Leverage investing: Borrow big, retire rich

Turns out you’re not so loopy after all. Borrowing money to buy stocks in your 20s and 30s can give you nearly twice as much money by the time you retire as a conventional investor.

That’s the word from a study called Life-Cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk. The study, by Yale University professors Ian Ayres and Barry Nalebuff, argues that most of us have things backwards. Rather than load up on stocks in your 40s and 50s, you should start investing heavily in equities starting in your 20s.

How? By borrowing an amount equal to what you have set aside to buy stocks. For instance, a 25-year-old who has $5,000 to invest should borrow another $5,000 and put the whole $10,000 in a stock market index. He should do the same for another 15 years or so before slowly deleveraging in his 40s.

Following that strategy will, on average, leave you with 90% more money when you turn 65 than conventional investment strategies, and give you enough to comfortably finance your retirement until you’re 112. According to the professors, the worst-case scenario is that you retire with only 30% more than the conventional investor.

Why does the strategy work so well? Ayres and Nalebuff base their calculations on U.S. stock market data going back to 1871. Over that time the average return on equities has been 9.1% and the cost of borrowing 5%, leaving someone who borrows to invest with a 4.1% net return after paying off their loan costs. By borrowing to invest early, you make the most of that favorable math.

Ayres and Nalebuff argue that borrowing to invest while you’re young is actually less of a gamble than the conventional path of saving first, then starting to invest only in your 40s. Take that 25-year-old again. This year he may only have $5,000 to invest, but 20 years from now he might have $45,000 to put into stocks. Fine. But by investing nine times as much in 2028 as he is today, he’s unwittingly betting that the stock market 20 years from now will über-outperform today’s market. If he’s wrong, and the best time to snap up bargain stocks occurred when he was young, he has no chance to make up for the lost opportunity.

“At what point in their life people invest the most money isn’t based on any strategy. It’s based on the availability of money,” says Nalebuff. Most people wind up making their biggest stock market bets when they have the most money on hand, not when it’s necessarily the right time to invest. If you’re unlucky, you could plop your life savings into the market just before it slides. In contrast, borrowing money lets you spread the risk of investing over many more years. “So our way of doing things is actually less risky,” Nalebuff argues.

Well, maybe. “I see a lot of problems here,” says John Nofsinger, a finance professor at Washington State University and author of The Psychology of Investing. The most obvious one: sleepless nights worrying about how much in debt you are when the stock market falls. When that happens, most people panic and sell.

“I call that the behavioral bomb,” says author and financial educator Talbot Stevens. “It’s not that the math of leveraging doesn’t work out, it’s that human emotions get in the way.”So is leveraging to buy stocks a good idea? Unless you’re sure you’ve got the stomach to ride out the market’s downswings while carrying substantial debt, probably not. If you do decide to borrow, specifics matter. Using a traditional margin account at a broker means that if stocks fall, you may be called upon to put in more money or be forced to sell. A handful of lenders offer no-margin-call loans to buy mutual funds or seg funds. Another option is to tap into a home equity line of credit.

But don’t go overboard. Stevens suggests asking your bank how much money you qualify to borrow. Whatever that number is, take out a loan for less than half the amount. Or be really conservative and don’t go over 25%.

Either way, keep the loan small enough that it won’t keep you up at night worrying. If, as the Yale study suggests, you will still be living the good life at 112, you’re going to need your sleep.