The Impact of Leverage

In earlier articles in this series, we have been discussing the “inputs” that will be required for an Investment Strategy talking about the different ways that money, time and knowledge will be required to plan, implement and manage an Investment Strategy and their impacts on the outcome of that strategy.  In the previous article, we discussed the idea that people will expect a return on their investment, and that their expected return will be influenced by the amount of each of these three “inputs” that they contribute.

Although all Investment Strategies will require some input from the investor, the use of other people’s time, money and knowledge in the planning, implementation and management of the strategy can have a dramatic impact on the outcome an investor receives in return for their own contribution.

Looking firstly at the use of other people’s money, the most common approach is to borrow money from a bank or other financial institution and use it to help fund the purchase of the desired investment asset.  When lending money, the bank will typically lend more money, and at a better interest rate, if they are able to use the investment asset as security for the borrowed funds.  When borrowing money to buy shares, this is usually referred to as a Margin Loan; when borrowing to buy property, it will generally be referred to as a Mortgage.

To see how this affects the return on the money that an investor contributes to their Investment Strategy, consider an investor with $100,000 to invest.  When investing in shares, either directly or using a Managed Fund, it is usually possible to borrow an amount up to 50% of the value of the share portfolio.  So the investor could purchase a share portfolio worth $200,000 using their own $100,000 and $100,000 borrowed using the share portfolio as security.

If the value of the share portfolio rises by 10% from $200,000 to $220,000, the amount of borrowed money remains unchanged, so the investor’s equity has risen from $100,000 to $120,000  –  a return of 20% on their initial investment.  The investor has been able to multiply their return by using borrowed funds. This is often referred to as leverage or gearing.

However, this effect works in both directions.  If the value of the portfolio falls by 10% from $200,000 to $180,000, the investor’s equity has fallen from $100,000 to $80,000  –  a loss of 20% of their initial investment.  So the multiplier effect works in both directions.  Also, in the case of a Margin Loan, the lender will usually require that the Loan amount be kept below a certain percentage of the value of the security, and the investor may receive a Margin Call, requiring them to either contribute additional funds or sell part of the portfolio to reduce the loan amount as a percentage of the portfolio value.

If the same investor were to invest in residential property, a bank will typically lend up to 80% of the value of the property in the form of a mortgage, meaning that the investor could use their own $100,000 together with $400,000 of borrowed funds to buy a $500,000 property.

If the value of the property rises by 10% from $500,000 to $550,000 and the amount of the mortgage remains unchanged at $400,000, the investor’s equity has risen from $100,000 to $150,000  –  a return of 50% on their initial investment.  The multiplier effect has been increased because the amount of the loan represents a higher percentage of the value of the asset.  This percentage is often referred to as the Loan to Valuation Ratio or LVR.

These simple examples are only intended to illustrate the impact of using other people’s money to help fund an investment and therefore don’t show the complete picture.  For example, they ignore the costs of borrowing the money, which will usually involve some form of up-front cost, and an ongoing cost in the form of Interest payable on the amount borrowed.  They also don’t take into account any up-front or ongoing costs associated with owning the investment asset.

However, the examples do clearly identify the potential for higher investment returns when using other people’s money to increase the amount of money available to fund an investment strategy.  Empower Wealth’s Personal Wealth Management Program (Property Portfolio Plan) includes sophisticated tools to allow you to see the effect of investment strategy decisions by modelling the effect of all the factors which influence the long term financial outcome of an investment, to give you the numbers you need to make an informed decision about your financial future.

If you would be interested in seeing how these tools and techniques could be applied to your own personal financial situation, please come and see us for a free one hour consultation.’