Many business analysts will tell you that it is always wise to finance a part of your investment capital with debt. And to some extent, the same can be applied to the stock market. But the technicalities involved can differ in many ways.
For businesses, combining equity capital with debt to come up with the optimal cost of capital is a common practice, especially for ongoing businesses. When it comes to investing in the stock market, though, investors are advised to use a percentage of their personal income rather than taking a loan.
But there is another practice in stock investing that most people forget that should actually be perceived as a strategy that entails borrowing money to invest. This practice is known as margin trading, and it entails investors borrowing money from the broker to fund a part of the amount required to buy a stock.
This is a high-risk method of stock trading and is only recommended for experienced investors. But even putting this aside, we have also seen instances where investors borrow money from the bank or friends to participate in a hyped IPO, or generally during a bullish market. Experience dictates that borrowing money to invest when the market is booming would be the wrong thing to do.
According to Warren Buffett (Trades, Portfolio), investors should “be fearful when others are greedy and greedy when others are fearful.” But most investors actually do the opposite and thus end up borrowing a lot of money to invest when stock prices are trending upward.
Based on opinions of debt servicing consultants, most borrowers who struggle with debt do so because they either borrowed at the wrong time or for the wrong reasons. Borrowing money to invest when the market is at the edge of a bullish cliff can often result in a catastrophic ending.
But when you follow the Buffett way and use the borrowed money to invest when everyone is running away from the market, then that could turn out to be a wise decision.
Notice that, in order to make “the borrow to invest” decision sane, the returns from the investment should be able to at least cover the interest payment on the loan, as well as any fees attached to the credit line. There are also additional benefits to your investment portfolio because of the tax advantage gained when deducting the interest payments.
On the other hand, borrowing when stock prices are high could easily lead to a reverse outcome. In this case, the return on investment is not enough to cover the interest charge let alone the loan fees. This situation results in a loss and even the tax advantage gained is likely to be insignificant when related to the overall portfolio performance.
In relation to margin investing where investors borrow a percentage of the investment amount from their broker, this is only wise if the investor has enough experience in the market. In margin trading, which is very common in the derivatives market, investors can easily lose more than their account balances if the stock prices go against their predictions. The broker then may ask the investor to top up the account when the maintenance margin is about to be breached, which means that in the end, it is possible to spend more than initially intended.
Conclusion
Investments can be funded with either debt or equity capital. Those are the two broad categories. When funding a business investment, it is highly recommended to use a combination of both debt and equity, especially if the business is already established.
When it comes to funding stock investments, the practice can be a little tricky because in this case, some situations can result in the investor spending more than what was initially allocated to stock investments.
Therefore, if an investor must borrow to invest in the stock market, then it is paramount that the timing is perfect to be able to cover the interest expense and any loan fees. The upside is that this can also result in significant savings on the tax burden.
