Getting started: Margin lending explained
What is Margin lending? Who does Margin lending suit? What are the benefits? What are the risks? What is a 'margin call'? How can the risks be minimised? What is Margin Lending? Margin lending means borrowing to invest. Investing a combination of savings and borrowed funds allows you to invest more, increasing the potential returns compared to investing savings only. In the same way as property investors will put down a 20-30 per cent deposit and borrow the rest, margin lending allows you to buy a significant share or managed fund portfolio with as little as a 20 per cent deposit. This approach is also known as 'gearing'. Who does Margin Lending suit? Investors who:
- are looking for medium to long-term investment opportunities
- have a relatively high, secure disposable income
- are willing to bear greater risk for the chance of greater return
- have adequate cash reserves or other security to meet margin calls
- have some understanding of the stock market and its operations
- understand that gearing multiplies losses as well as gains
What are the benefits? Many investors would like to increase their exposure to the sharemarket - yet lack the funds to do so. For such investors, margin lending can be a simple and flexible 'gearing' option. Gearing your investment increases your potential gains because you reap returns on money you have borrowed from someone else as well as your own money. You also have the flexibility to switch holdings within your portfolio, using the adviser of your choice. What are the risks? While borrowing to invest can accelerate your investment returns, it also increases your exposure to investments that can also decrease in value. Margin lending therefore magnifies the potential for both gains and losses. It is recommended that you seek independent advice and make sure that you fully understand the tax implications as well as the legal and financial ramifications of margin lending. Lenders are not authorised to give tax or investment advice. What is a Margin Call? Lenders want to be sure that the value of an investment portfolio well and truly covers the amount borrowed to finance it. When the value of your portfolio drops too close to the value of your loan, the lender may step in and make a 'margin call'. You would then need to restore this 'buffer zone' by :
- injecting more cash to lower the borrowed amount
- buying more shares to raise the portfolio's value
- selling some of the existing portfolio to raise cash to lower the loan amount
How can the risks be minimised? There are a number of ways to minimise the likelihood of a margin call:
- Don't use all your available funds ie gear yourself to 50% not to 80%. In this case the value of the portfolio would need to fall by 30% for you to receive a margin call.
- Diversify across different sectors. A portfolio might consist of industrials, banks, telecommunication and possibly resources. A diversified portfolio enhances the ability to balance exposure over various sectors.
- Stick to your original strategy and evaluate your portfolio regularly.
The responsibility for the management of your portfolio ultimately rests solely with you, the investor. It's up to you to keep you margin lending account in order at all times. The lender will use its best endeavours to contact you if needed, but final responsibility remains with you.