Home' Forge : Vol 4 No 1 Contents wealth creator // 103
Investors learnt many painful
lessons during the 2008–09 global
financial crisis – particularly with
regard to the double-edged sword
of gearing. Borrowing to buy shares
is great when markets rise, but is
potentially catastrophic to your
wealth when prices tank.
Households could not get enough of
margin loans when the bull market
took hold earlier this century.
Margin-lending volumes peaked
at $41.5 billion in December 2007,
and Reserve Bank of Australia
data shows that there were 260,000
margin-lending accounts soon after.
Then the party stopped abruptly. As
the GFC struck, speculators were
reminded that gearing works both
ways, magnifying gains and losses.
Margin-lending volumes tumbled
in 2008 and were worth $11.5 billion
in September 2017. Margin-lending
client accounts halved.
The use of margin lending has
flatlined in the past few years,
despite a rampant bull market
in US equities and an improving
performance in Australian equities.
Investors who geared over US
shares (through an index approach)
would have achieved stellar returns.
Therein lies the problem with
gearing: too many investors borrow
to buy shares when markets
are red-hot. Call it greed. Call it
stupidity. Inevitably, they borrow
when markets are overheated, and
overlook the benefits of sensible
gearing when markets are cheap.
Horror stories about over-gearing
in bear markets abound. I knew
an investor who had a $2 million
portfolio at the share market peak in
2007, partly financed by an $800,000
loan. With $1.2 million of equity,
and a debt-to-equity ratio of 40 per
cent, the investor was flying. His
portfolio looked conservatively
geared, on paper.
But the portfolio halved to $1 million
during the GFC, and the investor
was too slow to react. The debt did
not change. He now had a $1 million
portfolio and $800,000 of debt – a
ratio that triggered a dreaded ‘margin
call’ because the loan-valuation ratio
exceeded the maximum gearing ratio
(he only had 20 per cent of equity).
With his account in margin call, the
investor had to sell shares – at the
worst possible time in a bear market
– to raise cash and restore the loan.
His portfolio was slaughtered,
because he underestimated how
quickly markets can fall and the
dangers of too much debt.
Benefits of sensible gearing
For all of the risks, gearing can be
an effective investment strategy for
the right investors at the right time,
provided you know what you are
Conservative investors who are in
or near retirement, and need income
from their portfolio to live on,
should forget about gearing. At this
stage of life, capital preservation is
key, and gearing has the potential to
amplify losses – it’s too risky.
But consider an investor in his
or her early 30s who is saving
furiously for a house deposit.
With a sensible gearing strategy,
this ‘growth’ investor can borrow
to buy more shares, increase
exposure to the share market,
and potentially quicken portfolio
growth. Unlike the conservative
investor, the growth investor can
take more risk and has more time
to recover from losses.
Also, understand what you are
gearing over. I’ve seen too many
investors over the years borrow
to buy shares in companies that
are heavily geared. They are
borrowing to own companies that
have too much debt as it is, and are
magnifying their risk.
Moreover, look for ways to
minimise risk. Gearing over an
index exchange-traded fund (such
as the S&P/ASX 200) provides
exposure to a diversified basket
of stocks, rather than a single
company. If investing directly in
a company, consider its quality
and volatility. Is it a smaller stock
that tends to be more volatile, thus
increasing your margin-loan risk?
Always have a plan B. Understand
what would happen if the value of
your share portfolio fell by 10, 20, 30
per cent or more. What would your
gearing ratio look like? How would
Consider reinvesting dividends
on stocks bought with borrowed
money, where appropriate, to add
more equity to your portfolio. Or,
try treating the margin debt like
other borrowings and make regular
payments on the interest – and
preferably the principal, as well.
Moreover, understand the features,
benefits and risks of borrowing to
buy shares. Margin loans are one
of several ways of borrowing to
buy shares, and come with several
variations (some that have no
margin calls). Here is a snapshot of
the main options.
1. Margin loans
A margin loan enables you to
borrow money from a specialist
lender, and use it in addition to your
own funds to invest in a range of
investments that are acceptable to
the lender, such as shares, exchange-
traded funds, listed investment
companies and managed funds.
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