The risks of hitting top gear
LEVERAGE, or gearing as it is sometimes called, can be one of the fastest wealth-building tools around.
This is because it magnifies the amount of assets you can have working for you. If you were left $300,000 you would normally do much better long term if you borrowed another $300,000 and bought property or shares worth $600,000, than if you simply invested the $300,000 on its own. .
That’s fine if everything goes well, but the multiplier effect works against you if the market falls. The person who has borrowed $300,000 is looking at a loss of $120,000 if the market falls 20% - a loss of 40% of their initial capital.
Gearing is fine, if all goes well, but there are now derivative products around that offer you super gearing – the ability to make huge profits, but at the same time huge losses. Unfortunately, they can also lure the unwary investor into losing far more than their original stake. The most popular of these are contracts for difference (CFDs) which are now being heavily advertised.
A CFD is a contract between two parties to exchange the difference in the price of a security between when the contract opens and closes. To put it simply, CFDs allow you to trade shares without having to physically own them, and the result is that you are borrowing money to bet on whether a share price or an index will go up or down.
The companies issuing them may permit you to borrow up to 95% of the value of your debt (or even more in some cases). That means with $5,000 you could buy a contract for $100,000 worth of shares – for $100,000 you could in theory buy a $2 million contract. With 95% borrowing just a 0.5% or 1% change in the price of a share can turn into a 10% or 20% gain or loss.”
As ASIC points out “Because of this borrowing, it's much riskier than a flutter on the horses or a night at the casino. Your losses are potentially unlimited and can far exceed the money you've wagered. You could wipe yourself out in a single day.”
Be warned - as always, the higher the return the higher the risk.
Noel Whittaker is a director of Whittaker Macnaught Pty Ltd. His advice is general in nature and readers should seek their own professional advice before making any financial decisions. His email is firstname.lastname@example.org.