Given the Australian average for margin loans is around 40% LVR (according to what I've read in the media), we are generally quite conservatively geared when it comes to shares and managed funds.

Why ? Because they are more volatile investments than property ?

Or are they ?

It may well be that shares and funds only SEEM like they are more volatile because they are readily traded, and there is daily information (instant for shares) available on the current market value. This wealth of information can cause emotional reactions, which can lead to irrational decisions about the best course of action.

Selling your shares or funds because they are going down is not necessarily the best step, even taking into account stop losses and a minimal-loss strategy. It all depends on your goals, and if you are a conservative long term investor, then it could be argued that selling your shares just because they are having a bad month - may well be the worst decision you could make.

What about property ? We get regular updates in the media that "property has dropped/rised by X% this month/quarter/year" ... but that doesn't tell us what OUR property is worth today, this very instant.

The real, tangible value of an asset is determined by what the market is prepared to pay right now for it. If I can't sell my shares for $5.20 because nobody is willing to pay that price - then they are not worth $5.20 !!!

It's no different with real estate. If nobody is willing to buy my property for $295,000 - it's not worth that !!!

So why don't we get all worried about our real estate portfolio if you can't find someone to buy your property right now for the price you want ? Because we generally don't care about the price right now - we are holding long term, and we'll be happy to wait a month or two to sell the house to get the price we want.

So why don't we take the same approach with shares ? Why are we not allowed to wait a month or two to get the price we want ?

Is real estate really more secure ? How come I can get a 95% loan on a house when we don't really know what it's worth because there is no instant market update ? How come I can't borrow as much on a share portfolio which we DO know the exact value of day-to-day ?

My suggestion is that it's all just a matter of perception.

Why are people happy to borrow 80%+ on real estate, but will only borrow 50% or less on shares and funds ?

It's because of fear.

It's not because they fear the value of the portfolio will go down though - otherwise they wouldn't borrow so much against their property either. It's because someone may well "call them out" on their perceived value of their shares and funds and change the situation. The lender may get nervous and insist that they sell down part of their portfolio (or provide more equity) to limit their exposure to a bad debt.

It is margin calls that scare people. This mysterious tragedy which the majority of leveraged share investors spend their lifetime fearing, but never actually experiencing.

But do the sums.

Following on from Nigel's examples in this thread... what are the returns on your share/fund portfolio geared to 50% ? What would the returns on that same portfolio by over the long term if you had geared to 60% ? 70% ? 80% ? The answer is a LOT more.

But what is the risk of a margin call ? And what is the true cost of a margin call ? If you can walk the fine line between maximising your LVR whlie never actually receiving a margin call - then you have truely maximised your returns, and will be so much better off than if you were more conservatively geared.

But how do we know how much is enough ?

If you have a goal to be worth $X within 20 years, then choosing an overly conservative investment portfolio, with an overly conservative gearing level, may well be a high risk strategy because there a very good chance you won't ever reach your goal.

Once again, it all comes down to risk.

Would you choose a lower return that is much more certain to eventuate, over a higher return that has a larger element of risk attached ?

Most people are fundamentally risk averse - especially when it comes to leverage, and a margin call is seen as a very risky situation - so most people strive to avoid it at all costs. This leads to a tendency to prefer quite low LVRs for shares and funds, despite the fact that a margin lender will offer a much higher ratio.

Margin lenders don't just offer an LVR based on the direction of the wind. They do their own analysis and determine how much risk they are prepared to take on based on the nature of the assets the fund holds and how well it manages them (or the strength of the company and the returns it offers).

Interestingly, I can get at least 75% LVR for most of the funds in my portfolio, without any cost to me. What's more they offer up to 10% buffer before initiating a margin call. That's an effective LVR of up to 85% without any cost to me !!!

However, I can generally only get 80% LVR on my real estate portfolio without cost to me ... any higher and I need to take out insurance for the lender to cover their risks. This is an up-front cost to me that eats into my returns from day 1.

At face value, this indicates that I may well be better off gearing with shares/funds than with real estate ? Of course it's never quite that simple

So is there really that much difference between lending for real estate and shares ? If we could somehow get some form of insurance for our margin loans to protect the lenders from a devalued portfolio - would we leverage higher ?

Now THERE is an idea for a finance product that could have a big impact on the way average people invest !

Could we synthesize our own insurance mechanism to minise the potential downside from margin calls ? Has anyone actually done any research into margin call management ? Would holding a cash buffer aside for a margin call situation allow us to leverage to a much higher level without fear ? Would we be better off simply depositing that cash into our margin loan and working from a lower LVR ? I haven't done the sums - but it would be an interesting exercise.

Ultimately then, the answer to the title of this post is that the REAL story of gearing to invest in shares and managed funds is a story of risk management, and if we have a good enough risk management strategy in place, then perhaps we can indeed start to approach the gearing levels of real estate, and hence find better returns for our portfolio.

Discuss