Answer to quiz: error in long-term gearing

April 13th, 2009

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In Reader quiz: spot the error in long-term gearing logic, we asked our readers to spot the common error in a long-term gearing logic. Today, we will give a full explanation of the answer. Our readers offered many good answers that you will do well to take note of. But for this explanation, we will concentrate on a most frequently made error in logic. For this, we will expand on what one of our readers, Pete, said,

– margin loans act as leverage to increase gains…or potentially increase losses
– David point 2 mentioned margin calls – these hurt a lot.

This is the most important point that any investor who is considering gearing should paste on to his/her forehead. We have seen investors applying this error because they were retiring and were afraid that they wouldn’t have enough to do so. It is precisely that they are retiring that gearing should be avoided.

Assuming that in the long run, asset prices will be higher due to inflation, what can go wrong if an investor used gearing to maximise the effect of long run capital appreciation? The problem is that asset prices do not go up in a straight line. This is especially true if the investor bought the asset at bubble prices (e.g. before the panic of 2008). In the short-run, asset prices can suffer major correction. During bubble prices, when the risk of a major correction is at its highest and investors’ optimism at its peak, applying this logical error on one’s investment can result in devastating losses. When the price correction occurs, losses are magnified and the investor’s equity can get wiped out. Then subsequently, when asset prices recover, the investor will not have the equity to take advantage of the upswing. Even if the investor has the equity to take advantage of the upswing, so much capital had already been lost that the overall return in nominal terms can still be negative. Even if positive nominal return is achieved after many long years of waiting (that can test the patience of most people), the investor can still lose money in real terms.

For those who used geared managed funds (that is the managed fund is internally geared and the loan has no recourse to the investor), wild market swings can result in some of these funds being completely wiped out (i.e. value goes to zero).

Such fallacious thinking is the reason why clients of Storm Financial were wiped out financially. It is criminal that the so-called financial experts who provided such ‘advice’ could not see this. Unfortunately, the financial panic of 2008 had taught this lesson to many investors the hard way. In Australia, there are still some property investors who have yet to wake up.

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