Should you invest in shares or pay down debt?

Investing in stocks and shares always involves an element of risk, but if you are investing money you don’t actually have, then it starts to get seriously dangerous.

Yet that’s exactly what growing numbers of investors are doing. They are borrowing money they do not have and investing in shares they think will make them rich, with the aim of repaying the debt and making a small fortune.

Borrowing to invest is known as gearing or leveraging. While it can magnify your returns in the good times, it also multiplies your losses in the bad.

As US technology stocks coninue to rise and Bitcoin creates billionaires, leveraging up is all the craze.

Last November, borrowing to invest hit an all-time high in the US, with investors taking out more than $722 billion in loans against the value of their stock holdings.

In December, gearing jumped again to $788bn, according to figures from the Financial Industry Regulatory Authority. This was a whopping $300bn higher than in March 2020, a jump of 62 per cent.

You only have to look at Bill Hwang to see how this strategy can go wrong. The Wall Street trader lost his $20bn family fortune in just two days after borrowing huge sums to invest in stocks using complex derivatives instruments known as total return swaps.

When the banks who loaned him the money got nervous, they initiated a margin call, selling his stock holdings at a massive loss to recoup what they could, and down he went.

Most private investors would not do anything on this scale, yet growing numbers are leveraging via online investment apps such as Robinhood.

Losing money you have is bad enough. Losing money that you have to pay back to someone else spells trouble.

Stories abound of ordinary people gearing up to participate in the Reddit-fuelled trading frenzy over US video games retailer GameStop. They include security guard Salvador Vergara, 25, who took out a $20,000 personal loan charging 11.19 per cent per annum to buy the stock at $234, only for its shares to drop 80 per cent.

While GameStop has recovered to $166, Mr Vergara is still well down on his risky punt. He also has to pay back that loan.

On the other hand, who doesn’t wish they had borrowed $20,000 to invest in Bitcoin at the start of last year?

The temptation will always be there, particularly during a record-breaking stock market bull run like this one.

Chris Keeling, a chartered financial planner at Dubai-based advisory firm The Fry Group, says there are tools to limit the downside, such as stop-losses, but cautions: “Realistically, this type of trading should be left to professionals and experienced investors.”

James Yardley, a senior research analyst at investment fund portal FundCalibre, says by leveraging you are doubling down on risk.

“Personally, I don’t think retail investors should ever mess around with margin debt. That is a recipe for disaster. Markets will crash at some point, this is inevitable, and if you get a margin call at the wrong time, you may face ruin,” he says.

Your investment may have tanked, but your debt will roll on. “As interest compounds, you could get stuck in a debt trap where you can never pay it off.”

Yet to a degree, almost every investor borrows to invest. Or at least, invests while also borrowing money, say, on a mortgage, credit card or personal loan.

That makes sense, up to a point. If you wait to clear your mortgage first, you would have left it too late to build serious investment wealth.

For someone with job security and a mortgage charging around 2.5 per cent, it makes sense to prioritise investing over paying down the mortgage faster, Mr Yardley says.

“I would go so far as to say a lot of people make the mistake of paying off cheap mortgage debt too quickly.”

If you could generate between 5 and 7 per cent a year from a portfolio of shares and other asset classes, you should be comfortably ahead.

However, he cautions that this depends on your personal and financial circumstances, and attitude to risk. “Stock markets are highly volatile, so you have to be comfortable with that. If tempted, consider financial advice.”

Some investors might take this a step further, by taking out an interest-only mortgage, and investing the money they would have used to pay off the capital.

The aim would be to generate a superior return that would both clear the debt and leave a surplus on top.

This was a popular strategy in the 1980s, particularly in the UK, where many took out interest-only mortgages backed by 25-year endowment savings plans.

It backfired when endowments underperformed, leaving millions facing a massive mortgage shortfall at retirement.

There are three dangers. First, your investments flop. Second, inflation picks up, meaning your mortgage repayments could rise sharply. Third, house prices crash, and you find yourself in negative equity and risk losing your home.

Your peace of mind will have gone long before.

Heather Owen, a financial planner at wealth manager Quilter, says with money cheap right now some have stopped worrying about paying down debts and are chasing share prices higher instead.

“This view ignores the long term, and the long term is what counts,” she says.

Interest rates may not stay low forever, particularly if we get a post-pandemic bout of inflation, as many expect.

“Investing is inherently a long-term strategy, and you should be prepared for short-term volatility. The worst outcome would be to prioritise investing over paying down debt, only to lose money on your investments at the same time as the cost of your borrowings starts to increase,” Ms Owen says.

The decision is straightforward if you have expensive, short-term debt, Mr Keeling says. “If you have outstanding credit card debt at an annual percentage rate of 30 per cent, paying that down should be top your priority.”

No investment can guarantee to deliver that kind of return, so you will be making your money work harder by clearing that first. Plus you also avoid a debt trap.

As a general rule, if you have any debts charging 5 per cent interest or more, clear them first, Mr Yardley says.

“If you have several debts, focus your firepower on paying down the most expensive, then concentrate on the next most expensive. Always make the minimum monthly payment across all of them.”

Dan Lane, a senior analyst at investment app Freetrade, says after clearing costly debt, the next step is to build a rainy day fund in an easy access account as a safety net to cover any unexpected emergency costs. This has an added benefit.

“It means you can have cash to hand and don’t have to sell long-term investments such as shares to make short-term spending needs.”

Today’s stock market is already overleveraged. History suggests that high margin balances tend to precede major stock market sell-offs, so now is not the time to start loading up on debt. If markets crash or inflation returns, you will suffer. Especially if both happen at the same time.