Sam wrote in with the following question:
I currently have no debt and am thinking of investing in the stock market. I can get loans with very low interest rates (4-5%) and can also do some credit card arbitrage to get money for a while at 0% rates. Should I take out these loans to invest in long-term stocks, given that most people estimate that stocks will earn 10% annually over the long term?
I don’t have the definitive answer to this question. Why? Because there isn’t one.
Like many other investment choices, this one is intrinsically tied to a person’s risk tolerance. This scenario actually has multiple dimensions of risk: the risk of incurring debt and the risk of investing in the stock market. Let’s look at both of these.
The risk of debt. Any time you incur debt, you’re basically promising that your future self will be able to pay off the debt. While Sam is in great financial shape now (presumably having a good job and so on), the future may bring a spouse, a child, job loss, etc. These are potential risks any time you incur debt. Obviously, the more tenuous your situation is now, the riskier the debt is – for example, if you rack up debts that your current self simply can’t pay, you’re actually betting that your future will be significantly better than your present.
The risk of stock investment. Any investment in the stock market has risk associated to it – past performance is never a guarantee of future returns. The Vanguard 500 has returned an average of 12% annually since 1976 – it may be reasonable to assume that level of return as a thumbnail, but if you legitimately expect that return every single year, you’re going to be disappointed. In any stock investment, there are going to be periods of losses.
Combining the two risks. Where things get really shaky is when you combine the two. Let’s say, for instance, that you worked for a dot-com startup in 2000 and you took out debt to invest heavily in the stock. By 2002, there’s a decent chance that you would have been out of a job, been facing this debt, and the stock you owned would have been nearly worthless.
The success here, however, could be tremendous – in essence, you could make free money. Let’s say you buy a stock that doubles up in a year, then you sell 70% of the stock to pay your debts and pay the taxes incurred. Suddenly, 30% of those shares you bought are now yours for free – and we’re not even looking at dividend earnings, either.
Sam’s idea is not a bad one, just a risky one. It’s far beyond my risk tolerance to invest in the stock market using borrowed money, but for others, the risk may in fact be tolerable.