Work your cash harder

Published in the Money Magazine, April 2013

Australian investors appear to be regaining their appetite for risk. 

Some have already re-embraced the share market. the more adventurous are considering the possibility of chasing higher returns by making use of gearing.

Leveraging, or gearing, is simply using borrowed money to increase your profits or returns. 

For example, you buy lot) S40 shares, using S2000 of your own money and a S2000 margin loan. The price rises to S60 and you sell. 

You receive $6000, pay off your S2000 margin loan, leaving you with S4000, effectively doubling the return you made from the share investment.

Of course if the price falls to S30 the use of a margin loan will increase our losses, which is why many people are still understandably nervous about adopting the strategy.

"There is an incredibly large amount of money currently held by Australian investors in cash and term deposits," observes Tim Mackay, a senior investment adviser with Quantum Financial.

Even lower returns on these investments, he argues, will finally prompt many of these investors to shift some of their cash hack into the share market.

"Fear when investing usually is the result of ignorance of not understanding your goals or the markets you are investing in,’ says Peter Ihornhill, principal of boutique investment counselling firm Motivated Money and author of Motivated Money - a guide to the psychology of investing.

He argues that the main way to help prevent fear interfering with your investment judgement is to inform yourself about the investments you intend to use. "Greater knowledge is the key to managing investment uncertainty and becoming a successful investor," he adds.

This is true of all investors looking to double their returns, from those who are currently sitting around 3% on cash held in an online savings account through to those, for example, who moved back into shares early and are now sitting on substantial unrealised capital gains.

Take on more risk

For the former the challenge is to decide whether to shift some of their money into, say, other income-only investments such as those examined in Investor as well as into shares.

Those already earning relatively high returns need to consider a range of other, more aggressive alternatives. 

Besides gearing into shares and managed funds using a margin loan or home equity loan, there is the option of adopting a more active share trading strategy, and taking an exposure to some of the less mainstream assets, such as foreign currencies and gold.

The really adventurous will also consider highly leveraged contracts for difference and other internally geared derivatives, while those keen to he ahead of the investment curve may decide to re-embrace that old Australian favourite gearing into property.

Mackay of Quantum Financial argues, however, that, while the outlook for commercial property looks promising, residential property offers less upside at the moment.

We see little in the economy that will potentially drive residential property values up over the next 12 to 24 months," he says.

Ironically, nervous investors who are sticking with cash may well he harking back with fond memories to what some may now regard as the "good old days" of investing that ran from late 2008 to early 2012.

For while the global financial crisis triggered a slump in share prices and all the talk was about how the world’s economies and share markets could deteriorate further, there was another side to the investment story, one that many of us perhaps didn’t fully appreciate at the time.

That side was characterised by two key features historically high real interest rates and an unprecedented federal government guarantee on deposits, including those of most banks, building societies and credit unions.

Back in late 2009, for example, it was possible to invest in a government guaranteed, three-year term deposit paying 7.5% a year or more, around 5 percentage points higher than the inflation rate at the time.

Today the government guarantee remains in force, albeit with a lower maximum investment cap, but interest rates have fallen heavy. 

As a result, getting a term deposit paying more than 4.5%, resulting in a real return of just 2.3% or so, can be a challenge.

In other words, hack during the supposedly grim days of the GFC it was possible for the average Australian investor to get a government-guaranteed, real (after inflation) return that was more than double the return available on similar investments today.

A longer time frame

This fall in returns is, of course, one reason investors have already shifted money into shares and some, no doubt, are giving thought to adding some gearing.

Many of our younger clients are definitely interested in using margin loans to gear into shares or managed funds," says Matthew Walker, a director of advisory firm WLM Financial Services. 

"From their perspective, gearing appeals because it has the potential to help them build a deposit for a home."

He adds that many other investors remain cautious about gearing, a point also made by Dale Gillham, executive director of investment training firm Wealth Within.

"Gearing at this stage of the investment cycle has to be used as a way to build wealth over the longer term rather than targeting a quick profit," he warns.

Whether or not you embrace gearing, higher returns carry one major downside: more risk. 

This was highlighted in late February when the local share market, having surged since mid-2012, was hit by a sudden selloff that wiped off $35 billion in a single day.

Yes, the market recovered, but the size and suddenness of the fall was a stark reminder that investment in equities involves taking more risk than one in government guaranteed hank deposits.

Judge your tolerance level

This is not an argument against taking investment risk but rather a pointer to the need to assess your ability to manage it.

Some strategies mentioned have the potential to deliver gains that are much greater than those required to double your current returns. 

Astute investors, however, will set a more modest goal and, in so doing, avoid the temptation to take on excessive risk.

The share market slump in the GFC decimated highly geared share investors who had used margin loans without taking proper account of the need for risk management.

Gillham argues that those using a margin loan at the moment should draw down no more than 4% of their approved loan limit.

This will minimise the risk of having to sell should share prices fall heavily.

The longstanding strategy of diversifying your investments has often been put forward as a way to control risk. 

Rut Walker warns that unless diversification is handled well and you have a reasonably long-term horizon, it won’t work. 

The GFC showed clearly that all diversification strategies aren’t equal," he says.

Higher returns rarely come without taking on more risk and the key is to make sure you understand how much you can tolerate and, above all, resist the temptation to chase quick profits. 

Doubling your return over the long term should he the aim, not chasing a big "score" now.

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