Top Gear

by daniel archibald

When a lot of people start out with a gearing strategy they tend to think that it will be fun and zany like that TV show, "Dexter".  Instead it can at times seem more dark and disturbing like that TV show, "Top Gear".

Gearing involves the borrowing of funds to invest in an asset.  Though most shy away from the term, gearing is very common - almost all property purchases are geared; most businesses need some level of gearing to grow.  But this gearing tends to be more to do with need than with principle - hard to buy a house without a mortgage; business opportunities often require high initial funding.

Another main form of gearing is margin lending.  This is what most investors think of when the subject is raised and has been, since the GFC, quite taboo.  In good times, gearing helps to multiply potential reward, in bad times, the opposite is true even more so.  With markets plummeting throughout 2008 (bad time) many geared investors lost much more than the 40%-50% drop in share markets.  Some investors lost it all.

Margin lending facilities try to help to avoid total chaos by enforcing the "margin call".  This mechanism is triggered when investments fall to the extent that the attached debt becomes proportionally excessive.  At this time, the debt must be reduced by either selling a large portion of the investment, or repaying part of the loan with cash.  This tends to not be a great outcome as it can force you to sell when markets are low (this is when you should be buying, right?).

Back to a previous point - many have no problem of borrowing over 80% to invest in a property, but would never dare borrow even 30% to invest into a share portfolio.  A few reasons for this may be that (1) most Australians believe property is much safer than shares; (2) most look to hold the property indefinitely; and (3) the cost of borrowing tends to be lower for a mortgage.  Regardless of the validity of these points it is important to understand that both are part of the same beast - geared investments.

So gearing may be right for some, wrong for some.  In the long-run, a geared portfolio is expected to produce higher returns, but the risks of losing in the short-term (and potentially losing everything), are significantly increased.  For those with shorter investment time horizons, a geared portfolio is likely to be inappropriate, regardless of the appetite for risk. 




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