When the markets rise, there is a tendency among investors to go overboard. Some even go to the extent of borrowing money to maximize their return. This is done on a premise that the rate of return on investment would outpace the interest rate. Although the assumption is not completely misplaced, it has the scope of backfiring quite badly if the markets crash.
Let us take an example of someone we will call Ajay Rastogi. He wants to raise his exposure to a particular stock or a mutual fund by ₹5 lakh. For this, Ajay could borrow a loan against his stock holdings at an interest of 10 percent per annum. Ajay does this because he is hoping the particular stock or the fund to surge by around 20 percent in a year.
The calculation is simple. Even after paying the interest, he would take home a neat return of 10 percent (20 -10). But here is the catch: On one side when other investors earn 20 percent on their investment on this stock, he would stand to gain only a half of that. Well, this reasoning is still justifiable so long as the returns are positive.
What if the particular stock starts declining and falls by a total of 12%? In that case, Ajay would not only have to bear the losses but would also face an added liability. This loss would worsen Ajay's financial state who already has a loan of ₹5 lakh to repay.
So, when other investors would suffer a loss of 12 percent, Ajay would stand to lose an extra 10 percent, making it a total loss of 22 percent. This could even lead to another loan – thus increasing the chances of Ajay slipping into a debt trap.
Repay your loans first
Experts also advise against investing with the money which you could use to repay an unrelated liability. For instance, when you have a home loan to repay, it is advised to repay it first before committing huge money to investment. In effect, even this kind of investment – with the money which could have been used to retire a part of debt – is a form of leverage.
To understand this well, let us take an example of someone called Mr Pratap who has used a surplus of ₹3 lakh to invest instead of lowering his debt burden. And soon after his investment, the market happens to crash, it would mop off a chunk of his investment , while his home loan still stands tall.
Conversely, Pratap could have used this surplus to lower his loan liability and waited for some more time to be able to invest with his own savings – which even if he loses, would not cause an additional financial pain in form of interest.
“Investing is a game of odds. When you invest the borrowed money, your losses — just as your profits — could magnify. If you have invested with the borrowed money, and the stock doesn’t rise significantly, you will lose big,” says Deepesh Raghaw, founder of PersonalFinancePlan.
He further adds that leverage, in the normal course of trading, is not unusual. “Institutional investors take leverage, and several forms of trading — margin trading and futures trading happen on leverage. But small investors will be wrong to borrow in nearly 98-99 percent of the occasions,” says Raghaw.
So, it is advised to avoid or reduce the EMI burden, and use the same money to subscribe to SIP. No matter how small the amount is, it can be used for wealth creation.