Wednesday, 8 November 2006

A Word a Day: "Gearing"

Gearing refers to the use of borrowings against equity to invest. It is calculated by dividing the total liabilities by the total assets.

I had a recent comment asking what level of gearing I thought was appropriate, especially for a 30 year old. Just to reiterate, I'm not a financial planner, so my thoughts are worth what you pay for them - nothing! And you should either make up your own mind after sufficient research, or go get some professional advice.

Having said that, many people have no qualms about borrowing 80% to buy a new home (gearing of 80/20 = 400%!), yet will be totally against any borrowing to invest in other assets such as shares. My views are
1. Gearing can be good to "convert" taxable income into tax-deferred capital gains when the tax-deductible interest you are paying on the loan is more than the investment income (eg. dividends) and IF it is deductible against other income (eg. wages), which is the case in Australia. Also, in case of Australia, capital gains get taxed at half your normal marginal tax rate if held more than 12 months.
2. Gearing should be against a diversified portfolio, NOT one or two "hot" stocks.
3. You must have a sufficient and secure income to cover the interest costs - don't just rely on dividends to meet the repayments (although if you only gear up to 50% or so your dividends may cover the interest costs - this is called "neutral gearing")
4. You should gear conservatively - for example if a share portfolio can be geared up to 70% LVR (about 225% gearing), you shouldn't gear up to the maximum. Generally I only gear up to 100% (a 50% LVR), so the market would have to drop considerably before I'd be worried about getting a margin call.
5. Have other assets and savings that you could use to meet a margin call. Ideally you should be in a position to buy more shares in the bottom of a bear market, not have to sell off your portfolio to avoid a margin call.
6. If you have lots of equity in your house you might consider borrowing against it to invest in a diversified share portfolio or, say, index share fund. This would be a viable alternative to using your real estate equity to borrow and buy a rental property (which many people do). I aim to balance my property assets (house and rental property) with my stock investments (direct stock portfolio, mutual funds and my retirement account investments).

This all assumes you have a high risk-tolerance like me. You really have to know your own risk tolerance before you can even consider gearing as an investment strategy. I'd suggest investing just your own capital to start with, and wait and see how you react to the first real bear market (-25% to -40% or more) before thinking about gearing. For many people gearing is TOTALLY INAPPROPRIATE as it doesn't match their personality, experience, knowledge, requirements or situation.

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