Don’t Be a Bank. Just Be an Investor.

You are not a bank. You are not Jamie Dimon. Although you can hire him if you want, by buying stock in the bank (JPMorgan Chase) that employs him.

Where the family fits

This post continues the discussion from my last post, on the risks for investors who inadvertently start playing the role of a bank. Why is this so important? Because at the core of this issue is an understanding of where a family fits, investment-wise, into the grand scheme of things. When families understand where they fit and why, they can be very successful. When families misunderstand their place and try to dabble in investment plans outside of their proper sphere, it usually ends in disaster.

“Borrow low, invest high” (No, don’t)

I can’ t tell you how many times I’ve been asked about an investment scheme that involves borrowing money from a bank and then investing that money elsewhere, supposedly for a higher return than the interest the bank charges on the money.

The basic idea is: Get money at a lower rate and invest it at a higher rate. Sound at all like what a bank does as well? Yes, it does. So if this is what the bank does, how can the individual investor do it, too?

Remember that the bank takes in deposits and pays them a low interest rate, and then loans out the money at a higher interest rate. The spread in the rates is the bank’s income. So if you are borrowing from the bank, you are on the wrong side of this spread for it to be a smart business move.

This doesn’t mean banks are bad. They provide an important function in society and, like all businesses, they have to make money. It’s just like a retail store buys at a lower price, sells at a higher price, and the spread is their income. The retail store is the party that makes the spread — not the family buying the clothes.

When borrowing makes sense

There are some situations where borrowing from a bank and investing elsewhere can be smart. First, if you are a business and are actually creating something, borrowing capital from a bank can make sense. Also, if you are borrowing money for a primary residence and are also saving money into a 401(k), this probably makes sense, primarily because of tax incentives (although for high net worth families I usually recommend that they own their home outright).

But in most other circumstances, a family investor is playing on the wrong side of the table if they are borrowing from a bank to invest in something else. If you really, really want to try to make money off of interest rate spreads, it makes a lot more sense to buy bank stocks rather than try an ill-fated attempt to play a bank yourself.

Of course, I would never recommend an investor just invest in a single bank stock or even a single sector, like banking. It isn’t sufficiently diversified. So it all just brings you back to the wisdom of keeping your debt low (or at zero) and investing in a broadly diversified portfolio.