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Building Your Future on Borrowed Money?

money-building.jpg“It’s wise to mortgage your future.” This was the headline in the July 13 “Insider Q&A” column in the Rapid City Journal financial section. The column featured Ian Ayres, a Yale professor who is an attorney and an economist. He recommends that young investors should save for retirement with borrowed money. He thinks, when you’re in your 20’s, it’s a good idea to buy stock index funds with margin accounts or options. As you get older, you should phase out your borrowing.

Ayres describes this strategy as “diversifying across time.” He agrees that leveraging stock purchases in this way increases short-term risk. He argues that this doesn’t matter because when you look at that risk over a long period of years, it is balanced by higher gains.

If you look at nothing but the numbers and the formulas, this theory seems to make perfect sense. With a margin account, you can borrow twice as much as you invest. This means, with a $5,000 investment, you can control $10,000 of stocks. The brokerage firm lends you the extra $5,000 and takes the stocks as security for the loan. Ayres suggests this is similar to buying a personal home with a small down payment.other-peoples-money.jpg

Certainly, one of the best ways to build wealth is with OPM (other people’s money) via leverage. It’s also one of the best ways to go broke. As I’ve learned over 25 years as a financial planner and realtor, looking at nothing but the numbers, possibilities, and formulas can be a fatal mistake.

For one thing, very few young investors (heck, very few investors of any age) would have both the knowledge and the self-discipline to invest with the care this strategy would require.

Second, Ayres’s theory skips over a few inconvenient details. One of the most inconvenient is the fact that when you invest on margin, if the value of your stock drops below a certain level, you have to cover that loss with real money—a margin call. If you’ve invested all your money already, where are you going to get more when you need to cover a margin call? If you don’t have the money to cover a margin call, the broker will sell out your position. Then you’re stuck with losses and you have no stock to appreciate when the market recovers.

Ayres’s comparison to buying a house with only a small down payment doesn’t hold up either. First of all, whether you’re paying rent or a mortgage payment, housing is a basic expense that is factored into your budget and that, presumably, you can afford. Besides, if real estate values plummet, you don’t suddenly have to come up with the cash to pay the difference between the decreased value of your house and the amount you’ve borrowed to buy it. You just have to keep making your already-budgeted payments.

I find it interesting that Ayers is 49 years old. He regrets that he discovered his investment theory too late to apply it in his own life. It seems to me he would regret it far more had he actually tried it when he was in his man-losing-money.jpg20’s. Investing in the stock market with borrowed money is not a wise way to save for retirement. Ayres’s theory may make sense in the theoretical world. In the real world the risk is not at all theoretical.

The only opportunity provided to small and inexperienced investors by margin accounts is the opportunity to lose a lot of money they don’t have. Please don’t try this at home.

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3 Responses to Building Your Future on Borrowed Money?

  1. Warren July 29, 2008 at 4:14 pm #

    Nice article Rick. Thanks for pointing out the pitfalls.

    Take care,

    Warren

  2. Susan Hotalling July 30, 2008 at 5:55 am #

    These academic idiots are part of the problem of why the government at all levels cannot manage money – look at the absolute lack of intelligence in the Fed concerning strong dollar strategies and policies.

    Our schools have never even gotten close to teaching our kids fundamentals of money, budgeting, and how about SAVING? I was one of the few at the college level in my Farm and Ranch Mgt. courses because my students didn’t have a clue as to credit cards, insurance, etc. So this academic genius thinks you can just turn these babies out there with yet another plan to

  3. Jamie November 7, 2008 at 12:21 pm #

    Interesting article, thanks!