Investment guidelines : The Power of Leverage.
I remember when I was quite young and was introduced to investing by my family – who as it turns out invested mostly in the share market. I was encouraged to buy my first parcel of shares. The business still exists today – Argo. After 12 months they had gone up and I remember proudly ringing my uncle and asking if I should sell, only to be told that “our family doesn’t sell” and that he would only help me if I was ringing to buy.
The message of course was simplistic but powerful all the same. To remember a conversation from so many years ago shows its impact. My early lesson was that investing is all about “time in the market” not about “timing the market”
There are many ways to approach investing – my comments are going to focus on guidelines for investing in property for the long term.
The first and perhaps most powerful message of all is “the power of leverage”
Let’s say you have $100,000 to invest and you can invest in an asset class that pays on average 7%pa. Let’s say you keep reinvesting the dividends or interest. In 10 years your money will have doubled to $200,000.
Now let’s take that $100,000 and use it as a 20% deposit for a property costing $500,000, meaning we borrow $400,000. With that same 7%pa return the property will be worth $1,000,000 in 10 years. With the $400,000 loan still in place your $100,000 has become $600,000
Give it another 10 years and the invested cash is worth $400,000, but the property is worth $2,000,000 and your investment worth a net $1,600,000
Invest for 30 years and the cash is worth $800,000 but the property is worth $4,000,000 and your investment a net $3,600,000
This is the power of leverage There are some cautions of course
- You will need to monitor the condition of the property and of course this is not cost free.
- There will be interest to pay on the loan – but you will receive rent to offset that.
- The power of leverage works in reverse as well – in a falling market your losses are magnified. As long as you service the loan however no bank will ask you to sell for a loss.
- This is not true of the share market where a lender can require you to sell at a loss even if you are servicing the loan. The share market is a legitimate market to invest in BUT if you are going to borrow it is a riskier proposition requiring a greater level of financial sophistication.
Alan Heath
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