Thursday, March 01, 2007

 

The Levers of Prosperity


Many Australians retiring in 5 to 15 years will need to proactively take control of their finances to achieve better returns than those available through managed funds... without getting sucked into phoney Get-Rich-Quick schemes.

Let's take the Rule of 72 again, and once more start with $30,000 to invest. If we can achieve an annual compounding rate of return of 18%, how long will it take to double our investment?

72 divided by 18 equals 4: four years.

This means after four years our investment will have grown to $60,000, in another four to $120,000. Four years later we've got $240,000 - and in another four years $480,000.

$480,000 is sixteen times $30,000 - and we did it in sixteen years. So we have effectively got 100% of our initial investment back EVERY YEAR for sixteen years!

This is the power of compounding interest.

But is 18% per annum on a sustained basis really achievable? We've been conditioned to believe that it's not.

But we saw in an earlier post that typical returns from Australian shares over a ten year period were around 10%. Suppose we were to borrow 50% of the money we invested in shares over this period. We put in $30,000 and borrow $30,000, investing a total of $60,000.

Using the Rule of 72, if we're getting a 10% return, our investment doubles after 7.2 years - to $120,000. But we only put in $30,000, so our investment has actually quadrupled. By the Rule of 72, our investment has doubled every 3.6 years (half of 7.2) and our effective compounding rate of return is 72 divided by 3.6 equals 20%!

Now this example ignores borrowing costs, but it's a simple example of how leverage can substantially improve our annual rate of return.

The simplest form of leverage in the sharemarket is borrowing a portion of the amount you invest - usually referred to as a "margin loan". That, and several other forms of leverage in the sharemarket are discussed in this informative article from the Melbourne Age by George Liondis: Feeling brave? Get your money in gear

Margin loans can be risky but profitable.

AUSTRALIANS love real estate. And most are willing to borrow up to the eyeballs to invest in it.

But buying investment property is not the only way to power up your portfolio with borrowed money.

You can also buy shares with someone else's money - a plunge more investors are willing to take in light of the record run of the Australian sharemarket.

More than 11,000 new clients took out margin loans - the most popular way to borrow money to buy shares - in the past year. And, when you do the maths, it is easy to see why.

If you had $50,000 to invest a year ago and were keen on BHP Billiton, which was trading at about $18 last April, you could have bought 2778 shares in the resource giant.

At today's price of about $30, those shares would be worth $83,340. Not a bad return.

But say you were a little more adventurous and borrowed an extra $50,000, giving you a total of $100,000 to invest. You could have bought 5556 BHP shares a year ago and your $100,000 portfolio would now be worth $166,680. That's an even better result.

Of course, borrowing to invest not only gives you a bigger return if shares go up, but a bigger loss if they fall.

Say you used your $50,000, plus another borrowed $50,000 to buy 23,256 Multiplex shares a year ago when they were trading at about $4.30. With Multiplex plummeting to about $3, your $100,000 would now be worth $69,768. That's a loss of more than $30,000, and you still have the $50,000 loan to pay off.

If that isn't bad enough, if you borrowed the money to buy shares through a margin loan and your investments performed exceptionally poorly, you could be hit with a margin call.

MARGIN CALLS

Margin calls are the bogyman of borrowing to invest in shares. They occur when the shares you buy with a margin loan fall below a level that is considered acceptable by the lender.

When it happens, the lender calls on you either to pour in more cash or sell down shares to pay off some of the borrowings, probably when you can least afford it, given the poor performance of your portfolio.

From there, it can be a slippery slope towards financial disaster.

One way to protect yourself against a margin call is to be conservative with the amount you borrow.

Research by BT Funds Management shows that if you borrow 50 per cent of the money you need to invest in an average portfolio of Australian shares, the market would have to fall by a massive 38 per cent before you would face a margin call.

If, however, you borrowed 70 per cent of the value of the shares, you could face a margin call if the market falls as little as 13 per cent.

TAX BENEFITS

The attraction of borrowing to invest in shares doesn't stop with the potential to boost returns.

There are tax benefits, too, which is why margin lending providers tend to get flooded with new clients in the run-up to the end of the financial year in June.

The tax strategy is simple: the Australian Taxation Office allows you to prepay the interest on an investment loan - whether it's for an investment property or shares or something else - up to 12 months in advance, but claim the tax deduction in the current financial year.

So, if you take out a loan to buy shares before June 30 and pay the interest on the debt for the next year upfront, you could claim the entire interest cost as a tax deduction.

Not a bad outcome if you have a big tax liability you are trying to allay; but it comes with a caveat: investing in shares is too important a decision to make based on tax benefits alone.

"It [the investment] has to pass all the other usual investment criteria as well," says ING technical services manager Andrew Lowe.

SOURCE OF FUNDS

While popular, margin loans are not the only way to borrow money to invest in shares.

AFG Financial Planning adviser Chris Craggs says he rarely recommends margin loans to his clients. Instead, he advises clients to consider using the equity in their home to buy shares - that is, borrowing money against the value of their house.

As well as never having to face a margin call, the major upside, Craggs says, is the cost. A typical margin loan interest rate is 8 per cent, whereas home loans charge less than 7 per cent.

Of course, there is one major danger. If your shares go belly up, you could be exposing your most important asset - the family home.

PUTTING OUT A WARRANT

HERE'S a deal for you. Say I offer to lend you the money to invest in the sharemarket, but say you don't have to pay it back. And I'll throw in a special cap that limits your losses if the market heads south.

Sound too good? In a nutshell, that is the proposition behind instalment warrants, a new and increasingly popular product for gearing up your share portfolio.

Not surprisingly, there is a catch. A few, in fact. But first, the upside.

Instalment warrants are a type of financial instrument that give you exposure to the performance of a particular share.

You pick the borrowing level that suits and, even though you don't pay for all the shares upfront, you get the full benefits, including all the dividends and franking credits.

A put option - a contract that gives you the right to sell out at a predetermined price - is included in the cost of the instalment warrant. It acts as a sort of cap, limiting your losses to the original amount you invest. The cost of the put option also covers the repayments for the amount you borrow, so you never have to pay the loan amount back. Not in a separate payment, anyway.

The downsides? One issue is cost. At a 50 per cent gearing level, you could pay an interest rate of about 8.5 per cent a year, including the cost of the put option. At a 100 per cent gearing level, it can be 10 per cent.

The main concern is the same as with all geared investments: a highly geared portfolio will magnify returns if shares rise, but will also magnify losses if they fall.

A cap limiting losses to what you put in originally sounds reasonable, until you realise it is another way of saying that you could lose the lot.

Another more sophisticated way of leveraging your returns in the sharemarket is via Options or CFDs. Using these instruments doesn't involve borrowing any money, but few investors have taken the time to educate themselves about these strategies.

Shares remain (IMHO :-) the easiest, safest, most profitable investment vehicle available to the general public. It amazes me that so many limit their investment horizon to cash (with very low returns), or property - where prices are difficult to access or even agree on, commissions are large, and selling can take weeks, months... years. While by investing in the sharemarket you can enjoy access to live market data, pay relatively small commissions (brokerage), and buy and sell instantly.

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