Overconfidence leads to borrowing
When the markets are on a tear, many investors get carried away. They begin to think that the only way markets will move is up. This is when emotions get the better of logic. Many investors begin to borrow to invest, thinking the returns will beat the cost of borrowing.
Investor Warren Buffett, an astute observer of human behavior, has often seen other investors make this mistake. He says as much in one of his Berkshire Hathaway (BRK-B) letters to investors. “Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to ‘time’ market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. It is good while it lasts.” But sooner, rather than later, reality bites and brings you crashing to the ground.
Borrowing to invest reduces long-term returns
Buffett offers another strong piece of cautionary advice to investors about borrowing. “Indeed, borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.”
Buffett doesn’t borrow to invest
Buffett uses float to invest. Float, in simple terms, is money you get before you use a service. One example of float is a traveler’s cheque. The money is already paid before you use any cheques. The insurance business is another example of float.
Buffett used Berkshire’s float to invest in his large holdings such as Coca-Cola (KO), IBM (IBM), and Wells Fargo & Co. (WFC). These three stocks account for 3.08% of the iShares Core S&P 500 ETF (IVV).