Remember the ABC portfolios? Adventurous had two-thirds in equities, Balanced had half, and Cautious one-quarter. The rest was in cash/gilts/index-linked bonds - the boring bit. None had 100% equities, certainly none had 150% equities, which is what happens when you borrow to invest. That is called leverage - yet millions of ordinary investors [that's you and me] are leveraged without even knowing it.
To understand it, first you have to realise that a loan is like a negative cash balance. It's exactly equivalent if savings and loan rates are the same. If you can say borrow £100 at 4% and deposit £100 cash at 4%, it is the same portfolio as having £200 loan and £200 in cash. It sounds obvious but it has very important implications.
Before we run with it - let's look at the two possible alternatives to this rule, where cash either pays more or less than the loan rate.
First, its unusual if you can borrow at 3% and invest at 4%. In this case cash and loans would not be equivalent in terms of risk and return and it would make sense to borrow as much as possible.... It would be a free lunch. Lest we forget, this is what ratetarts and banks try to do.
Second - and more usual - you might have to pay more for your loans than you get for your savings. That's why, in the real world it makes sense to pay off loans with any spare cash, because we will be charged higher interest on the loan than we get on the savings. The classic example is credit card debt.
However for today we will make them precisely equivalent - a loan is negative cash. Having cash of £200 and a loan of £100 is just the same as having £100 and no loan.
So now we have two principles
1 No leverage. [Don't borrow money to buy shares]
2 A loan is negative cash.
So far, so bland. But it means that:
if you have a mortgage you shouldn't invest in shares
Let's see how we reach this rather startling conclusion by looking at Trisha's savings.
She has a balanced portfolio £20 000 in cash/gilts and £20 000 in shares She also has a mortgage of £100 000. She doesn't realise she is living her [financial] life on the wild side.
Straightaway we can see that she could pay off £20 000 of her mortgage using her cash. A portfolio of £20 000 in shares and an £80 000 mortgage would be exactly the same as what she has now. And yet now she has her savings in 100% equities.
Trisha examines her 'new' but exactly equivalent portfolio and is profoundly shocked. 100% equites? Scarey - this is not where she wanted to be at all. In fact she realises that things are even worse than she thought. She has effectively borrowed £20 000 to invest it all in shares.
She sells her shares and pays down her mortgage. The new Trisha portfolio is now: zero securities, zero cash. But her loan[mortgage] is down to £60 000.
Note there are two stages in this argument.
1 Loan is negative cash gets you a set of portfolios that are the same .
Savings of £50k in gilts/cash, and a loan of £50k is the same as savings of £100k in gilts/cash and a loan of £100k. There's nothing to choose between them. They are equivalent. But that equivalence gives us a powerful new way of looking at your own holdings. By removing cash from your portfolio (by paying off your loans), you can see the underlying structure [in risk terms]. Is your portfolio really as safe as you think?
2 Borrowing to buy equites gets you a set of portfolios that have the same [net ] value, but a range of risk/reward characteristics.
A loan of £50k and £10k in shares is very different [in risk terms] from a loan of £100k and £60k in shares. But the net loan outstanding [£40k] is the same in each case. There are real choices to be made here for professional [leveraged] traders. For vanilla investors the choice is simple. We don't do leverage, so we don't borrow to buy equities.
Don't hold any equites until the mortgage is paid off.
Which is another way of saying that once you have built up your cash balances to where you want them (the 'emergency cash fund' much beloved of financial advisors), all your savings should go into paying off the mortgage.
The Vanilla Test
If you are still paying off the mortgage, but don't quite believe this rule - try the vanilla test:
Add up all your savings - and deduct them from your mortgage. You have now reduced your borrowings to the minimum. [We are assuming here that vanilla investors do all their borrowings from their mortgage account, there are no other debts.] Now decide how much do you want to borrow to invest? Ok it's a trick question - because you don't want to borrow to take a punt on the stock market.
Let's take a look at Terry. He has a £50 000 left on his mortgage, and savings of £20 000 all in a global commodities unit trust. Terry does the vanilla test. It comes down to this.
If he had a mortgage of £30 000 would he really borrow another £20 000 to invest in the stock market?
There is no doubt is Terry's mind, the answer is absolutely not. He sells his shares, and chops his loan back to £30 000.
Reasons why you might ignore this rule
1 Cash in hand. Some people like having extra cash around for an emergency fund. So they will have £10 000 in cash and a mortgage. Or they worry they won't be able to borrow next year [maybe they are losing their job] and therefore they should keep/take loans while their credit rating is good. So they hang on to £25 000 in cash rather than pay off the mortgage. Note this is not strictly breaking the vanilla rule - you are just switching your cash/loan balance around - you are not borrowing to invest in equities.
2 You want to pay into a pension fund - and you will miss the tax breaks if you don't. For the average taxpayer the perks of a personal pension [run by an insurance company say] are not that great. For a 40% tax payer they are a bit better, but you do lose flexibility [ie you can't get all your money out again as a lump sum, just an income once you are 55]. Also - you can pay in more later, when your mortgage is paid off, but maybe you worry you won't be paying 40% tax by then.
3 Your employer makes a matching contribution into your pension scheme. This may be well- worth having, even if it means diverting some mortgage repayment money.
In these cases you may want to break the rules and channel money from paying off the mortgage into pension saving. But don't fool yourself, you are borrowing money to do so. You are carrying more debt than you have to. You may in the end decide it is a good idea - but at least the vanilla test lets you make an informed choice. It would, for example, have kept anyone [who was reasonably sane] from buying a with-profits endowment mortgage.
Remember that in an endowment mortgage the amount borrowed does not decrease. Instead the excess mortgage payments made [after paying the interest charges] are invested. You are investing with borrowed money. It's a leveraged punt on the stock market, although I doubt if it was sold in those terms.
But let's look at a successful £100 000 20-year endowment mortgage a month before it ends. The stock market fund holds £100 000 - enough to pay off your mortgage. Apply the vanilla test and you discover you have ended up borrowing £100 000 which is now all invested in the stock market. Is this what you wanted? Probably not. All you can do is sit tight, be glad your fund has reached £100 000, and just hope the stock market doesn't crash in the next 30days.
Frequently Unasked Questions
Listen - this is all nonsense. I only borrowed money to buy a house
Wasn't it Gertrude Stein who said 'A loan is a loan'. [No, it wasn't, it was Greta Garbo] . Use the vanilla test to figure out how low your borrowings could be - and then ask would you really want to increase your borrowings to get back to what you have today. You might do - which is fine.
But surely a mortgage only applies to a house not to shares?
A mortgage just means there is security for the debt [in this case a house]. But even if the house became worthless - you would still have to pay back the loan. Don't think of the debt as being attached to the house - its attached to you.
I do have a mortgage - but all my savings are in a cautious managed fund. That's not leverage is it?
A typical managed fund might have 40% equities and 60%bonds. The equities bit is your leveraged bit. Because in theory [but not in practice] you could sell off just the shares and thus reduce your borowings.
So the bonds bit is OK?
It's OK but pointless. Why are you borrowing at 3.5% from your building society to invest in a bond that pays 3.75%. Because you can be pretty sure the management charges and expenses will eat up any difference. Chances are you are losing money on the bond side, and playing with fire on the equity side.
You've made my portfolio far too volatile...
No I haven't
Last year I lost 5% - this year after I did the vanilla test I lost 20% in the same market conditions
Last year you had £75 000 in gilts and £25 000 in shares. When shares dropped 20% you lost £5000. This year you paid off your debts with the gilts and started with savings of £20 000 all in shares. When the market dropped 20% [again] you lost £4000.
But I lost 20% - thats far more volatile
The share moves have been unchanged - its just that you can see them now clearly. Don't forget that the net effect is still the same with the new portfolio make-up [all shares]. The vanilla test has highlighted something you didn't spot before.
But should anyone with a mortgage sell off their unit trusts and trackers and ..?
Yes, it would be a start. In fact it should be the start. As in - 'you start from here, and decide if you want to add to your borrowings so you can invest more'. That way people will have their eyes open.
But every financial advisor tells me I must have some money in shares..
Yes, and maybe 3 out of 4 years theylook good because shares handomely outstrip the mortgage rate. But every now and again you will wish you had put your borrowed money somewhere else. Or maybe not borrowed any in the first place. It's your choice; but most people don't realise they are investing with borowed money.
But I have a 25year mortgage to pay off..
You will be surprised how much quicker it goes when you pour all your savings into it.
And then what ..I end up at age 49 with no savings, and my mate has £40 000 stashed away
Yup - but your mate may still have £45 000 to pay off on his mortgage
Yeah I forget. Still it feels funny having no savings..
It feels funny because what you have got is no debt. Plus you own your home free and clear - that's an asset.
Even so - if I don't have any shares I will miss out any market rises for the next ten years
Yes you will. You will also miss out on any market falls. But a market rise would test your resolve severely. Just ask anyone who didn't buy internet shares during the tech boom of 1996-2000, while their friends got rich with very little effort.
So maybe I could put £5k into shares....?
You could - but only because you are aware of what you are doing. If you have done the vanilla test and say - I don't care I still want to borrow that extra [ie not pay off] £5k so at least I have a stake in the stockmarket. Fair enough - but it is leverage.
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