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Sunday, 4 June 2017 | MYT 8:02 AM

Five golden rules for investing borrowed money

Unfortunately, many investors use leverage to make a single big bet on a stock.

Unfortunately, many investors use leverage to make a single big bet on a stock.

SIMPLY defined, leveraged investing means borrowing capital for an investment and expecting the profits to be magnified. 

Borrowing to invest, also known as leveraging, is more common than you think. We seldom think of property purchases as leveraged investments, but that is in fact what it is. 

Property investors borrow money (home loan) to invest in an asset they would not otherwise be able to afford (a home), expecting investment returns in the future (property value increase). 

Other than property investments, you can also use it to invest in Amanah Saham Bumiputera (ASB) through ASB Financing, as well as options and futures.

Although the idea of amplifying your returns sounds like a great idea, it should be used sparingly, until you understand how it works and the risks involved. 

 It’s a fact that any investments come with risks. The basic logic is that the bigger the potential returns, the bigger the risk. 

Leveraged investing can be a double-edged sword. If you get it right, you can potentially make a lot of money. 

However, if your investment goes south, you would still have to continue servicing your “leverage” even when your investment value is lost. 

This is why it is important for any investors to follow these five golden rules when they are considering leveraged investing:

1) It must match your risk tolerance

When it comes to investments, one should always weigh the potential rewards with the risks. It is important to ask yourself, what your risk appetite and tolerance is.

Risk appetite is the amount and type of risk you are willing to take to meet your investment objectives, while risk tolerance is about what you can actually cope with. 

This is applicable even when you are not using leveraged investing because your investment portfolio should always reflect your risk appetite and tolerance. 

However, when it comes to leveraging, you need to ask yourself; how much investment debt do you feel comfortable having and assess the best and worst case scenarios before deciding to leverage. 

If you have a low risk appetite and tolerance, it doesn’t mean that you should never use leveraged investments. It just means that you need to understand how it works and learn how to mitigate the risks by investing in a diversified portfolio. 

2) The cost of borrowing must be lower than the return on your investment

When leveraging, the loan interest rates must be low so debt servicing will not eat into your returns. It sounds like common sense but most investors have unrealistic expectations on the potential investment returns.  

The returns on a leveraged investment is all about the spread between the interest you’re paying and the return on your equity investment.

For example, if you invest RM10,000 and borrow RM30,000, making your investment RM40,000, here’s how much difference it would make to your investment in a year if the return is 10% per annum. 

 

 

Interest rate of 5.55%

Interest rate of 7.00%

Annual interest: RM30,000 x 5.55% = RM1,665

Investment return: RM40,000 x 10% = RM4,000

Total return: RM4,000 – RM1,665 = RM2,335

Annual interest: RM30,000 x 7.00% = RM2,100

Investment return: RM40,000 x 10% = RM4,000

Total return: RM4,000 – RM2,100 = RM1,900

The effective returns after leverage (%)

RM2,335 / RM40,000 = 5.84%

The effective returns after leverage (%)

RM1,900 / RM40,000 = 4.75%

 

A mere 1.45% difference in interest rate translates into RM435 difference in returns. The lower you can keep your interest rate, the more net returns you will see. 

The current IBR is 3.0%, making the financing rate 5.50% per annum. This is lower than most personal loans with interest rates between 6.00% and 11.00% per annum. 

Other ways of leveraging is using the home-equity line of credit to invest, which is about 6.88% per annum. The good thing about using home-equity line of credit is the flexibility in repayment. However, if you are unable to pay your loan or overdraft, you could lose the investment and the roof over your head.


3) It is not gambling

You received a hot tip on a stock, and you’re convinced it will move upwards in a short amount of time. However, you have a very low investment capital so you’ve decided to borrow more from your friends and family to invest in this stock that is “guaranteed” to skyrocket (according to your hot tip anyway). 

Sounds like a disaster waiting to happen? Unfortunately, many investors use leverage to make a single big bet on a stock. Needless to say, that it is very risky and you could end up getting burned in the process. A more conservative approach is to always have a diversified portfolio. 

Leveraging also works best with a longer-term horizon, such as a 10-year horizon in mind. The worst thing to do when you are using leveraged investing is to pull the plug at an inopportune time. This is why your risk tolerance is very important when you are leveraging because seeing the long-term investment through can be challenging.

4) Consider other debts as well

Before you decide to leverage, take a look at your overall debt. Many would advise that only high net worth investors should bother with leveraged investing, because they can afford it. 

The reason for this common advice is because most investors who are not high net worth are already overburdened with debts – from a car loan to a home loan. This makes it very difficult for them to afford another repayment every month. 

If you are considering leveraging in your investment, you must make sure you have a stable source of cash flow to make your monthly loan payments. Never rely on your leveraged investments to help you repay your loan. 

You will not be able to do so if your investments have dropped in value, or your returns are just not enough to pay off the debt entirely. 

The trick is to not borrow too much that the repayment will affect your cash flow. One rule of thumb is to only borrow half of what you can afford, and also save up a sizeable emergency fund to cover your repayment for a year. 

5) Borrow to invest when the market is down, and pull back as it gains strength

Unfortunately, most investors do not do this. They would leverage when the market is gaining strength. 

For example, if you have RM10,000 to invest when the market is down, the share price can be as low as RM4.19. This means you will be able to purchase about 2,000 units. However, if the market gains strength, and the price goes up to RM5.99, you will only be able to purchase about 1,600 units with the same amount of investment. 

By buying when the market is down, you will be able to purchase more units, which could translate to higher potential returns, if the share price goes up. However, investors should be careful in selecting the stocks to invest in, because purchasing units at a lower price would mean nothing if the stocks are not worth investing in, in the first place. 

Many investors, even those who are experienced, tend to make emotional investment decisions rather than logical and strategic ones. Leveraged investing should be treated with caution. However, you should not complete write off leveraging as a strategy or method of investing.

If you’ve been told to never leverage in your investment, remember it’s not the method that is dangerous but the lack of understanding that is. Just like any investment method or product, you should always study and understand how it works before deciding if it’s suitable for your risk appetite and tolerance. 

For more information, please visit https://www.imoney.my/ 

 

Tags / Keywords: Stocks , Banking , Personal Finance

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