Very few people wanted to borrow to invest in March 2009, after the FTSE 100 had halved in two years and the US markets had been in meltdown.

The sad fact is gearing up ¹ only becomes popular in optimistic times.

Unfortunately, when the economy is doing well, shares and other investments have usually been rising in price for years. They are then typically very expensive, and so less likely to deliver good returns in the future.

This makes borrowing to invest in happier times much riskier than if you did so in a bear market.

When you should borrow, you won’t want to

In a bear market when prices are cheap, fewer people are willing or able to borrow to invest.

The thought of your borrowed money getting eaten up double quick by falling share prices is a terrifying one — and quite rightly, too, given the risks of borrowing to invest in mark to market assets like stocks.

I was fully invested by the end of March 2009, but I would never have been able to stomach gearing up to take on even more risk in those emotionally draining times. Just staying in a bear market takes willpower — borrowing could easily push you mentally as well as financially over the edge.

Tip 1: We’re all only human, so here’s a good rule of thumb: When you feel it’s safe to borrow to invest, it’s not actually safe to do so.

Money’s too tight to lend on

Ironically, it’s harder too to get anyone to lend you money when times are tough, cash is king, and assets are truly cheap.

Just ask a first-time house buyer after several years of falling prices. To get a mortgage they’ll need a perfect credit record and a deposit of 20% or more, to buy a house that’s maybe 25% cheaper than at the peak.

Buying the house after a crash is actually less risky for both them and the lender because it’s not so over-priced. Yet many won’t get financing.

Of course, such caution doesn’t last. In a decade or so the easy money will be back, and lenders will be doling out mortgages to all-comers. A few years ago you could get a 100% mortgage without even proving your income. It’ll happen again.

Similarly, in bullish times for shares, lending money to investors seems like a win-win for everyone.

Gearing up for the worst market ever

An example of lending to investors gone bad was the Wall Street Crash of 1929.

The speculators you see in those famous old black-and-white photos selling their cars or leaping out of windows weren’t just upset because they’d lost their money. They’d also lost lots of borrowed money, faced huge margin ² calls, and knew there was no way they would make the money back to repay their debts.

How did it happen? Well, the years leading up to 1929 were the definition of a go-go era for stocks. As a result, lots of brokers allowed their clients to invest on margin. This meant they could get, say, twice the exposure to a stock for the same money, which was great while prices were rising.

And prices did keep rising for longer than expected, helped in no small part by all the borrowed money entering the market. But then prices started falling, everyone tried to take their borrowed money out at once — which drove down prices even faster — and to cut a long story short, the world had the Great Depression on its hands.

Tip 2: Again, if people are only too happy to lend you money to borrow to invest in stocks, it’s almost certainly a bad time to do so!

Another way to gear up (if you must)

If you really want to borrow to invest — for example if you’re reading this article in bear market, and you think now is the time to be contrarian — then you might want to research covered warrants (aka options) or subscription shares.

Some of these offer a way to increase your gearing as with borrowing, but they limit the downside to you losing the maximum amount you invested in them.

Obviously losing all your money isn’t ideal, but it’s better than losing more money than you’ve got.

What’s the catch? Well, derivatives like these expire after a given time. This means if your investment doesn’t come good before a certain pre-determined date, you’ll lose your money when they expire.

Introducing a deadline into an investing horizon when dealing with volatile assets like stocks is a whole new kind of investing risk. You get nothing for free in the stock market.

Please remember, I am not responsible for your actions. Borrowing to invest and using derivatives is a game for specialist investors. You are very likely to lose money, as I hope I’ve made clear in this article.

1. Gearing is another word for borrowing — like a gear on a bicycle debt it can increase your output for the same input, but with shares it can also work the other way if prices fall.[↩]
2. Margin is jargon for using borrowed money from your stockbroker or dealer to buy shares[↩]

Great reads from around the web.

I can rarely recall such a busy time in the UK. Decisions are being made now that will shape the economy for years to come.

On education and fees, the great student riot has been covered to death elsewhere. Regular readers may remember I feel the problem is simply too many weak students doing too many pointless degrees, creating a funding crisis. I’m all for aspiration, but it has to be credible, not fanciful. The world only needs so many digital photographers and marine biologists.

Those hungry for more should check out A Grain Of Salt’s link below to see why the debts aren’t so onerous, and Simple In Suffolk’s hopeful suggestion that revolting students could at least kill off the heinous X-Factor.

Common sense has at least broken out on welfare reform. Three cheers for Ian Duncan-Smith’s single universal benefit plan (a flat tax next, please!) People need to support themselves, and to aspire to a better life, whether it be materially or in terms of some other lifestyle choice. That thousands spend 20 years or more in a paid-for council house living on hand-outs from the State would shame the founders of the Labour movement. There’s far more dignity to sweeping the streets or cleaning the drains then scrounging off those that do.

Finally, the stock market continues its steady advance, as the global economy (ex-US and Europe) continues to roar ahead.

Many Monevator readers rightly follow a passive portfolio strategy, which means rebalancing when appropriate and ignoring the noise.

But those who’ve tried to be clever (like me!) can’t afford to get the big calls wrong, and the last couple of years have been all about big calls.

In particular, any UK investors who timidly stuck to cash and ignored the recovery in the stock market from its March 2009 low has paid a steep price. Instead of excellent double digit gains, they’ve seen a loss in real terms, especially after tax, due to high inflation.

According to the Bank of England, inflation has been above target for over 40 of the past 50 months! With commodity prices booming, the economy picking up steam, and monetary policy still super loose, inflation still seems to me far more likely going forward than deflation.

The FTSE All-Share still looks reasonable value, although clearly no longer bargain basement cheap. In particular, 10-year Gilt yields are edging higher, while rising stock prices reduce the yield on the All-Share.

At some point the risk-free returns from Gilts will make the return on equities look expensive. But whether it’s in six months time or a decade, nobody knows.

[continue reading…]

The Annual Management Charge (AMC) is one of the most useless terms bandied around the world of investing. It’s trumpeted time and again in the media, in errant fund screeners, and by online forum dwellers as evidence of low cost funds that are worth investing in.

But the AMC is as misleading as a price that doesn’t include VAT. The sting is in the final bill.

What is TER?

The Total Expense Ratio (TER) is the cost to look out for when comparing funds. It’s a FSA-approved measure ¹ that offers a more accurate picture of the annual operating expenses that drag down the performance of your investment.

These operating expenses include:

• Annual management charge
• Legal fees
• Administrative fees
• Audit fees
• Marketing fees
• Directors’ fees
• Regulatory fees
• The mysterious ‘other’ expenses (biscuits, perhaps?)

Unlike reading that list, the TER will never make you yelp with pain. It’s not deducted directly from your bank account. It’s a stealth cost: a percentage silently shaved off your fund’s investment return over the course of a year.

The lower the TER the better, although you’ll struggle to beat a TER of 0.27% on a UK equity tracker fund. A TER of 1% on a similar fund would be like daylight robbery with extra kickings.

What difference does the TER make?

As fund firm Vanguard put it in their own prospectus:

Even seemingly small differences in expenses can, over time, have a dramatic effect on the Fund’s performance

We can witness that drama like an episode of 24 by comparing the TER cost of two otherwise identical funds:

	Fund A	Fund B
TER	0.27%	1%
Initial investment	10,000	10,000
Annual return	7%	7%
Holding period	25 years	25 years
Total return	£50,952	£42,919

Fund B has been whacked for over £8,000 more in charges over the period. That cuts your return by a painful 15.77%.

This sort of needless loss can be avoided by choosing funds with the most competitive TER wherever possible. You can compare TER damage yourself using a fund cost comparison calculator.

The illustration above also shows why it’s important to deal in TERs not AMCs. For example, Fidelity’s MoneyBuilder UK Index Fund declares an AMC of 0.1%, which is nearly three times smaller than its TER of 0.27%. A difference guaranteed to knock your calculations out of whack if you listen to lazy journalists.

TER twists

Beware that TERs are not fixed. You can find the TER in the fund fact sheet or prospectus, but you’ll also find small print explaining the fund manager reserves the right to charge extra for any unexpected operating costs.

That’s because the TER is a calculation based on the previous year’s events. Published TERs therefore represent an expectation of costs rather than a guarantee.

Don’t expect listed TERs to be accurate when you’re screening for funds, either. I’ve yet to find a fund screener that’s 100% up-to-date, or above occasionally quoting the AMC. The only way to be sure of an accurate TER is by checking the latest fund literature.

Hidden costs not in the TER

Sadly for the weary investor, the TER is not the one-stop cost-shop it’s often thought to be.

Though it’s the most practical tool we’ve got for instantly comparing funds, TER doesn’t tell you anything about:

• Initial charges and exit fees
• Brokerage fees
• Bid-offer spreads
• Market impact costs
• Taxes (e.g. stamp duty)
• Interest on borrowing
• Soft commissions

You’d need to subject most funds to a forensic examination to suss the impact of that lot upon your costs. Happily though, there are some useful rules of thumb that help show the way. I’ll return to that in a future post.

Suffice to say, the passive investment strategies adopted by index trackers make them far less prone to these costs than active funds.

Take it steady,

The Accumulator

1. TER = Total Operating Costs / Average Net Assets[↩]