldn't make up given a few more years). A $10,000 investment would be worth $9,500. But by paying 6% interest on the $5,000 you borrowed in addition to your $10,000 investment, and paying that loan back (plus interest) in five years, you'd be left with less than $7,800. All that borrowed money just magnified your otherwise small loss.
But because of the reduced flexibility of borrowed dollars, there's a decent chance that you wouldn't have escaped so easily. The people who lend you money will not be as patient with your investments as you are. They'll ask for it back or change the terms of the loan -- driving up interest rates. And since patience is the ally of every investor -- just take a look at the recoveries of Amazon.com (NASDAQ:AMZN) and Yahoo! (NASDAQ:YHOO) since the bubble burst -- borrowed money is no way to beat the market.
For value investors (like those of us on Philip Durell's Motley Fool Inside Value team), the problem with borrowing is even more acute. We buy exceedingly cheap companies that are likely to outperform in the long run. So we love market corrections -- they offer the opportunity to pick up outstanding companies at ridiculously low prices. If you borrow money to invest, however, the fall in the market significantly reduces your purchasing power to pick up the market's bargains -- right when you need it the most.
Foolish final thoughts
A wise way to build wealth is to avoid potential financial pitfalls -- like borrowing money. Instead, simply save and invest your hard-earned dollars in the common stock of undervalued companies. This is what we do at Inside Value, and it's worked so far. Since our inception one year ago, we've bested the market by 6 percentage points -- no leverage needed. In the current issue, you'll be able to read about the techniques we use to evaluate investments and you'll have full access to our year-end review, which identified our top nine recommendations for new money. If you want to check it out, click here for a free 30-day trial. There is no obligation to subscribe.
Richard Gibbons is a puny man, so he uses leverage to raise boulders, furniture, and any other large objects that seem to need lifting. He does not own shares in any of the companies discussed in this article. Amazon.com is a Motley Fool Stock Advisor recommendation. The Motley Fool has adisclosure policy.
