Nita has been pushed by her banker to use her gold assets, which are passive. The banker advised her to borrow money against her gold coins, jewelry, and other possessions and use it to invest in equity markets. The banker claims that doing this will increase her wealth and bring life to her passive assets.
Borrowing at 8.5 percent and investing at 12 percent, which appears to be a simple arbitrage, is not quite that simple. The deal might be successful if stocks yield extraordinary returns, but such assumptions are unachievable.
Many investors, including Nita, are thinking about taking out a loan against their gold and using the proceeds to buy stocks because the equity markets are doing so well.
The calculation
Let’s say Nita borrows Rs 30 lakh, with a one-year repayment period and an interest rate of 8.5 percent per year (p.a.). The monthly EMI is equal to Rs 2,61,659 in this case. Let’s now assume that this Rs 30 lakh is invested for ten years at a 12 percent annual return in a Nifty 50 index fund. After deducting the interest paid in the first year of the loan, the investment would have been worth Rs 91,62,633 after ten years.
Nita has the liquidity to invest the money in the same Nifty 50 Index fund for ten years, earning Rs 91,95,316, rather than taking out a loan.
It appears that taking out a loan in order to invest has little purpose.
What makes 12 percent superior to 8 percent?
Investors often take out loans or switch from debt to equity in order to maximize their equity investments when the equity markets are performing well. Yet, there may be protracted periods of drawdown in stocks, and their returns are not always linear. During recessions, will investors keep holding onto their equity investments? Probably not, considering that only 50% of equity SIPs are retained for longer than two years. Investors don’t stick to a basic index fund and instead are continuously chasing the best-performing fund, even in strong market conditions.
After taking out a loan, there is an even greater need to act. However, there is no assurance that the investment will be profitable, and historical data indicates that churning portfolios increases costs and risks rather than yielding higher returns. Therefore, what would appear to be a simple arbitrage opportunity—borrowing at 8.5 percent and investing at 12 percent—is not quite so simple. If stocks provide extraordinary returns (above the expected average), the deal might be successful, but such assumptions are unrealistic.
And does the risk of incurring debt really outweigh the possible reward? Although Nita had the money to pay the EMI, there may be circumstances in which the investment’s income is required to cover the EMI. Undoubtedly, erratic instruments are connected to the market.
Rather than concentrating on these tiny gains, investors ought to see if their entire portfolio is outperforming inflation. Less than 10% of most households’ financial assets are inflation-beating assets, so a shift in those holdings can have a significant impact on their wealth. By switching from factor-and-omission (F&O) or concentrated stock portfolios to diversified equity mutual funds, investors can potentially lower risk and stabilize returns even in the stock market. Recall that long-term success in investing comes from discipline.
