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Strategy
No. 10:
Borrowing to Buy
One strategy that some
investors find valuable is that of borrowing to buy
shares.
When interest rates are
low, investors can expect a far better return from the
share market than from banks.
The margin between the
two investments is often wide enough for you to consider
borrowing funds to buy shares. In effect, you're using
someone else's money to invest, and using part of your
profit to repay the interest.
For example, if you had
$25,000 to invest in the share market and if your
investment was successful you would get the benefit of
the dividends and the capital growth in the share value
of $25,000 worth of shares. Alternatively you could buy
$100,000 worth of shares by using the same $25,000 as a
deposit and using the shares you just bought as
collateral or security to borrow the balance of $75,000.
Many banks and
stockbrokers will lend you the funds to do this. Now you
would be able to reap the rewards of the dividends from
$100,000 worth of shares as well as the capital gains of
a portfolio initially worth $100,000. And you would have
still outlaid the same $25,000. This process of
leveraging your investment is called gearing and in this
case it could multiply your profits four fold.
Many investors have done
well out of gearing their share portfolio, and when the
market rises they have achieved results much higher than
they could have without gearing. But the risk is also
magnified. If the share market slumped and on average
prices fell by 25%, an investor who started with a
portfolio worth $25,000 would now have shares worth
$19,500. On the other hand, an investor with a portfolio
worth $100,000 has had the value of the shares cut back
to $75,000.
This means that the
value of the initial deposit has been lost and that the
bank or broker would ask for their loan to be repaid, as
there is no longer sufficient security. After selling
the shares, the investor has enough money to pay off the
lender but is left without any of the capital.
Furthermore, brokers fees and stamp duty would have to
be paid.
Negative gearing works
best when you have invested in shares that have a high
rate of growth over the medium term, and have a
relatively low risk of large or prolonged slumps in
prices. Also, if you are considering negative gearing,
ensure that you have income available from other sources
so that if the shares do not perform as expected, or if
the dividend income is lower than expected, you are able
to cover the difference between your investment income
and the interest bill. You also need to have the funds
to cover margin calls which occur when the bank or
broker asks you to ‘top up’ your account to provide
the security needed because the market value of your
shares has fallen.
Because negative gearing
allows losses on share investments to be offset against
tax payable on other income, the main beneficiaries are
high-income earners. Negative gearing is a high-risk
investment and there is a risk of losing all your
capital - and more! Yet for the right investor, who
selects the appropriate stock, the possible benefits may
well be worth the risk.
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