by Darwin on June 21, 2010

I read a rather controversial article recently in the Wall Street Journal aptly entitled Leverage Baby! outlining the case for taking on debt to invest it at a higher rate.  The main premise of the article was that now may be an optimal time to actually take out loans at extremely low interest rates, use that money for higher yielding investments and keep the proceeds.  While this concept sounds plausible and this practice is actually being employed en force by the countrys largest banks (borrowing Fed Funds at 0% and investing it and loaning it out at higher rates), youre not Goldman Sachs and neither am I.  I think this is a risky proposition, especially for routine retail investors.

• Stocks May Have Seen Their Best Days With markets rocketing 70% off their lows in March 2009, what would make you think theyre going to continue to proceed at the historical long-term return rates of 8-9% annually?  The S&P500 went basically nowhere from 2000-2010 in what will forever be dubbed the Lost Decade.  Theres no reason to believe the next decade will be any different.  In light of the fact that income producing instruments are delivering virtually zero returns, then yes, I do choose to have my investable assets in stocks.  But Im not leveraging up to do so.  I just view stocks as the most aggressive asset most likely to exceed inflation, not necessarily that Id mortgage my house to throw more money at the next BP.

• Youre Not a Sophisticated Investor Even investors who do qualify under the conventional sophisticated investor are virtually never sophisticated enough to protect themselves from themselves.  Thousands of investors were taken for a ride by the various Ponzi schemes the collapsed in the past 2 years (Madoff was just one of dozens) and many more lost millions in exotic CDOs, MBS and other acronyms they probably didnt understand.  While many of us think were smart investors, what the data tells us is that most of us (professional money managers included) arent any better at picking stocks than a monkey throwing darts at the stock section of a newspaper.  Making the presumption that by leveraging up and investing with any particular assumed return in mind is ludicrous.  Stocks could be up, down or flat over the next decade in aggregate.  And individual equities?  Its anyones guess.

• Leverage Can Kill If Youre Called Early What about if its the harmless borrowing from a 401K or a home equity line of credit?  That cant hurt, right?  Well, it can, especially if the market implodes again and you have to pay back those funds immediately.  For instance, if you took out a 401K loan with your employer and you leave the company or are separated, in most cases, that money is due back immediately or it counts as a distribution subject to a painful penalty with taxes to boot.  Also, many borrowers were shocked during the financial meltdown to learn that their lines of credit were being called in.  This could very well happen again in 2011.  The economy isnt exactly firing on all cylinders and the Euro zone could well have ripple effects elsewhere in the world.

This kind of reminds me of when I used to engage in peer lending on Prosper.com (subject of a whole other post someday).  I used to come across some borrowers who would state that they were looking to borrow on Prosper and use that money to invest at higher returns.  I couldnt help but laugh.  This 20 year old guys is going to borrow money at 9% and make a positive return?  What is he investing in?  And who are the fools willing to lend him the money in an unsecured loan assuming theyll ever see that money back?  Well, the ideas proposed in the WSJ article arent that much more far-fetched.  Borrow at 4-5%, make 8-10% in stocks and keep the rest.  If only it were that simple