Care have to be taken for those who wants to borrow money to kick start their investing journey. When people wants to borrowing money, often they only see the bright side where everything is going as planned and the profit will accelerate. But what happen if the trade is not going to the direction we want ? You may not only lose all of your money, but on top of that you still need to pay additional amount plus also the interest. Is that the kind of risk that you want to carry ? maybe not….

Let see exactly what happen on the example below.

Let say, you have $10,000 to invest and decide to open a margin loan account with interest rate of 5% and the LVR (Loan to Value Ratio) is 50%. (This means if you have $10,000 then the lender will lend you another $10,000. So in total you will have $20,000 for the investment – the loan is 50% of the otal value). Let’s also assume that the stock you want to buy is $25 each. Then:

Yes, It Accelerates Profit

Now, let see what happen if the stock price is now $40 after 2 years. (increase $15 or 60%)

As described on table above, without borrowing we make 60% profit from 60% price increase. But with borrowing of 50% LVR, we make 110% profit from the exactly the same price movement and time. Even after paying interest… So, with gearing we definitely getting a lot better result and it inded accelerates our profit.

But, It Also Multiply Loss

Then we compare if the price was down by the same amount (decrease $15 or 60%)

This is the situation you need to understand fully. Without borrowing you lose $6,000 of your money (but still have $4000 in hand from the proceed of the share at $10 each). But with borrowing, the proceed of the sales is only 800 * $10 = $8,000. Remember that your starting capital is $10,000 and you have another $10,000 from the lender. That’s mean, you need to add extra $2,000 from your own pocket just to pay off the money you borrowed . Beside that, the original $10,000 is now gone (loss). To make it even worse, you also need to pay that $1000 interest.

So, you’re not only loss of all your initial investment, you also need to pay additional money just to close your trade.

Conclusion

Borrowing money to invest is double-edged sword, it can give you benefit but also give you a disaster.

But as soon as you realize this fact, then we can go to the next level: what we can do about it ? Can we still make use of the benefit of the leverage without having to carry such big risk ?

Fortunately, the answer is yes, we can ! So,  we can enjoy the advantage of the money we borrow that will accelerates the profit as shown on above calculation, but when the price move against our expectation, the capital is protected (preserved): that is in this example, you don’t have to lose even the $10,000 should the price go down as example above.

How exactly we can do it ? You will find it on other article in this website talking about hedging / risk management.

Have a good day!

Denis Kristanda