Dubai: How do you know when you should stick to the safer route and save or risk more to earn bigger returns and invest? The next question is whether you should ever borrow money to invest?
Saving is the safer route because the dirham amount in your bank account won’t typically decrease unless you withdraw funds, but interest rates on savings accounts don’t allow your money to grow very quickly either.
Unfortunately, interest rates are often lower than the rate of inflation. This means your savings could lose purchasing power over time.
It’s tempting to want to invest to receive higher returns and beat inflation. Unfortunately, the value of your investments won’t always go up. In some cases, investments can become completely worthless.
When it comes to borrowing money for the sole purpose of investing, which is again a popular trend, the only time it makes sense to borrow money for an investment is when the return on investment of the loan is high and the risk level of the investment is low.
Also, if an investor takes out a loan it does not make sense to place the money in an investment that will mature after the loan is due. It is also important that the investor makes sure that the return on investment is greater than the cost of the loan.
But first, let’s find out whether you should save or risk more to earn bigger returns and invest?
Saving vs. Investing – How do I choose?
There are plenty of benefits to saving rather than investing. First, the dirham amount you save in a savings account won’t decrease over time. This is important because some goals need to happen regardless of whether investment prices are up or down.
Saving rather than investing also allows you to reach your goal on time as long as you save the proper amount each month. Take the total you need to save and divide it by the number of months until you need to reach your goal to find the amount you need to save each month.
Saving does have downsides though. Due to inflation, the money you save will decrease in value each year. If you earn interest, that interest may partially offset the negative effect of inflation. Unfortunately, interest rates rarely keep up with the rate of inflation.
Saving also means you’ll have to set aside more money each month than you would if you received higher returns investing. If you’re only earning 1 per cent interest in a savings account but could earn an 8 per cent return investing, you’ll have to make up for that 7 per cent difference by putting more money in your savings account to reach your goal at the same time.
Investing can be beneficial, too. Investing gives your money the potential to grow faster than it could in a savings account. If you have a long time until you need to meet your goal, your returns will compound. Basically, this means in addition to a higher rate of return on investments, your investment earnings will also earn money over time.
The benefit of higher compounding returns is you won’t have to invest as much each month as you would need to save each month to reach your goal.
Investing isn’t always a good thing, though. Investment prices could go down right before you need the money which could leave you in a financial bind. If this happens, you will have to either settle for an option that doesn’t cost as much, delay your goal until you can save more money or delay your goal until your investments increase in value.
When to save and when to invest
You’ll have to decide whether to save or invest to reach these goals depending on your flexibility and time frame of your goal. If you absolutely must reach a goal by a certain date, you’re probably better off saving rather than investing.
If you’re a bit more flexible about when you reach a goal, investing may be an option to consider. You could receive higher returns on your money, but a bad year in the markets could substantially delay when you reach your goal.
If you have short-term goals, save
First, if you absolutely need the money by a certain date, save rather than invest. With saving, there is no risk of your balance decreasing. On the other hand, investments can decrease in value.
If you have long-term goals, invest
Next, investing provides an opportunity to get greater returns if you have a long time horizon and can delay your goal if things don’t go as planned.
The key is being able to delay your goal. If investments are down at the time when you originally planned to reach your goal, delaying by a couple years could result in your investments returning back to a higher value.
Or, do both?
You can mix saving and investing, too. You can save the money you absolutely need and invest the money that would be nice but isn’t necessary to meet your base goal.
Another option is investing toward the beginning of a long-term goal and slowly switching to saving as your goal gets closer. This helps avoid a sudden drop in your investment values that could delay your goal.
Now let’s weigh whether you should invest with borrowed money and how much the costs of the loan would eat up into any returns or profits you make from investing.
Do I borrow to invest in shares? How do I do it?
Borrowing can help you accelerate your wealth creation. It can allow you to buy assets such as an investment property, or shares that you may not be able to afford outright. However, borrowing to invest is considered a high risk strategy and can result in you losing more than your invested capital.
Before taking out a loan for the purpose of investing in shares, you should ensure that you can service the costs associated with the loan, including repayment of the loan principal. Now let’s see how you can go about it.
You can take out a margin loan to invest in shares. A margin loan allows you to buy shares by paying only a fraction of the cost of the shares upfront, and the lender uses your shares as security for the loan.
The prices of shares move frequently and you risk losses if they fall in value. Lenders often express your level of borrowing (otherwise known as gearing) using a loan-to-value ratio (LVR) or gearing ratio. The LVR is the amount of your loan divided by the total value of your shares.
If the value of your shares falls to where LVR exceeds an approved maximum, you may be required to top-up your loan collateral or repay some of the loan. This is known as a margin call. If a margin call is not met within a timeframe set by the lender, your shares may be sold by the lender to satisfy your margin obligations. This may result in you suffering a loss.
Set a borrowing limit you are able to comfortably repay and stick to it. Make regular interest repayments on your loan to keep your loan balance within a manageable limit.
Check your LVR regularly, because the value of your investments can change quickly. Have funds available to deposit if your lender makes a margin call and you do not wish to sell your shares.
What are the benefits and risks of borrowing?
You can build a larger portfolio than if you were using just your own funds. Some lenders allow you to borrow using an existing share portfolio as collateral. This allows you to increase the size of your investment without having to deposit additional cash.
You can manage concentration risk by diversifying your portfolio. For example, if your share portfolio is overweight in a certain sector and you do not want to sell the shares, you could use the equity in your current portfolio to borrow and invest in companies in other sectors.
While a loan for the purpose of investing in shares can help accelerate the growth of your portfolio, it can also magnify losses if prices move against you and you can lose more than your invested capital.
Interest costs associated with your loan may reduce your profits. Interest rates are also subject to change, and can result in an increase in the cost of servicing your loan.
Investing with borrowed money can be a big win — for some
Professional traders have used leveraged money to invest in funds and other stocks for decades, but this tactic can be ruinous for the average individual investor who is not careful, say investment and finance experts.
There has been evidence that trades on margin or on leverage (borrowed money or placing a collateral for money) are increasing as the stock market continues to rise, which although demonstrates investor confidence – at what cost?
The decision to invest with borrowed money comes down to comparing the cost of borrowing versus the expected investment returns. If the returns exceed the cost, then the transaction makes economic sense.
Today the spread between the two is so wide that with proper diversification, it can still work. But because borrowing costs are fixed and stock market gains are variable and unpredictable, it is not a perfect formula.
And understandably, borrowing ‘on margin’, or using stock you already own to buy more stock, is one thing, but borrowing against your home to buy stocks is another. So there is also the question of the how much you borrow and to what extent are you willing to go to get the money you need to invest.
Take an investment that offers an expected return of 15 per cent, but with actual results that might range between 15 per cent and 30 per cent. Even if the cost of borrowing is low, say 4 per cent, the transaction is very risky.
On the other hand, if a collection of diversified investments can offer a 10 per cent rate of return with a narrower range of 9 per cent to 11 per cent, then the risk of the transaction has been dramatically reduced.
Weighing the risks of investing borrowed money
Essentially it’s a strategy that can win big but also lose big. Here’s an illustration.
If a Dh10 stock you purchased with cash rises in price by 10 per cent, you have made a Dh1 profit. If the stock loses 10 per cent, it is worth Dh9. However, a Dh10 stock leveraged with a 2-to-1 margin trade would make 20 per cent, or a Dh2 profit. But if the stock loses 10 percent, the scenario can be bleak.
For example, if you have 2:1 leverage, it means you can borrow twice the amount of your investment from your broker. Let's say you want to invest Dh10 in a stock but only have Dh5 in your trading account. Using leverage, you could buy on margin at 2:1. So you'd have Dh10 to invest.
After paying back the margin costs of about 5 per cent or more, you lose Dh2.50 (or 25 per cent) on the original Dh10 investment. To make matters worse, if the stock were to decline substantially, you could be subject to a margin call, where you may be forced to sell that stock at a loss, or potentially throw good money after bad.
Ultimately, it’s up to you to decide whether saving or investing is the better choice to reach your financial goals. And of course, how and whether you invest, save, or do a combination of both will more than likely continue to shift over the years as your priorities and goals change.
When it comes to taking a loan to invest, a person may be tempted to do that if they see an opportunity to make money. If a person could earn higher returns investing the money they borrow than they pay in interest, they could come out ahead.
This can be very tempting after a stock market crashes and then starts rebounding. In some cases, you may see sharp gains for a few days or weeks that would exceed the costs of some personal loans over a year.
Taking out a loan to invest in anything, including the stock market, only makes sense in one scenario. This scenario is when you know with a relative degree of certainty that your returns will exceed your costs. Investing in the stock market at any rate of return is far from certain.