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Gearing

What is Gearing?

The use of Other People's Money alongside your own money to extend your ability to purchase and increase your return, typically for investment.

Also known as a Leverage, a Margin Loan, or a Gearing Ratio, Other People's Money (OPM) can be used in addition to your own funds to increase the profit on an investment. Caution must be applied as gearing can magnify losses too.

An Example of Gearing

For example lets assumed you have $5,000 (the green box) but wish to purchase a $15,000 investment (grey box). You borrow $10,000 (yellow box) from the bank to meet the shortfall.

 

Gearing 33.3%

This gearing ratio is 33.333%, or 1 part your money to 2 parts borrowed money.

A 50% gearing ratio for the same $5,000 would involve you borrowing another $5,000.

 

Gearing 50%

How Gearing Increases Returns

If the $15,000 investment (above) returns a $5,000 profit then that would be a 33.333% profit on the $15,000 invested, but a 100% profit on your $5,000 stake in the investment (which is your Return on Investment). So instead of making 33% you made 100%, not bad.

How Gearing Increases Losses

If the $15,000 investment looses $5,000 then that would be a 33.333% loss on the investment, but a 100% loss on your $5,000. $5,000 invested minus a $5,000 loss equals no money left. If the investment lost 50% then you would lose more money than you put in. In fact those lending you the money would not be waiting around for the investment to recover and would want their money back including the loss. This is known as a Margin Call.

Gearing Requires Experienced Risk Management

Before entering any gearing arrangement make sure you perform a risk assessment. Take the time to know all the risks and be sure you are comfortable because that fear in your stomach indicates you are taking too big a risk with your level of experience. Perform smaller trades or paper trade until you are comfortable.