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Assuming that I can take personal loans of about ~10k€ (up to 20k€), how risky is it to invest in 'safe' stocks (e.g. dividend aristocrats)?

Assumptions:

  • I am a recent graduate, living in France;
  • 0.95% / year interest, payment in 3 years;
  • After all costs of living, taxes, personal emergency fund contribution and the monthly payment of a 14k€ student loan (that will be paid off in 2.5 years), I still have about ~600€ / month left;
  • I already have 18k€ invested right now;
  • I know how to budget;
  • My goal is long term investment (and early retirement, if possible).

This thought comes from the fact that I can either :

  • Pay off all debts right now and have my net worth reduced to my emergency fund (~5k€), and invest whatever I can from now on;
  • Be more aggressive, increasing my liabilities while increasing my investments to 40k;
  • Do nothing.

The point is that by investing slowly with no debts, I will be years behind a more aggressive investment, as long as things do not go terribly wrong.

Any thoughts on how risky such a loan would be?

  • What's the interest rate on your student loan? Are your investments in retirement or other sheltered accounts that have a penalty for withdrawal? – D Stanley Sep 16 at 19:24
  • Student loan: ~1% / year. Part in a saving account (Livret A, 0.75% / year), most of it in large cap stocks (in a deferred-tax account, PEA) – user100860 Sep 16 at 19:56
  • Is 3 years the longest loan term you can get? The longer the better when it comes to investing. Over 3 years, the odds of the market being ahead of where it is today aren't as good as if you're looking out, say, 5 or 10 years. – Chris W. Rea Sep 16 at 20:43
  • "I will be years behind a more agressive investment" ... or ahead of. What is your target situation? Retired at 35? Never broke? 1M€ in net worth? What is your worst "fear" or "unwanted situation" - losing all investments? It is hard to answer without you listing a set of objectives to your investment strategy. – Stian Yttervik Sep 17 at 11:32
10

You are contemplating leverage

In finance, leverage is borrowing money for investment, with the expectation (goal) of gaining higher gains than the cost of borrowing so that you end up with a net profit. This is the same principle behind margin accounts, where money is borrowed to hold an equity position you don't have the cash to cover on your own. It is indeed even the same idea as buying a house with money you've borrowed from the bank. It also follows all normal loan rules, including regular interest payment, requirements to pay back the principle on a set date, or margin calls (in the case of margin trading, but that doesn't apply to a personal loan as examined here).

Leverage multiplies both gains and losses

When you succeed in your investment, leverage multiplies your gain. Lets say you start with $100, and you invest without leverage on an investment that gets you 5% return in a year. At the end of year 1, you thus have $105.

Alternatively, you decide to take your $100 in addition to $1000 you borrow at 1% interest. You still get 5% return on all invested money. At the end of year 1 your $1100 invested returns you $55, less a cost of $10 in interest, for a net gain of $45. On your cash investment of $100, it is as if you had been investing at a 45% rate of return!

So leverage is great, right? Well, sure, when you win - but what if your investment was down 5% instead of up?

Unfortunately, when you lose you still have to pay back the money with interest. So you invest $1100, you are down 5% on top of having to pay 1% in interest, and you end up with a value of $1035 at the end of year 1 - a loss of $65, leaving you with $35 of your own money, a 65% loss. Ouch! And all that for just a 5% loss in what you invested in?

Leverage Means Risk of Not Having the Money to Pay Off the Loan

The higher the leverage you use, and the higher the potential downside on the investment (and the market can certainly go down more than 5%), the higher the chance that at the end of the loan period you will have less investment money than the total on the loan. This means that not only can your investments wipe out your at-risk capital, but they can put in you debt as you lose more than invested. You will then continue to pay penalty and interest money, as well as likely a hit to your credit, as you shovel money that would have gone into your savings/investment to cover the money you borrowed.

As an example, in the above example if the market had gone down 10% the $1100 invested would have become $990, less $10 in interest, meaning you end up at -$20. That's a total loss of the $100 you invested, plus you have to pull from savings just to cover paying back the loan. And if you don't have it - even worse, as more interest and penalties will add up.

Leverage increases risk of ruin and maximum drawdown

Overall, leverage means you have a greater risk of ruin (losing all you invested or more), and increases the maximum drawdown your investment strategy can experience relative to your own capital.

If you "pay" these risks, you get magnified returns.

If you only consider upside potential in investments, you will end up bankrupt. You have to decide your own personal appetite for risk, including your ability and willingness to handle ruin (not being able to cover interest or pay back the principal on time, bankruptcy and beyond). Leverage is a magnifier and increases risk, while offering the potential - but not the guarantee - of magnified gain.

  • It is pretty tempting for people to leverage with the low-interest-rate loan on under-performed stock ;-) – mootmoot Sep 17 at 9:29
  • Where can I get this 0.95% loan? Because I can get a term deposit of 2.7% for three years. Probably in a different currency, of course... – Someone Somewhere Sep 18 at 6:27
  • @SomeoneSomewhere I was thinking about Boursorama : (boursorama-banque.com/credits), although other banks have similarly low rates. – user100860 Sep 18 at 19:45
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Pay off all debts right now and have my net worth reduced to my emergency fund (~5k€)

Paying off debt does not reduce your net worth - your net worth is all of your assets less what you owe, so it is a wash from a net worth standpoint.

Also note that "dividend aristocrats" are not necessarily "safe" from a wealth standpoint. The value of a stock goes down by the amount of a dividend, so it is also a wash from a wealth standpoint. Yes, the dividend may pay your interest payment and a little of the principal, but if there is no growth in the stock, you'll end up underwater (the stock will be worth less than the balance of the loan).

Borrowing to invest is always risky. You are financing a risky investment (risky in terms of loss of value, not in terms of going bankrupt) with a "risk-free" loan (you're going to owe payments regardless of what you earn in investments). You might end up OK, but you might also end up owing more than your investments, which is a tough hole to get out of.

The point is that by investing slowly with no debts, I will be years behind a more aggressive investment

You'll be "behind" for a little while, but if you stick to responsible spending and get rid of the debt payments, you'll be able to accelerate your investments very quickly. With the friction of debt payments gone, you'll be ahead before you know it.

  • 1
    Just to add, it's the OP's liquidity that will be reduced by paying off the debts (if the OP wants a term to replace "net worth"). – chepner Sep 17 at 13:49
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You ask:

Any thoughts on how risky such a loan would be?

The simple answer is that it is riskier than whatever you invest in.

Other answers have addressed the possibility that the value of your investment drops.

There are other risks, including:

  • not being able to pay an interest instalment at some point
  • an unexpected call on capital
  • a margin call
  • not being able to take out a mortgage because of 'too many loans'
  • etc

You might consider some of these to be negligible risks, but beware the nature of risk - even the tiniest risk can be a huge pain in the unlikely event that it materialises.

Whether you invest this way is your call - as you say, there is also an opportunity cost if you take the 'safe' route.

Disclaimer: the above is not to be construed as financial advice. Please consult an appropriate professional for financial advice.

1

If

"10k€ ... 0.95% / year interest, payment in 3 years" means that you'll be paying a lump sum of €10287.71 in the autumn of 2022, then yes I would strongly think about doing it.

However

if your aggressive investments take a bath, you're still going to owe €10287.71. Of course, if you have an Emergency Fund, you can always use it to make up the difference between the low sale price and the loan balance due.

1

Leveraging investment is always risky because you could end have a big loss and end up owing more money than you have. You mention "safe" stocks, but keep in mind that in a market crash, no stock is safe. How sure are you that you can tell if the market is about to crash? What will you do if you get caught with your pants down, with your investment down 50% and still on the hook for the loan?

The bank is probably not stupid, and knows about the stock market. They are just as able as you to simply buy a bunch of dividend stocks. If it made more money than the interest, why would they not do that investment instead of loaning it to you? Of course, there could be many reasons, such as interference from the government. But it is still an important question to consider.

If you can get a 3-year, 14k loan at 1% APR you will pay back a total of 14,424 or 120/mo. That sounds a lot better than your student loan payments of 600/mo. I would take the personal loan and immediately pay off the student loan. You can invest the extra 480/mo however you want.

I am not familiar with any dividend aristocrats, but generally dividend stocks vs. dividendless stocks pay out about the same. This is something of a dead horse among researchers. When a stock pays dividend its price drops by about as much as the dividend - the dividend is not free money, and shareholders already make their own dividend by simply selling shares. In fact, dividends are arguably undesirable as they make taxes more complicated. Instead of academic quantities like the dividend of the company, I would suggest basing your investment strategy on things actually predictive of future gains. As for aristocrats, last I heard they didn't fare too well in your country.

In any case, you should compare the interest of the loan to the projected gains from your strategy. It is important to remember that the interest is never going away, but people overestimate their expected gains all the time. You must also factor in the possibility of catastrophic failure (eg. market crash or personal emergency). If the gain is much higher than the interest, go ahead. However, generally it will not be, because if it was the bank would have made the investment instead of lending to you. Your interest of 1% sounds really low, so you might have a chance there, who knows. In most cases the interest will be such that it is impossible to make money with typical market returns after considering fees and taxes - the leverage only makes sense if you can beat the market. But if you are asking about 10k personal loans, chances are that you don't have the experience to do that.

By the way, there are three simpler ways of leveraging your investment:

  • Trading on margin
  • Trading options
  • Trading leveraged (2x and 3x) ETFs

All of these are subject to the same risks as using the personal loan or any other loan, but the terms will often be much more convenient. You may not be approved by your broker for the first two due to low funds and/or experience and/or knowledge - if so, consider whether there is some wisdom to the broker's decision of withholding leverage from you. The third, as far as I know, is currently a loophole allowing you to circumvent that wisdom.

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