Gearing

3 min read

Gearing simply means borrowing to invest and, if managed carefully, can be a way to magnify your investment returns. Care needs to be taken because it can also magnify your losses

What is gearing?

Rather than steadily drip-feeding your own money into an investment, it is possible to borrow funds to purchase an investment. The use of borrowed money for investing is referred to as “gearing” or leverage.

Gearing can work in your favour. For example, rather than miss opportunities because you don’t have the necessary funds, gearing can mean you can be better positioned to respond to market opportunities as soon as they arise. Borrowed funds can also be used to diversify your portfolio and help manage risk.    

Having said that, gearing needs to be managed with care as it can also work against you resulting in losses.

Here’s what’s involved.

Gearing can boost returns

To understand the benefit of gearing let’s look at a simple example which has been provided for illustrative purposes only.

We’ll say a hypothetical investor – Anthony, has $20,000 to invest in shares. He can choose to buy only $20,000 worth of shares, or he can borrow an additional $5,000, and buy $25,000 of shares in ABC Limited. Both scenarios are illustrated in the table below.

Level of borrowing

0% 

20%

Your own money

$20,000 

$20,000 

Loan amount 

$0 

$5,000 

Initial portfolio value

$20,000

$25,000

Change in portfolio value1

$22,000

$27,500

Loan repayment

$0

-$5,000

Net position after period2

$22,000

$22,500

Gain

10%

12.5%

Assumptions: 1. Change in portfolio value of 10% p.a. is for illustrative purposes only, it is not a reflection of actual market performance. Loan interest, dividends, franking credits, tax and other fees and charges have been excluded. 2. Any change in assumptions could significantly alter the results. 3. It is recommended you should seek independent professional tax advice before investing.

Now we’ll assume the shares of ABC Limited rise in value by 10%. Without the benefit of borrowing, Anthony’s $20,000 shareholding rises in value by $2,000.

However, with the benefit of borrowing, and given our assumptions, Anthony’s $25,000 shareholding rises in value by $2,500. So Anthony has made an additional gain of 2.5% (based on his original $20,000 investment).

Gearing is a double-edged sword

Just as gearing can magnify returns, it can also magnify losses. Let’s see what happens if the shares in ABC Limited fell by 10%.

Level of borrowing

0% 

20%

Your own money

$20,000 

$20,000 

Loan amount 

$0 

$5,000 

Initial portfolio value

$20,000

$25,000

Change in portfolio value1

$18,000

$22,500

Loan repayment

$0

-$5,000

Net position after period2

$18,000

$17,500

Loss

-10%

-12.5%

Assumptions: 1. Change in portfolio value of 10% p.a. is for illustrative purposes only, it is not a reflection of actual market performance. Loan interest, dividends, franking credits, tax and other fees and charges have been excluded. 2. Any change in assumptions could significantly alter the results. 3. It is recommended you should seek independent professional tax advice before investing.

If Anthony borrows to invest, his portfolio would have dropped in value to $22,500. Because $5,000 of this amount is the bank’s money (and it must be repaid at some stage), his original $20,000 investment is now worth $17,500. So in other words, because of his use of gearing, and given our assumptions, a market fall of 10% has seen Anthony wear a personal loss of 12.5%.

Solutions for a gearing need

Gearing is common practice when investors buy a rental property, and the instrument used to effect the gearing is the investment property loan.  

Investors can also use gearing to buy shares or a managed share investment with a product called a “margin loan”. These loans usually have a limit beyond which the lender will implement a “margin call”. Put simply, if the value of underlying shares you purchase with the loan falls below a certain level, the lender may contact you and ask for money to be tipped into the loan to reinstate the original “loan to value” ratio. 

The possibility of a margin call makes it important for investors using gearing to select and manage their shares or managed investments with care. You must consider the risks, which include:

  • Gearing not only magnifies potential gains, but can also magnify potential losses; 
  • A market downturn may result in a margin call and require additional funds to be applied to the loan. Your secuities may be sold to satisfy this requirement; 
  • Interest rates may increase, making the cost of gearing more expensive; and 
  • Investment income may reduce 

The bottom line is that gearing can have its benefits but it is a higher risk strategy which will increase the overall risk of your portfolio. 

Like to know more about gearing to invest? Contact us to arrange the type of advice that is appropriate for you
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