Borrowing to buy shares is very risky, but if you do it right, the risk is manageable.

Let’s look at what might have happened if you’d borrowed to buy shares in one of Australia’s best performing stocks — and one of our biggest and safest companies — the Commonwealth Bank of Australia (CBA).

It’s early 2009 and you have $10,000 to invest but you decide to borrow another $10,000 so you can buy 400 CBA shares at $50 each costing a total of $20,000.

Today, CBA shares are worth over $80 so you’re on easy street, right? Well, maybe, maybe not.

A few months after you bought your shares, the Global Financial Crisis caused a massive sell-off in shares generally, but especially in bank shares.

CBA shares dropped to $25.

Scenario #1

You just lost all your initial investment and your lender demanded another $5,000 in loan security (more on margin loans another day) ­— money you didn’t have and certainly didn’t want to invest in shares that had just cost you all your savings. You sold the shares and repaid the loan, but the $10,000 you started with was gone, and over the next five years you watched bitterly as CBA shares rose to $95 and above.

Scenario #2

You had borrowed unsecured to buy the shares and stuck to your long term view —that the Commonwealth Bank was well run and a pillar of the Australian economy. You held your nerve and were rewarded as the shares bounced back, achieved new highs, and paid increased dividends.

Things to consider

If you’re contemplating borrowing to buy shares, here are a few rules to keep you safe.

1.     Time — only invest if you’re in it for the long haul. Share investments are extremely risky in the short term, even without global crises (in recent months CBA shares have fallen 15% from their highs). Over 10 years or longer though, the risk is very much lower.

2.     Risk Tolerance — only invest if you are prepared to ignore market fluctuations. If you sell after a market fall, you will lock in your losses and miss out on the eventual recovery.

3.     Loan Amount — only borrow as much as you can afford to repay even if the prices of your shares fall and even if dividends decrease for a while.

4.     Loan Terms — ask yourself what will happen to your loan if your shares halve in value. Can you afford to provide more security if your lender has the right to demand it? Can your lender demand early repayment?

5.     Diversify —  don’t put all your eggs in one basket. Spread your risk among several companies (a dozen or more if possible). You could also spread out your investment timing too, over say 12 months (more on cost averaging another day).

6.     Do Your Research — get professional advice.

What are your thoughts?

Are you tempted to borrow to buy shares? Is there anything else you’d like to know about geared investing?Join the conversation — leave a comment below and let us know what you’re thoughts are.

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