Gearing: Using Debt To Increase Risk And Reward

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Gearing gives you the ability to aspire to even greater reward for any given level of risk.

What is gearing?

Gearing is the use of borrowed money to increase your risk and potential reward.

Why does gearing increase the risk?

Because you are introducing another element into the risk equation that has a potential to be negative.

If used properly gearing can seriously increase your wealth. And as an investor you have probably used gearing without even knowing it.

If you own property then you have almost certainly used gearing.

If you used a mortgage to purchase your house then you 'geared' your purchase.

Let's consider this in an example:

• How much (in percentage terms) did you make when you purchased your home with a mortgage of £200,000, a deposit of £50,000 and then sold it for £500,000?

A quick calculation gives a profit of £250,000 or a 100% profit on the £250,000 paid for the property. Yes?

No!

You've hit the jackpot!

With gearing the calculation is:

Your profit divided by your investment multiplied by 100 (to give it in percentage terms).

Which equals (250,000 / 50,000).X 100.

Hey Presto! It's 500% not 100%.

Of course there are charges to be deducted as there always are with any investment - but no tax (in the UK, if it is your main residence).

So, thanks to the power of gearing, you can make a large profit by banking all of the capital benefit accrued from the borrowed money.

The lender gets his percentage interest, but none of the benefit of the investment you made.

So, from now on, in investment terms, you should think of borrowing as gearing, as opposed to debt.

You should take onto your investment strategy only the level of risk with which you, as an investor, are comfortable.

Each investment type has a level of risk associated with it.

Within those investment types there are factors unique to individual investments that increase or decrease the level of risk, in comparison to other investments, within the investment sector, and outside, in other investment types.

In order to determine the level of risk associated with a single potential investment, all criteria that could affect the investment must be analysed with a cool head. You as an investor must not be swayed by psychological factors, such as 'fear of loss', 'fear of regret' and 'aversion for risk'.

In order to increase your percentage reward from a particular investment you should use, where possible, other peoples money.

This is the art and science of gearing.

But be aware that gearing can add an element of risk to the investment that must be analysed to see if the level of risk is still within your investment risk parameters.