I was talking with a friend who had recently decided to go back to school. One can’t discuss school for very long without the subject of loans coming up, and my friend indicated that he would indeed be taking some out for his program.
Now, he’s like me, in that he likes to see what parts of the system he can game, so he brought up an interesting idea. He wondered if he could maybe take out more loans than was necessary and invest the extra. With student loans charging low interest rates, one could presumably invest the money in a higher-return product, and make money on the exchange.
It was an interesting idea, and among much else, it brought to mind a phrase attributed to a medieval Franciscan friar.
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Robbing Peter to pay Peter
That idea of taking out a loan and investing it in a more lucrative product is what’s known as “investing arbitrage.” At first glance, this seems like a no-brainer. If you take out a loan at 5%, and you invest in a product that returns 8%, then you’ve made 3% for doing almost nothing. Sounds good, right?
In fact, this is what banks do with your money all the time. When you make a deposit, the banks invest your money in more sophisticated products, netting them a handsome profit. And as most bank interest rates are 0% to us, we’re in effect lending our money to the bank for free, minus the services they provide to you.
So if the banks can do it, why can’t you?
Well, the simplest reason is that it may be illegal. Loans often usually come with stipulations as to what the money can be used for, an usually this doesn’t include a brokerage account.
But jaywalking is technically illegal too, so if that’s not a compelling enough reason, the scheme most likely won’t work anyway. Here’s why.
Real returns aren’t so real
When you make a profit on money invested, you need to pay taxes on it, called capital gains tax. Without getting into the weeds too much with details, the tax you will pay will likely be between 15% and 39%.
So let’s take an oversimplified example. Let’s say you took out $10,000 extra dollars from your student loan vendor (don’t worry, they have enough). Your interest rate is 5%, and then you invest this money for five years at a product that returns 8%. Assuming you pay nothing on the principal, you will owe $2,500 in interest ($10,000 * 5% * 5 years), but you will have made $4,000 in interest ($10,000 * 8% * 5 years).
Notice that after all that, you’re only looking at a profit of $1,500. But now remember the capital gains tax. Assume that you only need to pay 15% (which is the rate on long-term capital gains when in typical tax brackets), so that will eat up $225 of that $1,500, leaving you with a paltry $1,275.
(Eagle eyes will note that if the person in question had no income at all, then the long-term capital gains tax rate is 0%, but even still, that’s an unimpressive return.)
Risky business
In the above scenario, you still earned money. And that brings us to the second problem with investing arbitrage: while you can guarantee the interest rate you will be charged, you can’t guarantee the interest rate you will earn.
This chart shows some year-on year returns of the Dow Jones index. Look at this chart and find the last five-year period where you could earn an average annual rate of 8% (That’s a total return of 47%, as (108%)^5 = 147%.)
Did you find it? Please check my work, but I had to go back to the period between 1996 and 2000. That was a long time ago.
Now, this is a bit of a contrived example, but I use it to show that financial products that generate large returns will not do so on command. Over the long term (10+ years), most quality mutual funds and the like will generate a good return, but this can’t ever be guaranteed.
So what if you don’t make 8% on your investment in the appropriate time frame? What if you don’t make anything? What if you lose money? Is it worth the risk?
The Razor
William of Ockham was an English Friar in the 13-14th century. He is best known for his statement, now immortalized as Occam’s Razor:
“Pluralitas non est ponenda sine neccesitate”
Or, with less Latin:
“One should not increase, beyond what is necessary, the number of entities required to explain anything.”
The colloquial interpretation of this is that “the simplest explanation is usually the best.” (Though there are plenty of quibbles on this interpretation.)
And I believe that this interpretation of Occam’s Razor applies perfectly to the subject of investing. In almost all cases, the simplest method is usually the best. Instead of picking stocks, use an index fund or mutual find. Instead of trying to time the market, invest consistently and for the long term.
And most importantly, don’t try to over-complicate your investment strategy. Don’t go for quick returns. You won’t gain all that much, and you could potentially get yourself tied up in knots.
Luckily, you have a Razor to cut you free.
But enough about me. Have you ever done any investing arbitrage, or other complicated investing schemes?
