Too embarrassed to ask: what is “gearing”?

Gearing might sound complicated, but it is a simple concept that is very important in investing. Here’s what it is and how it works.

“Gearing” – also referred to as “leverage” – is a very important concept in investing. It refers to the use of debt to fund an investment. 

This can apply to a business itself. For example, a company might borrow money to invest in new technology. The higher level of debt means the company has a higher level of gearing, but it also applies to investments in shares or other assets made by investors. For example, a hedge fund manager might borrow money to invest in a market or company that he or she has a high-conviction view on.

Why would anyone borrow money to invest? The easiest way to understand this is to think about using a mortgage to buy a house. 

Say you buy a house for £200,000. You pay a deposit of £50,000. You take out an interest-only mortgage of £150,000 for the rest. A year later, house prices have gone up by 10%. You sell for £220,000. You pay the bank back the £150,000. You get £70,000. That’s a £20,000 profit, or a 40% return. So prices only rose by 10%, but the power of gearing meant you made 40%. 

The danger is that gearing works the other way too. If house prices had fallen by 10%, you’d still have had to pay the bank its £150,000, and you’d have been left with £30,000. So you’d have made a 40% loss. 

The same mechanic is at work when investors borrow money to invest in bonds or shares, or even currencies. It’s what individuals are doing when they spreadbet – they’re using borrowed money to bet on asset price movements, which is why so many spreadbetters lose all their money.

There are lots of detailed ratios you can look at to measure the extent to which gearing is being used, both by companies or investment funds, but the key point is this: debt can boost your returns if things go your way. But it also increases the overall riskiness of any investment you make. 

All else being equal, a highly-indebted company is a riskier investment than one with no debt. Always bear this in mind when considering any candidates for your portfolio.

For more on debt and investing, subscribe to MoneyWeek magazine.

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