Boost your wealth
Boost your wealth
This article is a general introduction to why you might borrow to invest and, if you decide it is appropriate, how to add a dash of leverage to a long-term plan. It focuses on borrowing to invest to reach medium to long-term goals, although there are other ways to add leverage.
There are four basic ingredients to achieve any financial goal:
- How much you save (including how much you start with).
- The time until you need to reach your goal.
- The size of your goal.
- The returns earned on your savings.
You may be able to manage some of these but, over the long term, returns tend to have the largest impact because of the power of compounding. Risk is the price for potentially increasing returns. An investment in shares is expected to earn much more than a bank term deposit, but has the potential to earn less or even incur a loss.
Leverage is about boosting potential returns.
This is not without risks; the investment might not perform well, for example. Successfully implementing a leverage strategy is all about managing the risks.
How to leverage
Step 1: Start with the end in mind
Financial goals drive investment decisions. Goals must be realistic and achievable, which can be difficult to judge.
The usual starting point is to consider your ability to recover from financial losses. This is appropriate but tricky, because people naturally dislike the idea of financial loss. Natural loss aversion can result in overly conservative investment decisions. Also, people often consider only financial risks without factoring in the cost of not achieving their goals.
An alternative is to identify life’s essentials. Things you can’t live without (including your health and ability to earn income) should never be risked. Set aside the essentials and whatever remains you can consider investing.
Step 2: Create choice
Having identified a baseline, the next step is to set out some reasonable scenarios: how much can you save, when do you need the money, can you delay, and (/or) can you get a similar outcome for less? The only unknown for each scenario is the required return. There are complications like taxes and fees, but we’ll keep it simple.
Some scenarios will clearly be unrealistic. Expecting to double your money in a year is somewhat equivalent to expecting to win the lottery. There may be a plausible scenario that requires only a low return. This will be the best choice – take no more risk than is necessary to achieve your goals.
More than likely there will be a few more palatable saving scenarios that require returns higher than safe, low-return investments.
Step 3: Do your homework
Finding investments expected to achieve the required returns can be complicated and is often the hardest step for investors. There are many factors to consider, including diversification, liquidity, fees and the reputation of the margin-loan issuer. Also, there will be many different views on the expected returns from different assets.
The best tip is to apply a scientific method. Don’t just look for information that confirms an assumption; look for information that contradicts your convictions.
Riskier investments like shares alone still may not achieve the desired returns. At this point you can consider whether borrowing to invest might boost expected returns. This means more research into current interest rates. Leverage is only ever sensible if returns are expected to be more than the costs.
Step 4: Goldilocks borrowing
How much to borrow is really two decisions:
- How much to borrow relative to the maximum amount the Lender will lend.
- How much in dollar terms.
The first step is often overlooked. The Lender sets a maximum amount you may be able to borrow against an investment or portfolio, called the loan to value ratio, or LVR.
If a share is worth $100, you may be able to borrow up to $75 (an LVR of 75 per cent), contributing $25 of your own savings.
It is important to understand a margin call. If the amount borrowed, relative to the value of the portfolio, exceeds a tolerable level you will be required to remedy the situation, usually within a day. There are three parts:
- Amount borrowed relative to portfolio value, also called your gearing ratio. For example, if a portfolio is worth $1,000 and you borrowed $600, your gearing ratio is 60 per cent. As the portfolio value increases (or you reduce the loan), your gearing ratio shrinks. As the portfolio value falls (or you increase the amount borrowed) your gearing ratio gets larger.
- Tolerable. Lenders set a buffer for most investments (usually 5 per cent or 10 per cent). Your gearing ratio is acceptable when it is below the LVR. It is in dangerous territory when your gearing ratio is above the LVR by an amount less than the buffer (gearing ratio of 79 per cent, LVR of 75 per cent and buffer of 10 per cent, for example). A margin call occurs when your gearing ratio is above the LVR plus buffer (90 per cent, for example).
- Remedy.This means reducing the gearing ratio to below the LVR by either reducing the loan or contributing to the portfolio. This often means selling some investments to repay the loan, but there are other remedies. This situation can be a double blow for investors as they can be forced to sell into and already falling market.
The critical decision is how much of a gap to leave between your gearing ratio and LVR. No gap means a small fall in portfolio value could result in a margin call. A larger gap means it will take a significant market correction for a margin call to occur.
In terms of dollar amount, never borrow more than you need to achieve your goals. Also, it is never sensible to borrow more than you can afford in repayments. Unlike a home loan, repayments on a margin loan are interest only. Don’t forget dividends but be careful of relying on these as the only source to meet interest payments. Dividends are not guaranteed.
If your portfolio has increased in value (in other words, your gearing ratio has fallen) you might consider borrowing to pay interest (called capitalising interest) but this must be assessed very carefully and as part of your overall leverage and investment strategy. Always maintain a sensible gap between your gearing ratio and the LVR.
Step 5: Now repeat
Things change. Portfolio values and interest rates go up and down, return expectations fluctuate and goalposts shift. You don’t want to respond to every micro change, but it is equally important not to let the strategy drift off course. Adjustments will be necessary and that means going through Step 1 to 4 again.
How often you should do this will depend on your experience, preferences and strategy. Just like a boiling pot filled to the brim, a small gap between gearing ratio and LVR means more monitoring. Most likely, this monitoring will be more often than once a month but usually less frequently than weekly.
Bringing it together
Achieving any goal takes time, dedication and resolve. A financial goal is no different. Leverage will not be necessary or appropriate for everyone or every goal. It is not until Step 4 that investors even begin to think about adding a dash of leverage. When implemented sensibly and using the right tools, leverage can help investors build financial self-sufficiency.
1 Examining the Oceania Cannabis Market. New Frontier Data.
2 Legal Marijuana Market Worth $66.3 Billion By 2025 – May 2019. Grand View Research.
3 2018 Cannabis Highlights. New Frontier Data.
4 What is medicinal cannabis and why is it important? The University of Sydney.
5 Cannabis stocks on the ASX: The Ultimate Guide. Small Caps.
Gearing involves risk. It can magnify your returns, however it may also magnify your losses.
Leveraged Equities Limited (ABN 26 051 629 282 AFSL 360118) is a subsidiary of Bendigo and Adelaide Bank Limited (ABN 11 068 049 178 AFSL 237879).
Information is general advice only and doesn't take into account your personal objectives, financial situation, or needs. The views of the author may not represent the views of the broader Bendigo and Adelaide Bank Group of companies (“the Group”). This information must not be relied upon as a substitute for financial planning, legal, tax or other professional advice. You should consider whether or not the product is appropriate for you, read the relevant PDS and product guide available at www.leveraged.com.au, and consider seeking professional investment advice. Not suitable for a self-managed superannuation fund.
Examples are for illustration only and are not intended as recommendations and may not reflect actual outcomes. Past performance is not an indication of future performance. The information provided in this document has not been verified and may be subject to change. It is given in good faith and has been derived from sources believed to be accurate. Accordingly no representation or warranty, express or implied is made as to the fairness, accuracy, completeness or correction of the information and opinions contained in this article. To the maximum extent permitted by law, no entity in the Group, its agents or officers shall be liable for any loss or damage arising from the reliance upon, or use of the information contained in this article.