Cash, Capital and Collateral
Why we must borrow when the giving is this good.
It seems like a lifetime ago when we could put our money into the bank and earn 5%. Clearly, things are very different now with interest rates near zero and it makes holding cash extremely inefficient. The same is true for holding bonds, but that is another discussion and luckily, we have the stock market which seems to only ever go up, which again is another discussion. However, be that as it may, the current state of things does open up an extremely interesting investing opportunity. One that is being ignored by many investors for all the wrong reasons, but let’s start at the beginning.
If you had £1m and wanted to invest that into the stock market, you would not expect to lose all of your money. As a matter of fact, there have been eleven crashes and major bear markets since 1929, during which stocks lost 42.92% on average. So, if we are only ever going to lose less than half, why not do something with the money that otherwise sits idle in our investment account? It’s a bit like buying a house, we put down a deposit to cover the bank against potential losses and borrow the rest. For some reason, when it comes to doing the same thing with our investments into other assets, people get apprehensive. After all, we are using the most dangerous of all capitalist inventions, something called “leverage” and it is synonymous with speculation, potentially huge losses and all that is wrong with the investment world.
Having cleared that up, let’s look at what we could achieve if we were to borrow an additional £500k to invest more money into the stock market. Most professional investors would expect to pay about 1% for that. Historically, equities have gone up by 8% on average per year, which means we could make an additional £35,000 on our borrowed money. Compounding that over say 10 years, it is equivalent to making £655,024 more than we would otherwise do, and that is after costs.
Why doesn’t everybody do this? The risk is of course that the stock markets crash. If that were to happen, we could run out of money in our margin account that is used as collateral against our equity position. This would mean that we need to sell (some of) our holdings in stocks to generate cash. However, markets would have to fall by more than 66.5% before we run out of money. In the last 100 years, stock markets have only ever lost more than that once (in the period from 1929 until 1932). And if you are really that worried about it then just borrow less, but taking money when it’s this cheap, you must.