When investing in property, it’s largely a given that you will be borrowing as a core element of the transaction. Indeed often you are borrowing the entire purchase costs.
Borrowing to buy shares however, is often approached with trepidation, despite the many advantages shares offer around ease of altering the transaction size, diversification, and speed with which investments can be liquidated.
In this post we’ll take a look at the pro’s, and the con’s, of borrowing – gearing – to invest in shares. Is now the time for a big move?
Before we dive in, it is important to remind you that this is general information. The appropriateness of gearing for you depends on a range of factors such as income security, savings capacity, debt levels, and investment time frame. Seek out professional advice before commencing a gearing strategy. Visit the advice page on the Financial Autonomy web site to see how we can help.
Also, if you’re fairly new to Financial Autonomy you may not be aware of our Invest in Shares with Confidence online course. This self-paced course is suitable for novice investors through to those with an intermediate level of experience. We take you through all the key concepts like dividend yield, PE ratios, investment selection, taxation considerations and plenty more. One of the bonus modules is specifically on gearing, so if this topic is something that resonates with you, and you’re a DIY type, visit financialautonomy.com.au/shares to find out all the details on that.
It’s tempting to jump straight into all the reasons why gearing into shares might make sense right now, but instead let’s commence our journey with a sense of caution and consider the con’s. What are the arguments or reasons against borrowing to buy shares?
All the negatives fall under the blanket of risk.
Firstly, gearing magnifies risk. Indeed that’s why the word “gear” is used – gears in a machine enable a small rotation at one end to effect a large rotation further down the line. The same occurs when we gear into shares. Let’s look at an example. I know numerical examples aren’t great in a podcast, so I’ll keep it really simple.
Scenario 1 – you have $50,000 to invest, you place it in the stockmarket, it earns 8% per year, and at the end of 10 years it’s worth almost $108,000. Nice. You’ve done a little better than doubling your money.
Scenario 2 – you have $50,000 to invest, you match that with $50,000 of borrowings and invest the total $100,000 into shares over the same period and with the same return. Let’s assume you pay 4% interest on your borrowed money.
10 years later, your $100,000 is worth almost $216,000. You of course need to pay back the $50,000 that you borrowed, and the interest. Once you do this you are left with just under $142,000.
Under scenario 1, your $50,000 grew in value by $58,000 – sweet.
Under scenario 2, your $50,000 grew in value by $92,000. That’s a pretty big difference.
Now of course this example is simplified, especially with respect to taxes. But you see the basic point. For an identical initial investment, gearing magnified your outcome.
The risk then is that in a losing investment, gearing also magnifies the outcome.
What about if instead of experiencing returns of 8% per year on your portfolio, you only got 2% per year.
Under scenario 1, the ungeared option, your $50,000 grows to almost $61,000.
But under scenario 2 – where you had borrowed money at 4%, your original $50,000 would actually become only $47,887 – less than what you started with!
Gearing magnifies outcomes – both positive and negative.
This loss scenario is especially likely where your time frame is shortened. A poor outcome over a 10 year investment is possible but not terribly likely. However if your investment term is 2 or 3 years, it really just comes down to luck as to whether you come out in front or behind.
It’s also worth noting that in the scenario I presented, we’ve assumed a pretty conservative gearing ratio – 50%. That is to say the $100,000 investment is 50% your money and 50% borrowed money. This is the ratio we typically recommend to clients in my financial planning business.
As mentioned at the start though, in a property investment scenario people often borrow 100% of the value of the investment, and with shares it is certainly possible to be more aggressive too. But again, gearing magnifies outcomes, and the higher your gearing rate, the stronger that magnification. If things go well, happy days, but if you get poor investment returns, highly geared portfolio’s will feel it all the more. Remember, no mater what happens on the share market, you still have to pay the bank back.
Beyond the inherent risk in borrowing to invest, another argument against a geared investment strategy right now is uncertainty in the world due to COVID. There is always some degree of uncertainty, but right now we really don’t know what the full economic impact will be. As shown in the earlier examples, low returns from your share investments really hurts a geared portfolio, so this is a valid concern.
The best insurance against poor investment returns is to have a long time frame, as we know from past experience that markets have poor returns from time to time, but if given long enough, there are more positive outcomes than negative ones.
An important consideration then for someone considering commencing a geared strategy is their degree of certainty that they can stick to it for the duration – say 10 years. If you’re a paramedic for instance, you probably have very high job security and therefore certainty of income. But if you’re a self-employed brickie, then in a housing downturn maybe income dries up for a period, forcing you to sell up your investments earlier than expected, increasing your chances of a poor result.
Okay, well there’s a summary of the potential negatives, If you’re still with me, let’s now consider the arguments for gearing into shares right now.
Number one is the same argument as above in my example of the 2 scenarios – gearing magnifies outcomes. We know that over a suitable time period, usually 7 to 10 years and certainly more than 5 years, share investments will likely grow. There is some underlying logic to this that I have explored in past episodes. Most companies on the stockmarket will make a profit. They’ll pay some of the profit out as dividends. But they’ll also retain some for future investment. (At the extreme end, Apple has over USD200billion in retained earnings sitting in the bank right now). These retained earnings enable companies to research new ideas, launch new marketing campaigns, or buyout a competitor. By doing that, earnings rise, and with them share prices.
Bottom line, shares don’t rise in price just to be nice to us investors. They rise for completely logical reasons.
Given this logical expectation of rising share prices, it stands to reason that the greater your exposure, the greater your profits. And how to increase your exposure to stocks – well you borrow of course!
The next reason gearing into shares can make sense is the ease with which you can diversify. Diversification reduces risk – it’s the classic wisdom of not having all your eggs in one basket.
You could buy individual stocks across different industries – for example a banking stock, a healthcare stock, a miner, and a software business. This will improve your portfolio’s resiliency to a bad event impacting one of the companies or even several.
Most people however (certainly those we work with), will take diversification up a notch by using funds – either ETF’s or managed funds – to greatly increase their level of diversification. Via a fund you gain access to hundreds, sometimes thousands of different companies. You can also far more easily get exposure to different geographic regions and industry sectors, again improving the resiliency of your portfolio.
When you compare the degree of diversification possible via a share portfolio, with that possible for property, the differences are extreme. It really is quite puzzling why borrowing for property is rarely if ever questioned, yet borrowing to invest in shares sometimes gets presented as a high risk strategy.
The final reason now might be the time to gear into shares is that money is cheap. Interest rates have never been lower, and whilst none of us know what the future will bring, indications from central bankers are that rates are likely to remain low for an extended period. The lower your borrowing costs, the less return you need from your investments for the whole exercise to be worthwhile. Low borrowing costs make the hurdle we need to jump over to achieve success lower.
Low interest rates will also encourage savers to shift their money out of bank deposits, where returns are less than the rate of inflation, and into growth investments such as shares. Logic would dictate higher demand for a finite number of shares will drive prices up.
Resources:Back to All News