The act of borrowing money for any business enterprise or investment comes with an element of risk. However, the perception of risk is vastly different when someone borrows money to invest in stocks. There is cultural belief that it is akin to gambling, but the reality is far from it.
I will explain this with a few examples. Take, for instance, if a businessman borrows money from a bank to expand his production capacity, then society considers that a healthy activity even though the capacity expansion may not materialize as planned. More often than not, the fate of entrepreneurs & businesses is dependent on the changing dynamics of demand and supply. Hence, the accumulation of debt can either pay off handsomely or destroy a business.
Similarly, borrowing money to invest is very common in real estate. There is an oversupply of organized financial institutions such as banks, NBFCs and also unorganized money lenders that are more than willing to lend money for the purpose of real-estate investment, in both the residential and commercial space. Since such investments are long-term oriented and the loans are usually backed by a capacity to repay the interest and principal, it is a win-win situation for both the lender and the borrower.
However, stock market investors are not given loans easily by banks, NBFCs or unorganized lenders because it is considered very risky and most of them stay away from it. Hence, it is the stockbrokers that provide loans to such investors. In India, there are a few ways of doing it, namely Margin Funding and Loan Against Shares (LAS). They also help the investor invest in shares through them. An important thing to note is that while you borrow to invest, in the event of non-payment or adverse price movement, the stockbroker can sell the collateral shares to recover the principal and interest. Usually, in margin funding, you can buy 2x of your capital, which means that the investor will contribute 50% and the other 50% will be funded by the stockbroker. The time duration of the loan is flexible and depends on the investor. On the other hand, Loan Against Shares (LAS) is given based on your holdings in the demat account after deducting the haircut which is generally in the range of 20-40%.
Pros of investing with borrowed money: You can earn a higher return by investing in a stock by using borrowed money. For instance, if you borrowed money and invested 2x in a stock that appreciated 20%, your net return will be 40% minus interest expense & transaction costs. This is almost double of what you would earn if you invested with your own capital. It is definitely worth taking such risks if you have a high conviction of a stock performing well. Also, it is advisable to take a position in more than one stock just to be diversified and spread your risk.
Cons of investing with borrowed money: Stock markets are generally more volatile than other asset classes. Hence, if you invest using borrowed money, the price can go against you. In the event that things don’t turn out the way you expected, your losses will also be double of what it would be without borrowed capital. For instance, if you borrowed and invested 2x in a stock and instead of going up, the stock price fell by 20%, then your loss would be 40% plus interest and transaction costs. Leverage is a double-edged sword and it must be handled carefully.
What to do?
Borrowing and investing in stocks is ideal for those who have a good knack in trading and short-term investing. This is because they are aware of the nuances of daily price fluctuations and can enter and exit stocks without becoming complacent. Also, traders are generally adept at handling higher risk instruments such as futures and options where the leverage is between 6 and 66 times. For such individuals, margin funding or loan against shares are relatively much safer with a better probability of success per trade due to lesser leverage. Also, it is easier to carry trades overnight with a 2x leverage. For instance, if the stock price falls 3%, the net effect on your position is 6% which is still manageable. However, if you are holding a long futures position and the stock falls by 3%, your minimum drawdown will be approximately 18%, which is very hard to digest for any investor. Hence, borrowing money to invest in stocks helps you deal with volatility in a much better and safer way. The other advantage is that you are investing in stocks with borrowed money. When you trade in derivatives, the price always has a premium amount which decays with time.
The best times to use this facility would be when the markets have bottomed out, are in an upward momentum or when there is consistent earnings growth. But one should never borrow to invest when the markets are in the declining phase. Bottom fishing is hazardous to your financial health; especially with leverage.
(By Tejas Khoday, CEO and Co-Founder, FYERS, an online stockbroking firm)