Should you borrow to invest in shares?

What are the risks and rewards of borrowing to invest in shares?

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Many investors confront the dilemma about whether they should borrow to invest in shares. For some, a redraw on a home loan can appear attractive – borrowing against your home at a rate of 5%, and investing in shares with long-term returns of 10% p.a. sounds like a good deal.

For others, their choices can be a margin loan, a personal loan, or a new type of equity loan that I have seen recently, which is similar to a margin loan albeit without the margin calls. If you're thinking about borrowing to invest, consider these things first:

Expected returns from your investment:

Many margin loans offer better terms for shareholders that invest in blue-chip companies like Wesfarmers Ltd (ASX: WES), Commonwealth Bank of Australia (ASX: CBA), and so on.

However, investors will need to keep an eye on the growth and dividends that these businesses pay. Large blue chips might be expected to grow at around 8% per annum, including a 4%-5% dividend and a 3%-4% growth in profits.

This does not leave much of a margin of safety if your loan costs 6%-7% per annum, for example.

Make sure also that you incorporate any establishment or account-keeping fees and so on into your expense calculations. They could hit you for another 0.5% per annum or so.

What is the downside?

Some loan formats, like using a redrawn home loan, have relatively limited downside. There are no forced sales of your shares to contend with (only your house!). The worst investing outcome is that your investments blow up and you must repay a loan at ~5% per annum.

Margin loans however, can lead to your shares being sold at the worst possible time if the value of your portfolio falls too far against the value of your loan. This means that temporary market upsets (or terrible share selection) could see you being forced to sell your shares at the bottom.

Focus on managing your risk

If you're borrowing to invest, especially with margin loans, you must avoid risky shares at all costs. Borrowing to invest is like piling a few more storeys onto a house of cards. You multiply the amount of capital that you work with, but your priority is ensuring that the house of cards survives long enough to bear fruit.

As a result, you should avoid highly indebted companies, miners like Rio Tinto Limited (ASX: RIO), and insurers with 'tail risks'. For example, Insurance Australia Group Ltd (ASX: IAG) may appear ideal as the target of a margin loan. But the shareholder is taking a gamble that at some point in the next 5 years (or however long the loan is) there won't be a freak storm that could wipe IAG's share price and profits.

Diversification via owning a group of shares (12 or more) can help spread some of your risks, as can keeping cash on hand, but if you borrow to invest, risk reduction should be your primary focus.

Motley Fool contributor Sean O'Neill has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of Insurance Australia Group Limited and Wesfarmers Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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