Gearing is an investing concept which can multiply your wealth a lot faster. But there are some issues you need to understand:
Gearing is risky
- You’re using debt to increase your exposure to the highs and lows of the market you’re investing in, whether it’s property or shares. Your potential gains are increased, but so are the potential losses. You need to be comfortable with the risk you’re taking
- You’re actually taking what experts call a market position. If you’re gearing into shares, you are expecting that 1. A particular share to grow and 2. The sharemarket is in a growth phase—because if the sharemarket takes a downturn, even if the company you’re investing in is sound, your shares will be impacted.
Look at the fundamentals
Understand the fundamentals of the investment you’re gearing into:
- If it’s a residential property, you need to be confident the suburb is expected to grow and the house itself is in good condition.
- If it’s a managed fund, you need to be confident that the mix of investments and the fund managers are the right ones.
- If it’s a particular share, you need to be across measures such as the price-earning ratio and be confident it will be stable or rise.
Have a buffer
If you negatively gear an investment property, there will be times between tenants when no rental income is coming in. Or you might need to make repairs, which are usually tax-deductible.
This is very important to understand. If your shares drop significantly in value, and the loan suddenly exceeds the loan to valuation ratio1 agreed at the outset (usually between 60% and 80%) you will receive a margin call. That means you need to top up your account with enough money to get your portfolio back up to the required level. You can do this with cash or by selling some shares, which may not be the right move when the market, and your confidence, is low.
<1: Loan to Valuation Ratio (LVR), is the ratio between the size of your loan and the value of the security.>
Understand the tax implications
Know the capital gains tax and income tax implications, but don’t let them drive your decision. Income tax may take a big proportion of profits made on assets sold which have been held for less than a year, but losses on other investments can be used to offset profits.
Holding your nerve in a market downturn
Renowned share investor, Warren Buffet, has always advocated buying in sharemarket downturns and selling when the market is high, which goes against most people’s behaviour. For instance, Commonwealth Bank shares fell below $30 during the GFC. In 2015 they’re over $75. It’s about sticking to your strategy.
Section off the debt
You need to ensure the money you’re borrowing to invest is easily discernible from other borrowings. This will help you see what interest is charged against the investment. If you want to draw against equity in your residential property, it will be worth talking to your financial adviser and/or accountant.
Play with your predictions
Try different investment return figures—both good and bad—and check the different returns. Experts call this sensitivity analysis. Are the returns worth the risk? What is the risk of some bad trends in the short-run? Can you handle them? The answer to these questions will tell you whether you should invest or wait.
Gearing is a risky investment decision and has to be based on the same basic principles of any investment: strong fundamentals, a growing market and you are comfortable with it. What you want to see growing is your wealth—not the amount of sleepless nights.
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