The Pitfalls of Borrowing Money to Buy Shares

The Pitfalls of Borrowing Money to Buy Shares.

Over the past few weeks the volatility and downward trend of the share market has caused traders and investors alike to lose very large amounts of money not to mention sleep.

For those traders who were prepared for such an eventuality, they lost very little of either. They would have lost around 5-10% whilst the average trader lost in the vicinity of around 20% if not more.

The average investor was drawn to the last "Bull Run" like moths to a flame. Having unrealistic expectations of easy money plus they are also being influenced by the media hype which is prevalent in a high flying share market.

The "Flavour of the Month" for quite a while has been Margin Loans. They are easy to set up. The paperwork is minimal as is the setting up costs. So you can be up and running in less than a .fortnight.

The average amount borrowed is usually around the $100.000 mark for which the potential trader has to put forward a fifth. In this case $20,000.But you can buy up to the full amount of the loan i.e. $100, 000 worth of stock. This is called leverage.

Now leveraging is a two edged sword, you can make good profits but you can have big losses as well.

The average investor who decides on a margin loan as a "Sure Fire" guaranteed quick way to make money invariably has neither the experience nor the knowledge necessary to cope with a sudden downturn in the stock market when it occurs.

Using the latest downturn in the markets as an example where share prices dropped downwards drastically in the region of at least 20%.Investors who had margin loans of around $100,000 suddenly had a paper loss of $20,000

When this occurred they were placed in the dilemma of either putting in more money (This is called a Margin Call.) or to buy more shares. In a lot of cases being borrowed to the hilt they were unable to do neither.

So their stock had to be sold at a loss which only exacerbates the problem as other traders are in the same boat having to sell their stock also. With a flood of shares hitting the markets all at once this forces share prices down even further. Causing more panic selling.

In some extreme cases investors were left with no share portfolio at all and still owed money on their margin loans. Not a nice position to be in.

So what precautions can the investor or trader employ to make sure that in the case of a downturn in the market, losses can be kept to a minimum?

The first thing to remember that the only security you have is the shares themselves. You have to maintain a margin between the amount you borrowed and the current value of the shares
This is called your" Loan to Valuation Rate" or LVR

If the market falls below your LVR you then have the choice of putting more money in or buying more shares. To bring up your LVR back again. Of course if you cannot do either then your lender will force you to sell all or part of share portfolio.

Having a diversified portfolio which covers several areas is a good idea as it is invariably one area that is hit the worst.

I personally know several traders who had only BHP/RIO in their portfolio who suffered disastrous consequences for not diversifying.

Another option is to start off with a conservative LVR in place.

A worthwhile valuable idea is to have an unused "Line of Credit" option in position. This will give you cash quickly if the need ever arises.

Lastly is of course to have "Stop Losses" (Conditional Orders.) in place to so that you can minimise any losses to 5-10% depending on the percentage you choose. This also has the effect of locking in any profits that you may have made prior to the market downturn.

Also remember the lender also charges interest on average in the 10% area per annum. That plus brokerage has to be taken into consideration as well as capital gains tax. All of which eats into your profit margin.

So if you decide that a Margin Call is the way to go then make sure you are aware of the pitfalls that can trap the unwary investor.
Good trading!