BORROWING intelligently can make us money but we should weigh those potential gains against their true costs.
To steal (and modify) a line from Shakespeare’s Hamlet, “To borrow, or not to borrow: that is the question.” My regular readers know of my well-documented history with painful credit card debt. I have racked up rolling balances charged to various rectangles of plastic, which took me years to pay off in full. And, slow learner that I am, I foolishly did so not once but twice.
My first foray into tough-to-repay credit card debt occurred in England in the 1980s, when I was there mainly as a student. My second such experience was when I was back in Malaysia, working as a modestly-paid business journalist in the early 1990s. Such protracted episodes of financial struggle with impoverishing consumer debt are painful to work through. Sadly they’re commonplace!
As for the use and usefulness of investment debt, our planet’s most successful living investor, Warren Buffett, chairman of investment behemoth Berkshire Hathaway, has much to say. In his latest letter to Berkshire’s shareholders, released in late February this year — on behalf of himself and his fellow investment genius Charlie Munger, the vice chairman of their company — Buffett wrote:
“Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need.”
Admittedly, when we intentionally employ debt-powered leverage for investment purposes, we may succeed and thus earn larger profits than we could if we had not used debt.
Most of us borrow money for real estate property purchases. So let’s use some examples to illustrate the value of borrowing money — in a restrained fashion — for real estate forays:
Let’s imagine we have RM1 million in the bank, and that we are presented with an array of shophouses to invest in. Each such property is selling for RM1 million.
We might choose to buy just one shophouse for an all-cash RM1 million payment or to gobble up, say, four shophouses by putting down RM250,000 apiece and securing bank loans of RM750,000 per property! (To keep things simple, in both scenarios I will ignore legal fees and stamp duties, bank mortgage payments and offsetting rental inflows.) That second option will see us using up all our own cash and also borrowing RM3 million (= 4 x RM750,000).
If, say 10 years later, the shophouses sell for RM2 million each, then in the first example we would make a capital gains profit of RM1 million (= RM2 million - RM0 in borrowings) - RM1 million in own cash outlay; but in the second example our profit would be a whopping RM4 million (= (RM2 million x 4) - RM3 million in borrowings) - (RM250,000 x 4 in own cash outlay).
Clearly borrowing for such a purpose is an attractive proposition. Property investors almost exclusively use bank leverage for their real estate purchases. But do realise that Buffett, in his 2018 letter, was NOT referring to real estate property purchases. He was writing about purchasing businesses outright and about buying fractional parts of a business through share purchases on the stock market.
Many people use margin financing when buying their listed shares because that form of leverage can increase the scope and range of their purchasing power. Then, if the stock market cooperates and wafts upward, they can sell their leverage-bloated number of shares for sizably larger profits.
Without leverage, the same upward stock market movement would yield much smaller profits just as the cash-only property example I gave you earlier generated much tinier gains.
That’s what Buffett meant when he wrote: “Our aversion to leverage has dampened our returns over the years.”
Yet, frankly, that dampening hasn’t hurt Buffett or Munger in any discernible way. Both are counted among the world’s current 2,208 billionaires (www.forbes.com/billionaires/)! (Munger is ranked 1,394, while the much wealthier Buffett is No.3 with only Jeff Bezos (1) of Amazon and Bill Gates (2) of Microsoft ahead of him.)
CONSERVATISM PAYS SOMETIMES
The reason it is unwise to use debt leverage for stock market or unit trust investments is the wild volatility of equity markets. Consider this scenario: What would you do if you had RM200,000 amassed in fixed deposits after, say, two decades of sacrificial saving, and were then introduced to a stockbroker who arranges a margin financing facility that allows you to borrow RM500,000 against your FDs to make stock purchases?
If the stock market cooperates with you, you will make a lot of money from that leverage.
But when — not IF — the stock market nosedives, you might find yourself facing a margin call that wipes out most or all of your savings. In truly horrendous situations, the margin call by your broker could be for more money than all the funds you possess!
Such eventualities, coupled with my early years of battling consumer debt, are why I don’t invest in shares of companies I want using any form of margin facility. I make a lot less money when their stock prices soar, but, like Buffett and Munger, my conservatism allows me to sleep well should their stock prices plummet!
The older I get, the more I value a good night’s slumber. You will, too.
© 2018 Rajen Devadason
Read his free articles at www.FreeCoolArticles.com; he may be connected with on LinkedIn at https://www.linkedin.com/in/rajendevadason, rajen@RajenDevadason.com and Twitter @RajenDevadason