Gearing Explained

Gearing means borrowing money for investment. By adding borrowed funds to your own funds you increase the total amount invested so that you control more investment assets. So the returns as a proportion of your original capital are "geared up", or magnified. This can be illustrated with some examples.

Example 1 Personal Funds $50,000 Borrowed Funds Nil Total Investment $50,000 A 10% increase in value gives a gain of $5,000. Compare this with: Personal funds $50,000 Borrowed funds $100,000 Total Investment $150,000 A 10% increase in value gives a gain of $15,000 which represents a return of 30% on the personal funds invested.

Example 2 Personal Funds $50,000 Borrowed Funds Nil Total Investment $50,000 A 10% decrease in value creates a capital loss of $5,000 Compare this with: Personal funds $50,000 Borrowed funds $100,000 Total investment $150,000 A 10% decrease in value gives a loss of $15,000 which represents a loss of 30% on the personal capital invested

In this simple example, gearing has tripled the size of the investment and tripled the return on the investor's original capital. A detailed analysis would incorporate cash flows and the net costs of borrowing.Note that gearing not only magnifies profits, it magnifies losses as well.

Why should you consider gearing?

Gearing not only gives you more funds to invest, it can also allow you to start investing sooner rather than later.

There are gearing plans available which allow you to get started without having to put in a large amount of your own funds. This is a big advantage for younger people who may only have limited savings, but have a reliable income which allows them to "kick start" their wealth building with the help of borrowed funds.

Gearing can help you own a better quality portfolio.

Another advantage of gearing is that it helps you own a better quality investment portfolio. For a start, with more funds to invest, you can spread your investments more effectively.

Diversification - the investment equivalent of "not putting all your eggs in one basket" - is one of the best ways of reducing risk. In a share portfolio, a spread of investments across different types of companies in different industry sectors means that one poor performer won't have an undue influence on your overall return.

Gearing may also open up investment opportunities which you could not otherwise consider

Some managed investments, for example, require a minimum contribution which may be out of your reach without the added financial muscle that borrowed funds can give you.

Gearing can reduce the costs of investing

Having more funds to invest can reduce the impact of transaction costs, which are sometimes a barrier for small investors. These days, it can cost very little more to invest $10,000 than to invest $2,000. So with more funds at your command you can benefit from economies of scale and reduce your average cost of buying and selling.

Gearing can be a very tax-effective investment strategy

The other major advantage of gearing is that it can be a very tax-effective investment strategy. This is because the interest costs on money borrowed for investment purposes can generally be claimed as a tax deduction. One of the main qualifications is that the purpose of the borrowing must be to earn assessable income.

This potential tax advantage is not in itself a reason for gearing, but it can certainly add to the attraction of a geared investment strategy.

Degrees of gearing - negative, neutral and positive

There is a common misconception that gearing automatically means negative gearing. In fact an investment can also be neutrally or positively geared. The difference is simply to do with cashflow. And that in turn depends on how much you borrow, how much interest you pay, and how much income you receive from the investment.

When your cashflow is negative - in other words your net investment income is less than your interest cost - the investment is said to be negatively geared. Although the interest cost exceeds the income from the investment, the excess is not wasted. It can usually be claimed as a tax deduction against your other assessable income, such as your salary or interest income, and so reduce your overall tax liability.

You are still left, of course, with a loss in terms of cashflow from the investment so to justify a negative gearing strategy you must expect that:

• The income flow from the investment will over time
  increase sufficiently so that your cashflow eventually
  becomes positive,

  and/or

• The capital value of the investment will increase sufficiently
  to compensate you for the negative cashflow.

Neutral gearing occurs when the income you receive from the investment matches the interest cost of the borrowed funds. At this break-even point your investment is effectively self-funding.

Once the investment income is more than your interest cost, your cashflow is positive and the investment is positively geared. This means additional investment income, which you can use to supplement your regular income, reduce your borrowings or add to your investments.

The degree of gearing you choose will depend on your objectives and your own financial circumstances. The more highly geared you are, the greater are the potential rewards, particularly if you are on a high marginal tax rate and may be able to take maximum advantage of the tax benefits of negative gearing.

Gearing is flexible

You can decide on your preferred level of gearing at the outset. You can also adjust that level over time, such as by repaying borrowings out of the profits from any investments you sell or from surplus income.

Remember, too, that the degree of gearing will often change naturally over time. A sound gearing strategy will take account of this. For example, the income from the investment may increase to the point where what was once a negatively geared investment becomes neutrally or positively geared.