Wednesday, October 15, 2008

Gearing – Using debt wisely (written by Daniel Kertcher)

Now, we know that as soon as we start talking about borrowing money to invest on the stock market, many people run for the hills. Some find it daunting enough just to invest their own money on shares, let alone borrow money for shares.

Most people fear debt because parents and other well meaning family members tell us to pay cash for everything. While there is an element of truth in this, it should not be taken as a blanket statement that all debt is bad. Debt for consumables can destroy wealth – debt for growing assets can build wealth.

Please bear in mind; you should never do anything in the stock market if it makes you nervous or uncomfortable. We will simply outline the concept of gearing, or borrowing, here. For more detailed information, please consult a professional accountant or financial adviser.

Borrowing for shares can be an excellent strategy to improve your returns. By borrowing, we are leveraging the power our money has in the markets. For example, if I have $1.00 in the market and make a 10% return, I will make ten cents profit. If I borrowed an additional $1.00, I would have $2.00 in the market. A 10% return now makes me a 20 cent profit, or 20% on my original $1.00. This is the power of leveraging, or gearing.

At the same time, however, I have increased my potential risk of loss. If I lost 5%, then I would have ten cents, or 10% of my original capital. Fortunately, I would have to lose more than 50% before I lost all my money. By using a 5% stop loss, I can limit my potential loss. Risk Management and stop-losses obviously become very important if you ever choose to borrow money for the stock market. Gearing is an advanced strategy and should only be used by experienced and successful traders who have sought proper advice from professional financial planners and/ or accountants.

To further consider gearing and the power it has, let’s consider two people who can each spare $4,000 a year. Fred Needy can’t wait to get behind the wheel of brand new $20,000 sports car that is going to cost him $4,000 a year over 10 years. Richie Rich decides that with his $4,000 a year, he can borrow another $4,000 and buy some shares. How can he borrow $4,000? Most banks will lend 50% on the value of shares. Therefore, Richie can buy $8,000 worth of shares with his $4,000 cash. Let’s look at the two situations.

Fred Needy got a great deal from his local bank and borrowed the entire $20,000, with a principal and interest loan at 14% reducing interest. At $4,000 a year for 10 years, he will clear the loan and own the car outright. However, in the first year, the $4,000 is made up of $3,000 interest and $1,000 principal. Richie Rich borrows $4,000 from the bank at 7.5% interest only.

His repayment is $300 for the first year, which is tax deductible. Richie receives a tax refund of $141 as he is on the highest marginal tax rate. So Richie only has to pay $159 interest in his first year. Each year, Richie has another $4,000 to invest. He must first pay the interest and can then borrow an equivalent amount of the remainder from the bank to buy some more shares.

After 10 years, at 11% depreciation per year, Fred’s car would be worth $6,236. Although he doesn’t owe anything on the loan at the end of the term, if he had sold the car at any time up to the seventh year, he would have been going backwards – for most of the time, he owed more than the car was worth.

However, at 11% capital growth (appreciation) per year compound, Richie’s shares would be worth $128,848. However, as he has been borrowing more every year he now owes $36,219, leaving Richie’s total equity at close to $98,000! If Richie ever wanted to stop borrowing and pay back the bank, he could simply sell some of his shares immediately and pay the bank back within a couple of days. (But why would he? The interest bill Richie was paying by the tenth year, after his tax refund, was only $1,333 a year. The dividends on his shares would pay most if not all of that).

Let’s go one step further. After 10 years, Fred Needy is left with an almost worthless car. To buy another car, he would need to borrow $40,000, because by then, that’s what a new car would cost with inflation.

On the other hand, Richie Rich, if he wants to, can sell some of his shares and pay cash for a brand new car. He’d also have enough to buy one for his wife, one for his son and to go on a holiday!

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