Margin lending is not the only way to invest in stocks with borrowed funds .If you want to borrow and invest this money in stocks, you can always ask for a second mortgage on your house (or even a first mortgage, if you have a home and are debt free) and use the money to invest in stocks. It's not as crazy as it sounds: if you buy a diversified porfolio and you have enough cash flow to pay for the service the mortgage, in the long run you profit from the rate of return differential: the interest rate on mortgage debt is about 6.5% in the US (4.5% in Europe) while the long-term rate of return of stocks is about 10-11 percent.
I think for most investors it is a call on 'do I pay down my mortgage, or do I put more cash flow into stocks'?
The answer depends on:
- risk tolerance
- stability of future cash flows (eg job)
- nature of stock investing eg a match on a 401K from your employer is probably a no-brainer
- risk of 'over consuming' on housing. Housing price booms, subtly, tilt all of us towards having larger portfolios in housing, and consuming more housing, than we need. Any expenditure on housing is easier to justify if the 'multiplier' is high-- ie if next year, it will make the property worth $10k more. That isn't the case in a flat or bear market.
My general take for a US investor is:
- buying a first home is (almost) a no brainer. Owning a principle residence is highly tax subsidised, and zoning in most places is only getting tighter. But beware market cycles (and when we are on the downside, as the US is now, remember that commentators will call the bottom too early, many times-- just as they have a vested interest in boosting it on the way up, so too they do on the way down, the real estate industry pays their freight. My own view is the US has quite a bit more pain to take (Your Mileage May Vary) and one should pay a careful eye to blogs like Calculated Risk (the gurus of the housing bubble):
- moving house a lot is going to kill your returns: 5-6% transactions costs (at least) on each move
- paying off your home over 20 or 25 years is a good idea, with a
*disciplined* investment of the extra cash in a mix of investment vehicles (IRA, 401k, straight holdings)
- going into residential property investment is a major decision, with significant impacts on your life. Conversely it is one of the few ways that 'ordinary Joes' can build very significant personal wealth.
Which is, de facto, the choice most investors make. They have one home, they can pay off the mortgage, or invest in the stock market.
However the thrust of this thread was whether to buy that first home, and have equity in that first home (presumably due to rising prices) which can be tapped to buy stocks.
Without that first step, no leveraged stock buying.
It's not as crazy as it sounds: if you buy a
See above. I agree perfectly.
Where it really pays off if you have tax shelters available on the stock investing: either due to post tax investment vehicles (IRAs or ISAs) or pre tax ones (401ks or pensions). This can, however, compound liquidity problems.
the interest rate on mortgage debt is about 6.5%
Tax is the thing to be careful of-- a lot depends on your after tax return. The other factor may be UK-specific: most mortgages here are floating rate, it's expensive to fix beyond 5 years (almost no one offers it).
I would be leery of assuming a long run return of stocks, going forward, of 10-11 per cent. 8 is my ruling assumption. (6.0% real) before costs. A good rule of thumb is to take the inverse of the market trailing PE (15 times in the US) as a real return: (6.7% in this case)-- but recall my caveat about corporate profit margins. Yes globalisation improves the returns to capital, but over time, that gets competed away (more investment takes place, returns are driven down).
If you invest the money in real estate, you can potentially build up a portfolio with a *lot* more gearing. However everyone and his wife is investing in real estate right now: UK yields (commercial and residential) are probably as low as they have been since the 1930s. This suggests to me that we are at the peak of a property cycle.
Property takes patience, local knowledge and hard work (especially in the early years). Right now I see lots of investors who lack all of the above.
Very true, but it still doesn't account for margin calls. A market downturn could trigger a margin call that would wipe out your equity and still leave you with a mortgage to service. Furthermore the HISTORICAL return on stocks has been 10-11% and there has been much debate as to whether that trend will continue.
That plan looks good on paper, but if it is meant as practical advice for someone, there is many a slip twixt the cup and the lip. In the area where I live, I have seen this plan recommended in periods when interest rates are low and the stock market is near its peak. I have never seen it recommended when interest rates are high and the market is low.
The pitch goes something like this. Salesman says: "Real estate doesn't look good these days, and houses just sit there, but the stock market has returned 11% historically. So take out a home equity loan and invest in mutual funds. If you pay 6% interest on your home equity loan, you will still be ahead by 5%. And I have a fund for you that has done just great in the last few years!"
No mention is made of the fact that interest rates could change in the next few years, and since they are extremely low at present, the most likely direction is UP. And no mention is made of the fact that 11% historical returns in stocks is over a long period and nothing is guaranteed in the next 3 years or 10 years. This scenario is especially disturbing if the person seeking advice is 65 years old (and also disturbing if there is a 5% front end loan on the great mutual fund recommended).
This historical rate or return -of about 7 percent in real terms- is relatively robust, it has been there for about 200 years (see Siegel's "Stocks for the Long Run") and there is little reason to think that is going to be lower in the future. In the long term, stock market returns are driven by corporate earnings, which grow at about the same rate as GDP. There is no evidence at all of a slowdown in GDP growth - in fact, if anything, the evidence is more to higher average GDP growth in the last few decades, just take a look at Paul Romer's papers-, so there is no evidence of lower earnings growth and therefore lower stock market returns in the future.
I won't pretend to predict the future, I can't say what trends will and won't continue. Romer and Siegel are fine. There are plenty of other respected and logical arguments on both sides of the debate. Crestmont research, for example, disagrees - and logically.
That still doesn't address my primary concern. The presence of margin requirements, and as a result margin calls, does not allow your strategy to achieve the "long term" it needs if the market suffers an early downturn.
Even if we asume that past trends will continue, in the past 30 years (the length of a traditional mortgage) the S&P 500 has posted a negative annual return roughly 1/3rd of the time. I'm not leveraging my house on a 33% chance that I may get in on a down year and get margin called. Furthermore, there are many day-to-day ups and downs that can trigger margin calls that aren't reflected in the annual returns. Just my risk tolerance showing here, not necesarily everyone else's.
In fact, the probability of negative returns for periods longer than
18 years is zero (the last 18-yr period with negative real returns was the 1902-1920 period).
Therefore, if you can hold a diversified portfolio of stocks for periods of 18 years or longer, you will always get a positive real return, even in the worst case scenario (that is, in the scenario in which you bought at the peak of the stock market and then you have many adverse shocks that affect your stock market investments).
======================================= MODERATOR'S COMMENT: Posters to this thread should relate comments to general financial planning.
Where you start in investing is pretty clearly important.
Stock investments made in 1929, or 1999, took/ will take a long time to make back what you paid for them (the more so now: in 1929, dividend yields were generally higher). Adjusting for inflation, 1968 was a very bad year to invest as well (by 1979, you had lost at least half your money).
The best rule of thumb I know of is to take 1/PE of the market (trailing). Which right now, in the US, is 1/15X or 6.7%. Which gives a forecast for *real* returns of 6.7%, and nominal returns of say, 9%. Compare that to 1999, when stocks were trading at 22X and over 30X for the largest stocks.
The wrinkle being that we are likely at a profits maximum, so the true PE (adjusting for the cyclical rise and fall in operating margins) is more likely to be higher than lower.
But 5-6% real is a number I am comfortable with, for the US stock market index.
By contrast real return bonds (TIPS) are going to give you less than
2% real, and ordinary bonds are going to give you around 4.5-5%
*nominal* ie maybe 3% real.
Strikingly, very large cap companies are at a discount to the market as a whole, which is the first time this has been the case in a long time, if ever (not since 1990 at least, and Barton Biggs says as cheap as he has ever been able to show they were). The GEs, Pfizers, WalMarts, Exxon-Mobil's, Citigroups etc. of this world look darned cheap, taken as a group.
Applying the same logic to US housing, you get forecasts of returns, going forward, which are strikingly low (on the basis of current rental yield or Price-to-Income multiples). The wrinkle is that the US has unusually favourable demographics, and zoning is *tightening*.
My conclusion. Own your own house, (massive tax advantages in so doing), but invest the surplus in stocks. And don't buy a house (in most US markets) right *now*.
And tilt your portfolio towards US large cap value.
Of course, past performance is never the guarantee of future results, but strong empirical evidence suggests what future results may be with a high probability. When you have 136 years data, you can be sure that the results are pretty robust and significant. In the same way, while you can always argue that the fact that the sun rises every day -it has been doing it quite consistently in the past- doesn't mean that it should rise tomorrow, it seems that given empirical evidence, it is quite likely that it will actually rise again tomorrow.
The reason stocks grant you outperformance, is there is a chance they will not ie it is a risky asset. (efficient market theory)
The other reason is likely that there are structural biases in markets, which mean investors overprice near term certainty (ie don't hold enough risky stocks relative to less risky assets). Also investors appear to overweight recent information. (behavioural investment theory)
Historic returns can lead one astray, especially recent historical returns. They are about to do so in real estate, I suspect.
That's assuming, of course, that stock returns are not serially correlated? ie that the performance in one year, doesn't have a correlation with the performance in a subsequent year?
Whereas, in fact, as I understand it, stock returns are 'weak form mean reverting'. A period of superior performance tends to be followed by a period of weak performance, and vice versa?
There is, of course, massive survivor bias in the data. The biggest world stock markets in 1890 included Berlin, Buenos Aires, Budapest, Cairo, Shanghai. All of these dropped to zero at some point during the subsequent 116 years-- investors were wiped out. Looking at the market which did the best (the US market) over that time, and asserting that that is the future outlook for stock returns, is data mining at its worst.
It's like buying a portfolio of residential investment properties in
1890. I have friends whose families carefully invested their money in Prague, Budapest, Vienna, Berlin pre WWI-- and lost the lot. Similarly in the US you could have invested your money in Cleveland, Buffalo and Detroit. Or in Los Angeles and New York and Atlanta.
The actual return from equities over the long run is good, but not as good as the US data implies.
In the same way, while
What you actually have to know is the underlying theory of *why* the sun rises and sets every day *that* gives you confidence in its continued trend.
Not true. The Swedish, Australian and South African markets did better than the US market between 1900 and 2006 (and the Canadian market comes very close to the US market). Just check Table 5 here:
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In general, the markets of those countries not affected internally by major wars -those who didn't have their physical capital destroyed by a war- did much better than the rest of the markets.
It all depends on future events. If you assume that the probability of a new major war in Europe -for example- is almost as low as in the US, then there is little reason to assume that the stock market is going to do substantially worse for these countries. For the US, since there is no evidence of a long-term economic growth slow down, it is hard to justify that corporate earnings are going to grow at a lower rate than in the past ( and therefore stocks returns are going to be lower as well).
Right. The same for long term returns of the stock market. Companies - and stocks- are worth -in an equilibrium- the same as the discounted stream of future earnings. If there is no slow down in future earnings ===> no reason for lower stock market returns in the long term.
Nope, if you look at Shiller's stock market data, you would have recovered the 1929 stock market investment by 1935, and the 1999 investment by 2006 (in real terms).
You would have recovered the 1968 stock market investment by 1972 (afterwards, you had a big bear market from 1973-1981).
That depends on your model. If the recent rise in corporate earnings is structural -caused by globalization, which tends to reduce the share of labor income and raise the productivity of capital investment anywhere, and therefore corporate earnings shares- then the current share of corporate earnings/GDP -about 10 percent- could be sustainable and you are not going to have a cyclical slow down in future corporate earnings growth.
Really? Have you calculated the alphas for these large cap companies? Alpha is the real measure used to claim that a company is trading a discount or not (a positive alpha means that the companies risk- adjusted expected returns are abnormally high). For what I know, it is almost impossible to find large caps trading at statistically significant positive alphas right now.
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