Your Money & You – May 2011

Margin Loans

As ADF members you know a lot about managing risk. When you embark on any new endeavour, it's good to know the risks involved so you can assess the situation and make an informed tactical decision.

Borrowing money to invest, also known as gearing, is a risky business. One of the most common ways of borrowing to invest is through a margin loan. ASIC has developed an online margin loan calculator at www.moneysmart.gov.au to help you assess the risks for yourself.

The highs and lows of margin loans
A margin loan lets you borrow money to invest and uses your shares or managed funds as security.

If your investments are successful, it can multiply your gains — but if they are not, it can multiply your losses, and leave you with a loan to repay.

Margin loans are for dedicated investors who actively monitor and manage their investments. Many people have suffered financial ruin when margin loans have gone sour. If you don’t fully understand how margin loans work and the risks involved, don't take out a margin loan.

How margin loans work
When you borrow money to buy shares, the lender takes as security the shares you buy with the loan. This means the lender can sell the shares to repay the loan.

Because share prices move frequently, you are exposed to the risk that the shares might fall in value. To gauge the risk of your loan, lenders use a Loan to Value Ratio (LVR). The LVR is the amount of your loan divided by the total value of your shares. Most lenders require you to keep the LVR below a maximum of 70%.

If the value of your investments falls to a point where your loan exceeds the maximum LVR, you will be required to top up your investment or repay some of the loan. This is known as a ‘margin call’.

In order to meet a margin call and bring the LVR back to an acceptable level, you will have to do one of these things:

• Find extra cash to pay the lender
• Sell part of your investment to raise cash
• Give the lender additional security (e.g. security over other shares)

The risks of margin loans
You may:

• Face huge losses if the market falls
• Be forced to sell part of your investment at a low price to meet a margin call
• Get an unexpected margin call if your lender decides to lower the maximum LVR for one of your investments

In extreme circumstances you could also:

• Owe more than your original investment was worth
• Lose your home if you borrow against it for the investment
• Be forced to pay off your loan at short notice if your lender decides the investment is no longer suitable as security

Nick's fortune dives
Nick took out a margin loan to invest in shares when the market was up and earned himself some decent money. But when the market turned sour his lender started making margin calls almost every day.
Nick did not have any money to pay his lender – all his cash was tied up in his investments. He had put up his apartment as security for the loan and was in danger of losing it if he did not make a substantial repayment to his lender. To avoid this, Nick was forced to sell most of his investments at low prices. The sale prices were so low that he was still left with a substantial debt, which continues to grow.

Managing the risks with margin loans
The first rule of margin loans is you should borrow conservatively. This means you should borrow much less than the maximum amount the lender offers you and never mortgage your home to invest in a margin loan. As a starting point, consider borrowing less than half of what the lender will give you.

You should also diversify your investment. Choose a diversified managed fund or a diversified portfolio of shares. You should spread your investments in different industries and/or markets.

Paying the interest on your loan keeps your debt under control. Most margin loans do not force you to make regular repayments; the interest can just be added to the loan (known as ‘interest capitalisation’). Making regular repayments can prevent your debt from increasing each month.

You should check your loan account regularly because the value of your investment can change very quickly. As your investment is used to secure the loan, you should ensure that you can sell the investment and repay the loan, if market circumstances change.

Have cash or security ready for margin calls. If your lender makes a margin call, you will have to respond very quickly, usually within 24 hours or less. The responsibility falls on you to increase the assets securing the loan or reduce the loan by the time set out in your margin loan agreement.

Shop around for the best loan. Margin loan interest rates and features vary so shop around for a lender that best suits you.

Make smart choices about money
Visit ASIC’s consumer and investor website, www.moneysmart.gov.au call 1300 300 630.

E-mail ASIC with topics that interest you at ADFcolumn@asic.gov.au.

Tony D'Aloisio BA LLB (Hons)
Chairman
Australian Securities and Investments Commission

Risk and Investments

All investments involve risk.  The risk of investing is different between asset and through time.

The higher the level of risk on an asset the higher the prospective return has to be in order to encourage investors to hold that asset.  Put simply, investors who want a higher return have to take on higher risk.

However risk means different things to different people.

To most investors risk is the danger they will seriously underachieve their investment goals.  They might consider:

• market risk (investments fall in value or provide less return than they expect)
• cyclical risk (assets are purchased at the top of the cycle)
• performance risk (their asset choice performs poorly compared to other similar assets)
• illiquidity risk (assets can’t be sold when needed)
• inflation risk
• legislative risk (for example, changes in taxation)
• the risk of fraud

Professional investors however tend to look at investment risk very differently.  Risk is seen as a measure of how variable returns were from year to year during an investment period.  This type of risk is represented by the standard deviation of past returns on that investment.  The higher the standard deviation the more volatile the return.

This measure of risk is often graphed with the average return over the same investment period.  These graphs are designed to give investors a feel for the likely return on an investment and how volatile that return will be from one year to the next.
There are shortcomings in this approach.  There are times when the past record of returns and their volatility is not a good guide to the future.  These graphs assume that risk is evenly balanced on the upside and downside.  That is, there is an equal chance of investments performing above or below their long-term average.

Free Seminars anywhere in Australia

In addition to its commitment to financial education programs in ADF training curriculums, the Consumer Council is happy to provide expert speakers free of charge on a range of financial topics to any ADF unit in Australia.

For more information contact us via our website at www.adfconsumer.gov.au. (www.adfconsumer.gov.au).