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Borrow to buy etfs?

Discussion in 'Exchange Traded Funds (ETF)' started by GG, 26th Jun, 2010.

  1. GG

    GG Active Member

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    Hi all

    I'm a bit of a newbie and pretty naive when it comes to investments - up till now I've just concentrated on working and earning as much as possible, and putting as much as possible into superannuation.

    About 6 months ago it seemed like I would be retrenched, and because I'm nearing retirement age I started thinking more about investments.

    It now looks like I won't be retrenched, at least for a few years. Recently we bought an investment property, 500K and borrowing 390K. We also have our own house, probably 800K.

    I have a lot in super. It's about 800K at the moment, and top of that I would get 40K index-linked pension if I retired now.

    Given that, I was thinking that I should borrow money to invest in shares - never considered this before, so I was interested in your opinion.

    Provided that I can afford interest payments for 10-20 years then would it eventually pay off borrowing 300K and investing in etfs? (Or how much would it be reasonable to borrow to invest??)

    Obviously you cannot give financial advice, but you can say what you would do if you were in my position.

    Or do you think I'm being greedy and should be happy with what I've already accumulated?

    Any opinions at all would be really good

    Many thanks!
     
  2. GunnerGuy

    GunnerGuy Index & Property Investor

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    GG,

    You say that you are a newbie, however at the same time I do not mean to talk down to you. Here is my 2 cents worth.

    As with any investment decision one has to decide how it fits in to ones overall long term investment / wealth management plan. A decision on borrowing to invest in ETF's can only be made after you have gone through he usual steps of your risk assessment, timeframe, capital growth/income requirements, current disposable income, monthly budgeting. Basically where do you generally want to be in 5, 10 and 15 years and what is the risk you are prepared to take.

    A question simply focussed on "should I borrow to invest in ETF's" has an easy answer - yes if you think the ETF will go up more than the borrowing costs + tax incurred, and also if the gain is more than you inerest rate on your offset account (if you have one).

    You state that you are nearing retirement. However I do not know all of your other circumstances but if you are close to retirement you should be focussing on wealth retainment and reducing you percentages on 'risky' assets. Bonds, fixed income, and reducing debt (should really have none now)Some people say that the stock markets will take 10 years to come back to where they were 2 years ago. Others say we are headed for a double dip recession. Others say Oz housing will come down again. Whether ones believes these or not (but I actually do) do you want to take the risk at this stage in your life or do you (should you ?) play it a little bit safer.

    Having invested in many different assets in many contries over 20 years I am by no means an expert, however there are certain things that should be considered at the different stages of ones 'wealth building' life. If you would like a one on one discussion please feel free to contact me.

    Gunnerguy.
     
  3. Chris C

    Chris C Well-Known Member

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    I agree with Gunner Guy.
     
  4. GG

    GG Active Member

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    Cheers, I guess I should do the risk assessment, where do we want to be in 15 years and so on. Although it's difficult - so many variables.

    And we might not be here in 15 years. Or we might live another 40 after that.

    Over 20 years is investing in ETFs - say STW going to pay off? Provided we can afford the interest payments, wouldn't having an amount in STW likely to pay off over that sort of time period.

    Even for people approaching retirement, why shouldn't they borrow to invest - provided that they can ride major downturns in the housing market or the sharemarket?

    More and more people will be living past 100 years - can they all afford not to borrow to invest if they are going to need income for another 40 to 50 years?

    Thanks for your comments!
     
  5. GunnerGuy

    GunnerGuy Index & Property Investor

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    I think 'general' forward planning is not really that difficult even for 15 years ahead.

    Take a look at these point below. I am not saying these will happen, all I am saying is that they have in the (recent)past and how would you feel if they happened again. Sorry not how would you feel, what would you do more importantly.

    Risk assessment, timeframe, diversification, managable leveraging, saving from a young age, accepting personal spending constraints.


    1. Over the past 50 or so years equities have been proved to be the best long term inverstment - I personally believe this will continue for many years to come but will be very volatile and thus agree to one having a portion of their assets in equities.

    However - Take a look at Japans market over the past 10-15 years. It is not pretty.

    2. Borrowing to invest has its advantages. I believe most 'ruch' individuals whom have created their wealth used significant leverage to achieve their wealth.

    However - Take a look at the interest rates in the UK in 1989 - 1990. Not a pretty 17%. I would not fancy having to service a loan with these interest rates but if equities gor up by more that 17% then OK.

    3. Trying to invest using leveraging at a later stage in ones life, ie.when you are close to retirement and possibly have no job income in the near future, I believe has to be assessed very very carefully. What wealth you already has needs to be protected - because we could to live to 100.

    4. People are starting to realise that we should have all started to save at a younger age ...... because we could live to 100.

    Don't get me wrong. Leveraging is OK in different scenarios, however before I would agree to you plan of borrowing and buying STW when you 'are close to retirement' and see how it goes for 20 years, I would need to look at many other financial aspects of you current financial status. If you plan to do this and servicing the debt would only cost you say 10% of your monthly fixed retirment income (from fixed income sources) then maybe.

    I agree as you say - Even for people approaching retirement, why shouldn't they borrow to invest - provided that they can ride major downturns in the housing market or the sharemarket - but the question is how long and how deep is the current/next sharemarket/housing market downturn going to be. Diversification of your assets will kep you safe. Remember the bilions of dollars of stimulus that have been added to the system. The significant rises in taxation that will surely come. The cutting in public spending.

    I believe that times ahead will be tricky.

    .... another 2 cents from me.
     
  6. GG

    GG Active Member

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    Hi GunnerGuy

    Many thanks for all of the comments. I'm keen to get as many opinions as possible on all of the different aspects of borrowing to invest.

    It's too much for me to consider all of the good points that you've made in one go, so I thought I'd concentrate on interest rates at first. Hope that's O.K!

    I can remember very high interest rates here in Australia - we had a mortgage. It's not a good thing, but we just paid the extra interest and luckily were never in the position where we had to sell our home.

    That would be the aim now - to have enough reserve to ride out the high interest rates, and not to be forced to sell shares below the price they were bought.

    Of course it's still not a good thing to be paying out so much in interest.
    But would inflation tend to be very high too? Would the borrowed amount of money start to look not so great as years of high inflation go past?
    How does one estimate such things?
    Do company earnings go up as well during high interest rate/high inflation periods?
    Or can you have high interest rates but not high inflation?

    Not that it would be any comfort to me, but wouldn't high interest rates be disastrous for many people with big home loans? Wouldn't we all be in a bad position?

    Any comments welcome. Where can I find out more about this sort of thing?
    Thanks everyone :)
     
  7. Chris C

    Chris C Well-Known Member

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    I don't have time right now to answer the above questions. Though using my good friend Google and Wikipedia should help you with some of the general questions.

    But please just promise me you will not only find answers to the above questions but become VERY well informed on all the above topics before you even consider using "leverage" with your investments.

    I'm confident that once you thoroughly understand all the of the above you will realise that leverage is not the route for you at this point in life nor with the strategy you have at this stage of the economic cycle.
     
  8. GG

    GG Active Member

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    I'm afraid that I'm not going too well on the self-education project.

    And will it pay off? It seems to me that people who have spent more time studying these things than I ever will haven't managed to reach a consensus on the wiseness or otherwise of borrowing to invest. I sees disagreements on forums like this, on blogs, on Switzer-like programs on tv etc.

    So how much should I expect to increase my chances of making correct decisions by holding off until I've studied inflation rates, interest rates and so on?
     
  9. GG

    GG Active Member

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    Certainly if the Aus market doesn't grow over the 20 years I will start regretting having borrowed money. I'm almost ready to rule that possibility out - a resource rich country, apparently a good banking system, continued immigration etc. What a disastrous situation if this should happen - whether somebody has borrowed money or not. Wouldn't there be many people retiring and finding that their super is insufficient? Can Australia afford so many dependent retirees?

    I wonder what the chances of this happening are? Anyone willing to hazard a guess?

    Current interest rate is between 6 and 7%. Distribution STW is just less than 4%. For each 100K one would have to come up with 3K or so per annum. The distribution is likely to grow over the years, and there will be capital gain. Whereas the loan amount won't grow.

    I guess that's how I see it. Where am I going wrong?
    I guess I'm making the assumption that the market moves in cycles, and will at some stage move up to a higher level. It's what has happened before - but is it going to be different this time?
     
  10. Johny_come_lately

    Johny_come_lately Well-Known Member

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    Hi GG

    The way I understand it, risk is for the young. When you get to retirement age, you reap your investments' growth.

    I use a old formula; that being Stocks=100-age. If you are 20 then you should hold 80% shares and 20% bonds, but if you are 70 you should hold 30% shares and 70% bonds/Fixed income.

    If you are going to borrow to buy, leave a big safety net for the unexpectant events.





    Johny.
     
  11. Johny_come_lately

    Johny_come_lately Well-Known Member

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    Hi GG,

    Have you come up with a plan yet?




    J.
     
  12. GG

    GG Active Member

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    Not really, Mr Comelately.

    My current feeling is that borrowing to invest in shares is a good idea. Providing that you have enough money in reserve to be able to keep up the interest payments even if interest rates go very high over certain periods. And provided you hold the investments long term. Even quite old people can take a long term view if they consider the benefit to surviving spouse or descendents.

    I'm prepared to lose money in the early years but at some point there will be sufficient compound growth of the share investment, linked to corresponding growth in dividends, that there will be a break even point where the dividends will pay off the interest. And from then on, things will get a lot better.

    I guess I'm influenced by the example of people borrowing money to buy an investment property. Eventually the rent will cover interest payments. There is capital growth of the property. If the house is 500K and there's a 10% increase in prices, there's 50K extra just there. And of course this is compounding, so the longer you keep the property, the better.

    If you can borrow to invest in etfs, what would be the difference? I've read discussions about what is better, investing in properties or shares? The general conclusion seems to be that property has turned out to be better for most people, but only because it is easier to borrow more in the case of properties.

    I'm still a bit uncertain because I lack experience in these sorts of things and it seems that the vast majority of people are dead against borrowing to invest in the sharemarket.

    I'm putting this down to the bad period we've had in the last few years and that most people are thinking about margin loans and not considering a person's particular case

    This sort of thing must have been endlessly debated in the past - any useful links?

    Thanks for the interest in this
    Cheers
     
  13. Waimate01

    Waimate01 Well-Known Member

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    I think it's overwhelmingly likely STW will return a positive return over 20 years.

    It's quite likely it will do so after borrowing costs.

    BUT:

    GG, you have done exceptionally well -- $800k house paid for, $800k in super and an investment property as well. This is the end result of your entire working life and your (evidently) careful and prudent attitude to money and expenses. People work their whole lives in pursuit of a situation that you find yourself in already, and probably most people will not attain it. Kudos to you; well done.

    So, on the cusp of retirement, do you really want to risk blowing that achievement in the pursuit of (to quote Montgomery Burns) "just a little bit more".

    You only get one chance at life, and you've got yourself lined up for retirement exceptionally well. Why get the wobbles now?

    By all means buy some STW, but be really careful taking on debt - although it may not be likely, it has the capacity to dramatically affect your outcome for the worse, at a time when you may have limited capacity to work your way back from that.
     
  14. GG

    GG Active Member

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    In those cases in which STW gives a positive return over 20 years - but not after borrowing costs

    am I right to think that given another couple of years, it will be overwhelmingly likely that STW give a positive return even after interest costs?

    I'm imagining that the amount originally borrowed will no longer seem like very much given compounding effect of inflation. And if the STW has given a positive return then dividends will also have grown. Sooner or later one (or one's descendents) must surely get ahead. Is this the right way of seeing things?





    I've always put the maximum amount into super, and it's grown well. But I had the fortune of receiving an inheritence, and I put most of that into an industry super fund.
    And I do have a mortgage on the IP


    The Burns point - That's a very difficult one. I think I just want to do the right thing in terms of investing. I don't know what might be needed by myself or somebody close to me in the future. I think that many very rich people still invest to earn even more. But obviously I don't want to blow things, so if I can understand how things could go so badly wrong then I will avoid any more borrowing.



    Second part -
    I'm struggling to understand the big problem with the risk that I would be taking. When I retire or get retrenched I'll have both an indexed linked pension plus tax free allocated pension from the industry fund super.

    Considering that I've been salary sacrificing to the maximum, plus paying 10% of salary into employer's super, it seems to me that when I stop work, my income available to spend will actually increase, and it will be more reliable than a wage derived from a job that you could lose at anytime.

    So I believe I can service the debt. I can afford to take a long-term view of things (especially if I think past my own lifetime to descendants who will benefit from this).

    So what can go wrong? I'm really interested in the counter arguments
     
  15. Waimate01

    Waimate01 Well-Known Member

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    Yeah, FWIW I think it's the right way. There's plenty who might disagree, but I'm not one of them.


    I guess it comes down to personal outlook and risk assessment/management. At the worst, we have a double-dip recession that destroys the world economy and eradicates all the fiat currencies and we instead represent our assets in cans of baked beans, ammunition and small blue beads. Possible? Sure! Likely? No. Severity? Extreme.

    Further down the scale, imagine Australian house prices drop by 50%. This certainly is possible and maybe even likely.

    Imagine, at the same time, we have a double-dip and share prices fall by another 30% and stay there for 15 years. Imagine this happens the day after you buy your leveraged STW shares.

    The bank rings up and says they want $190k cash because your IP loan has just gone negative equity and they don't want to be at more than 80% of value. ($500k reduced by 50% - $250k, 80% of valuation means the bank doesn't want to lend you more than $200, but you currently have $390 borrowed, so they want 190 back).

    Then the other bank rings up and says (for example), you borrowed $500k to buy $500k of STW, which is now worth $333k. They want $167 back.

    So you urgently need to find $357k.

    You sell your STW and your investment property to reduce debt. Total debt was 390+500=890. Proceeds from asset sale = 250+333=583 (less costs). You still owe the bank $307k which you don't have.

    Your home, which had also dropped by half but which you weren't worried about because you still get to live there and had no intention of selling, is the only asset you have left and the bank grabs it. House is sold for $400k (less costs), and the bank takes their $307k.

    You're left with $97k (less costs - probably more like $50k) - no house, no IP, no STW. Most of your government pension goes on rent to pay for your onsite van. Your main asset is a rosy recollection of how comfortable you used to be.

    Now that's pretty grim and it's not likely. But in terms of "what can go wrong", it's an outcome with a non-zero probability. If you took a knock like that in your mid-30's, you could bounce back. But mid-50's would be a bunch harder.

    Only you can assign probability numbers to the possible futures, and only you know your appetite for risk, and FWIW I think you're very wise to think about this stuff before just striding in.

    Absent a crystal ball, there's no right answers. Do whatever will give you fewest regrets should the converse eventuate.
     
  16. GG

    GG Active Member

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    Well done Waimate01 - I asked for a 'what can go wrong' scenario and you've come up with it!

    So one needs to be prepared to survive through the worse case - 50% drop in house prices, prolonged drop in sharemarket.

    I'll consider more your figures. I was thinking 300K shares as a maximum, and that would be LVR of 30% or so. I guess it all comes down to being sure that you are never forced to sell.

    As an aside, I'm wondering if the bank would be arranging for a valuation on my IP if there was a crash in prices. I wonder how often this has happened in the past. I've no idea. Also I'm wondering if the banks would be swamped with problems of other borrowers in a worse situation than me, and would leave me alone whilst I'm insisting that I can keep up the mortgage payments! Wishful thinking?
    Thanks again for your helpful comments
     
  17. GG

    GG Active Member

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    That's funny - I was trying to understand the effects of inflation better, so I did a Google search "compounding effect of inflation" and this thread was one of the results. And of course it came from one of my posts!

    OK, I've got a question for people on here that understand these things.

    I borrowed 'Economics for Dummies' from the library.

    Page 104 of UK edition
    summarized -

    suppose that a borrower and lender agree that 6% is a fair real rate of interest, and that inflation is likely to be 3.3% over the course of one year. Using the Fisher equation they agree 9.3% nominal interest rate.

    A year later the borrower repays 9.3% more money than was borrowed. The money is is expected to have only 6% more purchasing power than the borrowed money, given inflation.


    My question - suppose the borrower asks to keep the money for a second year. He pays the 9.3% interest though. And they agree that inflation will be again be 3.3%. Does the lender agree that 9.3% is the fair nominal interest rate again? And if he does and it becomes a 30 year loan, with inflation 3.3% per year, is the fair nominal rate 9.3% every year?
     
  18. Waimate01

    Waimate01 Well-Known Member

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    Exactly.

    I tend to think you have the choice between, 10-years from now everything works out so well you're kicking yourself you hadn't borrowed more, or 10-years from now you identify your big mistake as having borrowed too much.

    On the one hand, it's "glass half full - I wish it was fuller", and on the other hand it's "where'd my glass go?"

    As long as you're never forced to sell, you get to keep your glass.


    On the subject of compounding interest, what you say accords with my understanding, and I'd be inclined to say 'yes', the interest stays at 9.3% per year. This is because the principal of the loan was fixed on day one, and the rate of interest applies to that principal.

    (Note this is different to what happens with yield when you buy shares. A share might yield 5% today, and 5% 30 years from now -- but the 5% yield they're taking about 30 years in the future will be on the share's price 30 years from now - not on the price you bought them today.)
     
  19. jrc77

    jrc77 Well-Known Member

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    GG,

    If you are going to borrow money to invest in shares, have you considered looking at buying put options on the shares to protect your capital? You could fund this by writing call options on them as well (eg. a covered call). Although this could limit your upside potential it could also be used to limit your downside risk.

    Depending on how far you put the strike price of the two options away from the current share price you may be able to generate some extra income as well. Might be something worth investigating.

    Regards,

    Jason
     
  20. Chris C

    Chris C Well-Known Member

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    This is THE biggest point. When you are using other people's money (debt, credit, margin) they set the terms. Banks will be unsympathetic to your plight if it places their principle at risk.

    If the US case is anything to go by it would appear that most banks opted to keep home owners in their homes if they were fulfilling their repayment obligations.

    The problem with this of course is when you have the prices of biggest asset in your economy fall significantly your economy normally goes with it, due to the reduced consumption which was based on the wealth effect (which basically refers to people spending more if they think they have assets to draw upon). This of course raises unemployment significantly which increases the number of defaults which often creates the deflationary spiral.

    This creates a situation where housing bubble declines are more protracted and go on for years until they find fair value or better.

    Almost certainly the banks will be swamped with other problems and if you continue with your repayments they will probably leave you alone, depending on your circumstances (how much negative equity you have, do you have collateral, how old you are).

    Before people ask what does "how old you are" have to do with a loan - to which I respond, "future serviceability". Going forward from this crisis I think banks will be forced to look at people's serviceability from a much more realistic perspective to reduce speculation.


    Makes sense to me.