“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.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
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.
-
House prices are falling in London but how does it compare to the rest of the UK?Advice The capital remains the most expensive part of the UK to buy a property, but it isn’t being as badly hit by the housing market slump. Where are London house prices heading?
-
Will a Santa Rally provide festive cheer for investors this year?
News Equities often get a seasonal boost during December - will there be a Santa Rally in 2023?
-
What is an investment trust?
Videos “Active” investment funds come in two main varieties, one of which is investment trusts. But what exactly is an investment trust?
-
What is a dividend yield?
Videos Learn what a dividend yield is and what it can tell investors about a company's plans to return profits to its investors.
-
High earners to pay nearly £2000 more in tax due to fiscal drag
Videos The government froze tax thresholds, which will drag employees into higher tax bands as wages rise with inflation. We explain what fiscal drag is, and how to avoid it.
-
What is a deficit?
Videos When we talk about government spending and the public finances, we often hear the word ‘deficit’ being used. But what is a deficit, and why does it matter?
-
Too embarrassed to ask: what is moral hazard?
Videos The term “moral hazard” comes from the insurance industry in the 18th century. But what does it mean today?
-
Too embarrassed to ask: what is contagion?
Videos Most of us probably know what “contagion” is in a biological sense. But it also crops up in financial markets. Here's what it means.
-
Too embarrassed to ask: what is a marginal tax rate?
Videos Your marginal tax rate is simply the tax rate you pay on each extra pound of income you earn. Here's how that works.
-
Too embarrassed to ask: what is stagflation?
Videos Traditionally, economists and central bankers worry about inflation or recession. But there is one thing worse than both: stagflation. Here's what it is
