All Ords Report 08 December 2015
Investors in China can no longer borrow double the value of their cash through a broker to invest in the market.
Should we apply a similar rule here to margin lending?
Currently, investors in Australia can borrow up to 70% of the value of their shares. To understand how margin lending works, if you have $30,000 in cash you can invest $100,000 in shares. If your shares rise by 10% your paper profit is $10,000, which is approximately a 33% return on your cash.
Without the margin loan, the 10% rise in shares will generate $3,000.
Of course the reverse is also true, and this is where the problem lies. Borrowing to invest in shares is fine, but what if your shares fall? Your risk is multiplied, which means much higher losses can occur with margin lending.
To set up a margin loan you are required to put up a ‘margin’, being cash or shares, which provides security for the lender. Therefore, it is relatively easy for investors to access additional funds to invest. And, you don’t even need to have any experience in the market to do it. Does that seem right to you?
If you are contemplating using a margin loan, or if you have an existing loan, and you don’t have any formal training in how to buy and sell shares and to manage your risk, then carefully consider the following points:
- I have long said, to build a portfolio of shares safely using borrowed funds, only borrow what you are prepared to invest. That is, if you have a dollar you borrow a dollar. Put simply, if you have $20,000 you would borrow $20,000, which equates to $40,000 to invest.
- The margin lender receives interest on the loan. It is important to observe the interest rate and compare margin lenders, as well as any conditions on any minimum amount the margin lender may set as a loan balance for the purposes of drawing interest, even if you have no borrowed funds.
- Make sure you have determined rules to buy and to sell, including setting a stop loss, an amount you are willing to risk as a percentage of your buy price. If you are not sure how to do this now’s the time to learn via the Trading Mentor Course.
The reality is that few investors, whether in China or Australia, properly understand their risks in the market and how to manage them. Many investors choose to set up a brokering account, and invest in the market before they have invested in themselves, which in my opinion is crazy!
However, I am seeing a change in thinking over recent months. I believe that the major falls in many mining companies held by investors in long term portfolios is driving the change. Investors are not only concerned about the losses from holding these stocks, they are seeing profits from other stocks being wiped out, so they want to get educated.
Generally, I find that the pitfall for many investors is being focused on how much they can make, rather than first getting the knowledge so they can manage the risks and minimize what they may lose in the event their shares fall in value.
Given that the Chinese have already made the change to lending, I believe that this rule ought to be applied in Australia. That said, the responsibility for managing your risk should not rely solely on the regulators. As an investor, it is your responsibility to learn how to manage your risk as your future wealth depends on it.
What do we expect in the market?
Last week, the Australian share market closed below the prior week’s close at 5305 points. Interestingly, this week the market has given up around half of the gains made two weeks ago when the All Ordinaries Index (XAO) traded up in a whopping 280 point range.
Whilst my analysis indicates that the market is likely to continue higher over coming weeks the XAO is still trading sideways post the August low. From here, I would like to see a strong weekly close above 5334 points to confirm the rise will continue. As mentioned previously, a strong fall below 5150 points would indicate an increase in the probability of a further decline.
What is holding the market back?
The answer is largely falling commodity prices and related mining stocks. Whilst there are many Australian shares that have been rising, some stocks are dead weights on the index. Take as an example, BHP Billiton Limited (BHP), which has fallen by around 50% since the high in August 2014. Last month, BHP continued to fall, below the low it fell to at $18.12 in November 2008. This doesn’t mean it’s time to buy BHP, as the share price may fall further into 2016.
To hear more about commodities and BHP, click here.
The good news is that much of the decline in the commodities, and related stocks, is coming close to its conclusion. Remember, as I have mentioned before, in a ‘normal’ market, the rule of thumb is that around one third of stocks will be rising, one third falling, and one third trading sideways. Right now I believe that our market is relatively normal.
However, there will be times when the bulls take over and many stocks rise together. So too, when the bears return many will fall. Also, whether or not you see rising stocks depends on where you are looking. As I teach my students studying the Diploma of Share Trading Investment, every now and then it pays to scan through the top 100 shares by market capitalization to look for opportunities to add to your watch list.
Good news! Australia’s growth lifted by around 0.9% for the September quarter and is up by around 2.5% for the year. Further afield, all eyes are on the US economy, with a rate rise apparently not out of the question for December.
Dale Gillham is Chief Analyst at Wealth Within