Should I Pay Back my Loans Early or Invest? The Equity Risk Premium. Part Four.

Should I Pay Back my Loans Early or Invest? The Equity Risk Premium. Part Four.

When should you invest that extra money in the stock market instead of paying down loans?

This is part four of this blog post series. You should really start from the beginning to get a good feel for the topic.

Link to the rest blog series:

 

 

Up to this point we’ve spent a lot of time discussing the advantages of paying down your loan, namely guaranteed return and when to invest in other forms of guaranteed returns like 10-year treasury notes instead of direct loan payback (when the return is superior). The primary role of risk was also discussed. This was all in preparation for the question that prompted this series of posts.  

Editor: Paying down debt and investing wisely is one part of your financial success. The other side of the coin is earning more income. This is where your most vital professional skill, negotiation, comes into play. As a physician, you’ll be expected to negotiate often, including your salary. It’s shocking how few Physicians have any training in negotiation, which places them at a huge disadvantage. NegotiationMD.com trains physicians to become experts in negotiation, while also teaching them how to preserve relationships. Check us out. We may be the missing piece you need to truly succeed.

So, when should invest in the stock market rather than paying back your loan?

  • Is is when your have some extra money laying around?
  • Is it when the pundits on TV says a bull market is coming?
  • Is it when your friend gives you a can’t lose shot stock tip on the next big thing?

Hopefully, you are going to have some guesses as to the answer. Go ahead and take some time coming up with guess. It’ll will be a lot more fun if you try to come up with your solution.

 

 

 

You should preferentially invest in the stock market when the Equity Risk Premium or the implied extra return for assuming the risk of stock investing is superior than the guaranteed return of the loan payback.

 

 

Determining the Equity Risk Premium is controversial in high finance.

You can imagine why. Billions of dollars move based on tiny changes in this value. I’m going to just keep it simple.

You can get your PhD in it if you’d like. I prefer to chill.

For our purposes of the typical Doc trying to decide what to do with their loan the equity risk premium can be determined as follows:

Calculate the Equity Risk Premium:

  • The Implied stock market return minus the USA 10-year treasury yield equals the Equity Risk Premium.
  • For the US market, the implied equity market return is often measured using the ICOC is 7.4% when calculated in December 2018. It’s usually somewhere around 7%-10%. Again, you’ll need to adjust for taxes yourself.
    • There are hundreds of ways to determine the implied or predicted equity market return. It’s up to you to chose the model you like. The important thing is is to be realistic and look at multiple sources. Just because the market returned 12.5% in the last 10 years doesn’t’ mean the same is true for the next 10 years.
  • The USA 10-year yield is currently 2.67%. This is a low return from a historical standpoint, having been driven down by the Feds to discourage savings and encourage investment in a bid to recover from the 2008 recession. A yield of 4-5% is more typical.
  • Based on this number the current Equity Risk Premium is 7.4% (ICOC) minus 2.67% (10 yr. yield) equals 4.73%.

Be careful! This meaning of this value can be deceiving…

 

 

Using the calculated equity risk premium to determine loan payback vs investment.

No surprise here, this will get a bit controversial. But here’s a few things you already know

  • Paying down your loan early is just not a simple matter of guessing what you’ll make in the stick market.
  •  The implied extra premium for taking on the risk of stock market investing rather than paying down loans is not a guaranteed return of 7-10% no matter what everyone may be screaming.
  •  Any conversation or post about loan pay-down vs investing that does not mention Equity Risk Premium as a central tenet should be taken with a grain of salt. If the discussion does not center around the Equity Risk Premium, I ignore it.
  • If you can get a favorable guaranteed return from loan payback or a USA 10-year bond keep that bird in your hand!

 

 

 

In Summation:

  • The Equity Risk premium is the amount of extra or premium yield you should get for the equity market in return for taking the increased risk of investment.
  • The Equity risk premium is the Implied or Estimated Equity Market Return minus the Guaranteed Return
  • You should invest in the stock rather than payback your loans when the Equity Risk Premium points towards a superior return from the extra risk
  • Check out this post if you still have questions Part Seven: I Answer your Questions!

In the next post:

  • Your loan is at a higher interest rate then the 10-year treasury guaranteed return. How does that play into your decision making?

 

 

Remember, the best way to have assets to invest or pay down loan is to earn extra income. Negotiating  a better physician contract is the surest route to more income. Be sure to check out out NegotiationMD.com and our educational resources.

Link to the rest blog series:

 

 

 

So what do you think? Does the concept of Equity Risk Premium make sense? Does it help you understand why the conversation on so many forum and Facebook Posts are confusing? Does the math make sense? What value do you use to determine the Estimated equity market return? Do you have any good links to those indices? Let us know your thoughts in the comment section.

 

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