This article is purely for the sharing of an evergreen investment philosophy. Examples may be used but they are strictly for illustration purpose and have nothing to do with any individual.

Most businessmen leverage, or borrowed money to start their businesses. They continue to make use of other people’s money (OPM) to grow them into successful companies and as a result, the owners become wealthy today. Without leverage, most of them would not have become as wealthy as they are today.

It is also a good practice for public corporations and listed companies to borrow money to do business and earn a better return for their shareholders. Shareholders of listed companies have unlimited upside when the company continues to make money with OPM. The downside is limited with just the capital they invested in the stocks of the company.

House owners are also using high leverage in order to buy a house, or even a car when starting to work, otherwise they will never able to own one if they have to save up the whole lot of money to buy the house or car with own cash.

Similarly, to become rich quick in the stock market, one should leverage, and borrow money from the banks to amplify returns from stock investment. Shouldn’t we?

However, there are some differences in using OPM from doing business, buying a house and investing in stocks, big differences.

Businessmen borrow money to do a business they are good at making money. They have the skill, experience and the capability to manage and control their business, otherwise they should not engage in the business at all.

House buyers purchase the house to stay in, or produce positive cash flows investing in it. They borrow within their capability and able to pay the regular mortgage payment, and banks are unlikely to recall the loan or force sell the house.

In the stock market, no matter how skilful and experience an investor is, he has no control of the macro and micro economy, political development, and the business they invest in etc.

Take for example,

• How many people had predicted that PH would win the GE14 Election?
• How many people had expected the sudden slowdown in the construction industry?
• How many people had predicted the winning of Donald Trump in the US Presidential Election?
• How many had seen the advent of the trade war between US and China?
• Which shareholder could stop those China companies, and also local companies listed here from squandering the money in the listed company?

The unpredictability and uncontrollable of the above events have seen the following shares plunging to less than half their value in a matter of just a few months, some even in a matter of a few days; very good companies included.

MyEg, Ekovest, Gamuda, George Kent, Genting, GenM, TM, Axiata, Prestariang, HengYuan, Jaks, Armada, Sapura Energy, etc, etc. etc.

There are scores more of them experience the sharp drop in share price in a short time. Mind you, we are just in a steep correction, and it is not even a crash yet.

Let us examine how much investors/punters would have lost with those sharp drops in share prices and what margin finance has done to them.

The Pros and cons of leverage in stock investment

Take the example of using own money of RM1m and borrow another RM1m, for investment/speculating in the stock market for one year. The leverage ratio would be 2 to 1.

Table 1 below in the Appendix shows the returns of your total investment and equity with different scenarios with a leverage ratio of 2 to 1. The interest rate is assumed to be 5%, with 1% margin finance set up fee, and brokerage and miscellaneous fee of another 1%.

You make an outsized return of 92.5% if your stock goes up by 50% as shown in scenario 1. Very happy indeed. With the popping of champion, wine, song and dance.  

But if the return of total investment is 3.5% or less (scenario 3), you will lose money. If the return of total investment is minus 25%, the investor’s loss will be amplified to minus 56.7% as shown in scenario 6. The investor would have lost all his money if the return of total investment is minus 46.8% as shown in scenario 7.

If the investment loses 70% as shown in scenario 8, the investor/punter would, not only have lost all his money, but still have to pay the bank RM463k!

The last two scenarios won’t happen as when the stock loses 25% as in scenario 6, the debt would be 70% of the remaining investment. At this scenario, the bank would have started to force sell all the stocks all the way down. The investor/punter would likely lose about 60%, or RM600k of his own money.

Haven’t you seen some stocks, good ones included, losing 25%, or even 70% in a matter of weeks or months recently?

Words of caution

There are some people who have made a fortune using OPM in the stock market. But there are thousands folds more who have lost their fortunes. Learn and understand statistics and probability.

It’s great to borrow a cow and selling the milk, but not until the cow runs off. Now you’re stuck. You owe a cow and don’t have one to return, and no milk. The risk of leverage is investing that debt and losing what you borrowed, which can wipe out your entire capital, and even more.

I personally don’t even advocate one should put all his money in equity during any stage of the investment cycle. More so, I would never suggest to anyone to borrow and use margin to invest.

It is a good practice to have a good assets allocation; some money in the stocks, diversify the stocks holding and invest in regional markets too, some in fixed income, cash and some in properties etc. if one has a lot of money.

KC Chong

ckc14invest@gmail.com

Appendix

Table 1: Returns with leverage