Not always a happy ending investing through margin lending
WITH the GFC well behind us, and the Australian stock market having traded to a nineyear high of 6256 points in January, more investors are considering borrowing to invest. But is this wise or a recipe for disaster?
For many investors, borrowing to buy stocks can be a double-edged sword. On one hand, it gives you the power to dramatically increase your returns in a rising market. However, it can also produce the opposite, as your risk of loss is magnified if the market falls.
Let’s look at an example.
Margin lending is one way to gain greater exposure to the share market. You’re able to borrow up to 70 per cent of the value of the stocks, which means you’re required to provide the other 30 per cent.
So, if you have $30,000 in cash or shares you can create a portfolio worth $100,000. Best of all, you receive dividends based on $100,000, not $30,000. So what’s the catch?
It’s important to consider both sides of the sword:
1. If your portfolio rises by 10 per cent, you make $10,000 or around 33 per cent of your capital.
2. If the market falls by the same amount, you lose $10,000 or 33 per cent of your capital.
This illustrates how both profits and losses are magnified by leverage and why you need to carefully consider whether leverage is for you.
Also remember, you must pay interest on amount.
Most of the demand for margin loans occurs just before a market top, and the biggest exit just before market bottoms.
Why? The simple answer is, people without proper knowledge are swept up by market euphoria and fail to gain the required knowledge to manage the risks involved.
Once you have the right knowledge, part of your recipe for success should be to never borrow more than you are willing to invest. For example, if the loan you have $30,000 in cash or shares, only borrow $30,000 to lift your total portfolio value to $60,000. You may get rich more slowly, but it’s a lot safer and you won’t end up on the wrong side of the sword. This week, solid gains were made on the Australian market, with the All Ordinaries Index (XAO) rising to around 6040 points on the last day of trade. This is a further positive sign for the XAO, as the market has risen steadily from a low of 5834 points on April 3.
Also, the move occurred over three consecutive weeks, which is often an early indication of the start of the next rise. However, at the time of writing, the market was trading 15 points below the week’s high, providing cause to apply a cautious approach to new buy opportunities.
Remember that the biggest mistake a trader can make is to assume they are right about the direction of the market, even if previous forecasts have been quite accurate. Dale Gillham is chief analyst at Wealth Within