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Understanding the pros and cons of investment strategies is a vital component of wealth creation. We examine gearing and its role in an investors portfolio
For investors, gearing can potentially amplify returns on equity investments. By utilising borrowed funds, investors can gain exposure to a larger investment portfolio, allowing them to capitalise on market movements and dividend income more effectively.
However, it’s crucial to understand that gearing, also referred to as leveraged investing or borrowing to invest, also magnifies potential losses, making risk management important.
While gearing in equities is fairly common, margin loans offer versatility and can be utilised for various investment strategies and financial needs:
To illustrate the potential benefits of leveraged investing, consider the following hypothetical case study over a 5-year period:
Chloe and Stuart both have $100,000 to invest in the S&P500 ETF. This passive ETF has returned an average compounded return of 16% pa over the last 10 years. Their strategy is to buy and hold the ETF to receive dividend income and benefit from capital gains.
Chloe invests her $100,000 directly into the ETF. Stuart borrows an additional $100,000 through a margin loan, giving him $200,000 to invest – effectively doubling his investment exposure compared to Chloe.
Over a 5-year period, both investors hold the same investment which returns an average of 16%pa.
At the end of the 5 years, Stuart’s geared $200,000 investment portfolio, after accounting for capital gains/losses, dividends received and interest expenses on the margin loan, has grown to $398,068.33. After paying back the $100,000 loan he will have $298,068.33.
This outperforms Chloe’s ungeared $100,000 portfolio, which grew to $210,034.17.
By gearing his investment with the margin loan, Stuart’s portfolio benefited from increased exposure to price movements and dividends over the longer 5-year timeframe. This resulted in a difference of $88,034.16 between the two strategies.
However, it’s crucial to note that while gearing amplified Stuart’s returns in this example, it also amplifies potential losses.
If for example, over the course of the first year, the equity market had a 10% decline, and both Chloe and Stuart sold, Stuart would realise a bigger loss given leverage also magnifies losses.
A 10% loss for Stuart in the first year would leave him with a $20,000 loss if he closed out his position, compared to Chloe’s $10,000 loss. In addition, Stuart would have to also pay the interest on his margin loan.
Some margin lending facilities include a margin call feature. If gearing levels are not managed carefully, sharp market moves may trigger margin calls. An investor would need to either sell down holdings at an unfavourable price or top up capital or add securities to maintain an adequate loan-to-value (LVR).
Investors seeking leverage without the risk of margin calls, can consider NAB unique Equity builder Read more.
Proper risk management strategies are essential, including maintaining adequate buffer levels to cover potential margin calls, interest expenses, and allowing for market volatility over longer holding periods.
Investors who want to learn more about how a margin loan works can Learn more.
Assumptions used in the example above
Return showing compounded return at 16%pa below
Year | 100,000 | 200,000 |
1 | 116,000 | 232,000 |
2 | 134,560 | 269,120 |
3 | 156,089.6 | 312,179.2 |
4 | 181,063.94 | 362,127.87 |
5 | 210,034.17 | 420,068.33 |
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Information correct as at June 2024.
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