# Leverage for Wealth Part 1



## dennisll (24 May 2006)

Why is it that most people would happily borrow 90% to 105% of the value of a home for purchase and yet cringe when presented with the idea of borrowing money to purchase shares?  I know a guy who borrowed $400K for his home, but would not even touch a $20K Margin Loan.  Is there a disconnect here?  Are shares that scary?  Is property that secure?

*Why use leverage?*
Leverage allows you to gain more from your investment using other people's money.  If the market you wish to buy into has returned 15% per annum on average, think about where you will be if you invested $30,000 cash versus $100,000 cash (after borrowing 70k to add to your 30k).

$30,000 investment after 10 years = approx $122,000
net profit = $92,000 or 300%

$100,000 investment after 10 years = approx $405,000
net profit = $260,000 - $70,000 = $190,000 or 1,350%

*interest charges and dividends not considered

I think the example speaks volumes and needs no further explanation.
*
Why don't most people use leverage for investment in shares?  *
I think some of the reasons are:
1. Fear of a Margin Call
2. Perception that shares are not as stable an investment as property

_Fear of a Margin Call_
It is well documented that if your loan to valuation ratio (LVR) goes above a predetermined limit, you will get a margin call and be asked to either sell some shares or add more cash to your account to reduce your LVR to acceptable levels.  Perhaps most people feel that they will get a call at the worst possible moment, where either they do not have any spare cash or when shares are cheap and they do not want to be forced to sell.

How to get over it?  As with most things, a better understanding of how margin loans work will quell most fears.  A simple tactic is to stick with high LVR stocks and maintain your LVR at a safe distance from the margin call trigger level.  Say you buy CBA shares with max allowable LVR of 70%.  To reduce the risk of a margin call, keep your LVR to say 50%.

_Perception that shares are not as stable an investment as property_
I've heard a lot of cliches that reinforce this perception.  "Stocks can go to zero, but not property" is the best example in my opinion.  Although true on the surface, one can argue that not all shares are equal.  Despite notable exceptions, there are businesses that have endured the test of time and will continue to do so.  These are the BHPs and the WOWs.  Thus, a reasonable strategy would be to stick to companies that have a track record that will lead to the conclusion that they will continue to grow and be around for a long time.  

From above, I think it is clear that just like everything else related to investing, it is all about managing risk.  
*
Risk Management Strategies*
Already some strategies have been discussed above, however another way to answer this question would be to think about how property investors manage their risk.  Most sensible property investors take out insurance (ie building, landlord's, etc).  Most people would consider property investors who do not take out some form of insurance to be playing russian roullete.  Ask yourself this question: If you were to buy a property, would you take out insurance?  If the answer is yes, why not with stocks?

Share investors too can take out insurance.  Probably the best insurance there is is the Stop Loss.  Stop losses, if set correctly, should protect you and get you out of the market way before there is even a threat of a margin call as you will be progressively selling down your portfolio as each stop gets hit.  However, in the event of a catastrophe (ie Oct '87 scenario) and the values of your shares gap down and miss your predetermined stop levels, your margin call is effectively your ultimate stop loss.  If prices fall too quickly and you are unable to execute your stops and you get a margin call, your broker will simply keep selling your shares for you, just as you would have done anyway with your own stops.  At the end of the day you would have lost much more than if you had sold at your stops, but the margin call has still preserved some of your capital, which is what a stop loss is meant to do.  I think it is this point that is not too well-accepted, but understanding this, I believe, pretty much eliminates the fear of a margin call.

In summary, when everything is considered I think that an investor is doing himself a great disservice if he does not use the power of leverage.  The potential benefits tremendously outweigh the potential losses.  As mentioned before it all comes down to education.  Instead of fearing leverage, one can strive to understand how to use it.

I hope I didn't bore you too much with this long post.  Thought I'd make this Part 1 and talk about strategies using leverage in Part 2.  Thanks for reading and appreciate your comments.

Cheers,

Dennis


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## tech/a (24 May 2006)

*Nice piece Dennis well written.*

A worthy and important topic for discussion.
I posted this elsewhere. 




> PEOPLE AREN'T TAUGHT HOW TO TRADE WITH LEVERAGE
> 
> Two things I would like to offer up.
> 
> ...


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