Typically, when long-term investors buy shares, they pay cash. Nice and simple.
We are seeing some stockbrokers offering investors the opportunity to borrow against their portfolios under various marketing names, but the underlying concept remains the same. This money would be used to buy more long-term holdings or for other expenses. I want to discuss how this lending works and the risks involved.
First, you will get a loan of only, say, 60% of the value of your portfolio, and that depends on the quality of what you hold. If the portfolio is made up of illiquid small caps, you won’t get anywhere near a 60% loan. But high-quality, liquid top 40 stocks and exchange traded funds will get you the higher amount.
You will, of course, be charged interest on the monies being loaned and that rate matters, especially if you plan on using the loan to invest in the market.
A high rate, say 15%, means the new shares being bought need to grow at 15% to pay the interest. You’re unlikely to be getting enough dividends to pay the interest and the growth is paper profits, so you’ll need separate cash flow to manage the monthly interest bill.
The problem comes if the market starts to sell off and the loan gets recalled. The details will be in the T&Cs; you should have read and understood them.
Say you have a R100,000 portfolio and you borrow 60%. Now you have R160,000 invested in the market, secured by your R100,000 portfolio.
Take a worst-case scenario where the US market crashes overnight and the next morning your portfolio opens down 50%, valued at R80,000. The lender is almost certainly going to call in all or part of the loan. Either you have to pay the R60,000 from other funds, or you’ll need to sell R60,000 worth of shares. If the latter, after repaying the loan you will have a portfolio value of R20,000. Big ouch.
This is the risk of, effectively, gearing your portfolio with a loan. Not only has your portfolio collapsed but you’ve had to sell at what may be one of the worst times, the day of a crash.
Somebody without a loan secured by a portfolio would also have seen a 50% loss, but they’ll still have a R50,000 portfolio.
The way to manage this risk is to reduce the loan size and scale it higher over time.
Even if you’re approved for a R60,000 loan, rather take, say, R15,000. You’re still geared but your downside risk is greatly reduced.
After paying the loan off over a year, the following year you could take a loan of R20,000. Pay that off, and the following year take another loan of, say, R25,000.
You’re growing the portfolio much slower than if you’d taken the initial R60,000. But more importantly, you’re protecting the downside.
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