Investment? What is this word you speak of?

[mriksman]

Hi all,

I stumbled across MMM's blogs today, searching through the myriad of articles of self-proclaimed experts. My mind literally hurts. For some time now, I have lived to my income. I'm in Australia, and started off in an average paid Engineering job; travelling every year and returning broke. Last year I disappeared as a tour leader through Europe. Since returning, I have now landed a very well paid job, that is 28 days on, 28 days off. Travel and work can now co-exist. I've never invested. I'm 30, and I don't own a house or assets. Travelling has been an expensive past time, but something I cannot stop doing. But now with this job, even with all the travelling, I will have a fair chunk of money that won't be spent.

So what do I do?

I have one lump of people saying; 'buy 1,2,3,4,... rentals', and another saying 'get a margin/investment loan and invest in shares/funds'. I see MMM recommends Index Funds.

* Should I use investment loans to invest in shares/funds?
* What kind of dividend payouts are the Vanguard index funds getting?
* Actually, how do I find this? This was in the Australian Vanguard PDS;

As at 30 June 2013, the gross distribution of 1.7855 cents per unit comprised
1.3455 of net (cash) distribution plus 0.4400 by way of franking credits and foreign
tax credits.

* Any other thoughts for a new investor?

Has anyone got a spreadsheet that can compare these two? I've sort of got something, but I am not confident in my calculations.

Thanks for any tips!

Mike

[gooki]

1. Never borrow money to invest in shares.
2. Past performance doesn't matter so stop worrying about it. You want to make sure your index fund is well diversified and low fees.
3. If it was me, I'd be putting the bulk 60-70% into AU index fund, 20% in US index fund, 10-20% cash/fixed interest.

[mriksman]

But when starting out, I have little to no cash. So, the profits realised will be small to start with.

Isn't that the power of mortgages? Leverage/Gearing?

[gooki]

But when starting out, I have little to no cash. So, the profits realised will be small to start with.

Isn't that the power of mortgages? Leverage/Gearing?

Correct, you will have small profits and small gains, and that is all OK. Over time it will keep getting bigger. By investing regularly over a longer period you will also benefit from dollar cost averaging.

Ask yourself this, why would someone lend you money to invest in shares when they could do it themselves?

[mriksman]

So why do people spruik investment/rental homes? If the capital growth is less than the interest rate on the loan - you are at a loss. Is it purely because the rental income offsets a portion of the interest expense; thus making it a viable option?

[gooki]

Correct, at a bare minimum your rental income should cover the mortgage interest, property taxes, and any maintenance costs.

In some countries there are also certain tax benefits to owning rentals.

[mriksman]

Or at least most of it? There must be a 'cross over' point... I did some sums on a 6.13% loan, for a 10 year term. If the return was 5.8%, then the investment would be worth the same as if I had put the same payments into an investment without a loan.

A lot of people talk about negative gearing. I find the idea kind of stupid; negative gearing means you are making a loss... Sure, you can get a tax break, but I'd rather be positively geared, and paying the tax man.

[Dr. A]

I'm willing to bet that every new investor reads about buying stocks on margin (investment loan) and thinks to themselves, "I'd be stupid not to do this!" However, we all learn (often through a painful experience) that it's a very bad thing for an individual to mess around with.

The problem is unequal risk and reward. Let's say you have $10,000 to invest and you can borrow another $10,000 at 6.5%.

Scenario 1 - You invest your $10,000 cash and borrow nothing

If your investment goes up 8%, you make $800 and end up with $10,800
If your investment stays flat, you make $0 and end up with $10,000
If your investment goes down 8%, you lose $800 and end up with $9,200

Scenario 2 - You invest $20,000 (50% cash, 50% borrowed)

If your investment goes up 8%, you make $1,600, pay $650 interest and end up with $10,950
If your investment stays flat, you make $0, pay $650 interest and end up with $9,350
If your investment goes down 8%, you lose $1,600, pay $650 interest and end up with $7,750

Even worse, after experiencing Scenario 2, you'd realize margin is a bad idea and now you have to grow your $7,750 without leverage by 30% just to get back to even after an 8% decline. Also, if your loan is through a broker, as your investment goes down you may be subject to a "margin call" forcing you to sell low.

I'm not experienced in real estate investment, but I'd say the biggest reason that a leveraged real estate investment is much less risky is that the value of the property and (even more importantly) the rent you can demand are much, much less volatile, so if you can conservatively say that your expected rent will cover your fixed expenses and interest, you can be relatively sure that you're not going to lose your shirt.

[mriksman]

Thanks Dr. Yeah it's all making a lot more sense now. After Excel'ing a spreadsheet showing gains with investing without borrowing vs. investing with borrowing; it was pretty clear to see the damage that can be done if the investment fails to grow at above the interest rate. And margin loans here (at my bank at least) are 8.3% - so you'd have to be pretty fortunate to safely make that back.

[beltim]

While I don't necessarily agree that margin is always a bad idea for investing, I certainly agree that it's a bad idea for new investors.  And it's always a bad idea at margin rates of 6.5 or 8%.  For advanced investors at a very low margin rate (2%?), investing in margin can make sense.  There's a book called "Lifecycle Investing" by Ian Ayres and Barry Nalebuff that argues that most people still socking money away should be leveraged, but never more than 2:1.  However, the math depends on having a low margin rate. 

Just as having a mortgage at 10% is far less appealing than 4%, so margin at 8% is much less appealing than at 2%.  In both cases, however, it's not a good idea for beginners and it exposes you to a lot of financial risk.