For the retail investor, the basic purpose of investment is to gainfully deploy the surplus for building a corpus over a long horizon of time. A loan comes at a cost, which is given. Investments are made in the market, where future returns are a matter of expectation, i.e., the return on investment is not a ‘given’. One may expect the market to yield high returns, but that is an expectation. Even if historically an asset class has yielded higher returns than the cost of your loan, it is not a guarantee for the future. Normally, if you are investing in an instrument with a given return, e.g., a bond with a defined coupon, your cost of a loan would be higher. For example, if you are getting a loan at 10%, the return on a bond would be either less than 10% or the credit profile of the issuer of the bond would be risky. Does it suit anybody?
Yes, there are corporate treasuries who are evolved and aware, and there are savvy HNIs who are serviced by multiple wealth managers. There may be certain situations where a leveraged investment in an instrument may be reasonably certain to yield a positive result. However, those favourable terms and those particular investment avenues may not be available to the regular individual investor who is not so active in the market and does not have the ticket size of investments required to belong to those circles. From a practical perspective, if you are a retail individual and do not have the size and savvy of a corporate treasury or big-ticket HNI, it is better to stick to what you understand.
When is a loan justified
When you have investments that are for the long-term and you are going through a situation of temporary cash flow tightness, instead of breaking your investments, you should weigh the cost of a loan and the cost of premature break in your investments. For example, if you require cash for a sudden expense which you expect to recoup and save over the next few months, one way of funding it is breaking one of your investments. As against that, if you take a loan, though it comes at a cost, if it can be repaid quickly the damage is not much and you can tide over the situation without disturbing your investments.
If you dispose of an investment and re-enter after sometime, the price may move up, which would impact you adversely. What we are arguing against in this article, is funding your long-term investment by a loan, where you are not sure of the outcome, something which is based on a return expectation only. The corporate treasury may have the advantage of treating the interest cost of the loan as an expense in books of account, thereby generating tax efficiency and effectively reducing the cost of the loan. As an individual, you would not have that advantage, unless you are taking the loan in your business account, in which case there may be end-use restrictions as per the terms of the loan. For HNIs, from time to time, there are certain opportunities that arise; e.g., the FCNR window for NRIs in 2013—only if you are ‘in the circle’ you can avail of it.
The temptation to maximise market opportunities arises in booming markets. For example, when the equity market is booming with returns more than your potential cost of a loan-based funding, or when an IPO-funding offer is going on in the market and the IPO lists at a premium, hindsight bias comes into play. This is where you have to be clear about your objectives: whether it is ‘playing the markets’ or is it about generating wealth over a long period of time.
The writer is founder, wiseinvestor.in