Stock Market Guide to Using Leveraged Equities to Double
Here's a simple way to learn to invest in
stocks using leverage - an essential part of your
stock market education.
Let's say we have $10,000 to invest
in the share market. And let's say that we can achieve returns
of 10% per annum on that money with our investment
That means after one year we can expect to
have earned an extra $1,000.
But suppose we were to borrow an additional
$10,000 to add to our own money, and invest the whole
$20,000 in the market using the same strategy.
After one year we can now expect to have earned
Ignoring borrowing costs, we have now effectively
make $2,000 for the year from our $10,000, doubling our return
from 10% to 20% per annum.
Using a small amount of money in this way
to get a large return is referred to as leverage
and the simplest (but not the only) form of leverage is to
borrow money to invest.
By borrowing as much, or more, than you put
up yourself, and investing the whole lot, you can effectively
double your returns
There's a special type of loan designed specifically
for investing in the share market in this way, known as a
margin loan . These are interest-only
loans secured by shares and they have become increasingly
popular in recent years.
You supply only a portion of the money required
to purchase the shares, borrowing the rest, but you still
get the full benefits of dividends and tax credits
applicable to the entire portfolio.
What about borrowing costs?
Interest rates on margin loans are typically
8-9% on the portion of the money you've borrowed, but for
individuals these costs should be tax deductible. Note also
that most margin lenders will require a minimum deposit on
the order of $5,000.
How Much Can I Borrow?
The amount you can borrow compared to the total
amount invested, is called the loan-to-value
ratio, or LVR. The higher the LVR, the higher
your leverage. The maximum LVR the lender will allow
depends on the shares you're investing in, but is usually
in the range of 40 - 80%.
For blue chip shares, the lender will
typically allow you to borrow more than twice your deposit
but I would recommend keeping the ratio at 1:1 (LVR
of 50%) to give you some buffer in case of a margin call.
What's a Margin Call?
Your lender will require you to keep your LVR
below the maximum, let's say 70%.
Now, of course, leverage is a double-edged sword.
It can magnify losses as well as gains.
Let's say the value of your portfolio falls.
That would mean that the loan-to-value ratio the amount
you owe as a percentage of the value of the portfolio
has increased. If the LVR then exceeds the maximum,
your lender will demand that you pay back some of
your borrowings to keep your level of gearing (or margin)
to no more than 70%.
To pay back this cash you may be forced to sell
some of the existing shares in your portfolio (which means
selling the shares after they have just fallen in
value and that is, of course, the worst time
Alternatively, instead in reducing the L,
you can increase the V. In other words, rather
than reducing the amount on loan, you may be able to buy
more shares to top up the value of your portfolio
so that the LVR is less than 70%. But again, this requires
you to have the ready cash on hand.
If you borrow only half of the total
value of your portfolio, as I recommend, the value of your
leveraged equities portfolio would have to fall by
nearly 30% before you would be subjected to the dreaded