Gearing explained

Understanding the risks

Gearing can magnify your investment returns, but it can also increase your risk of financial loss, which is why it makes sense to understand the different types of risk involved, and how to manage them.

The risks of gearing include:

  • Margin calls (read more about margin calls)
  • Added exposure can increase losses
  • Sharemarket risks
  • Interest rate risks
  • Changes to taxation legislation

How to manage the risks of gearing

Gearing does have its risks, but there are ways in which you can manage your investment to maximise the benefits while minimising the potential downsides:

Gear conservatively

  • Don't overextend your borrowings. Consider your ability to meet interest payments and possible interest rate changes.

Diversify your investment portfolio

  • Never rely exclusively on one investment, or one type of investment. Aim for a balance across sectors - don't put all your eggs in one basket.

Invest for the long term

  • To ride out the unpredictable characteristics of the sharemarket, invest for a minimum of five years, and preferably seven or more years.

Have a reasonable cashflow

  • A stable, regular income is essential to meet your interest expenses. You should never rely solely on dividend income.

Build in some flexibility

  • Don't get forced into a position where you have to sell when you don't want to. Build in some flexibility to cope with unexpected personal or job-related changes.

Seek professional financial advice

  • Gearing can be very effective, but you should always seek professional advice to help develop a plan that suits your individual circumstances.

What is a margin call?

The main difference between say, a margin loan and a conventional property loan, is that your shares and managed funds can change in value each day. If your equity - the value of the assets that you contributed to the investment - falls below the agreed lending ratio, you may be issued with a margin call.

If this happens, your lender will ask you to provide additional funds to restore at least the minimum equity position.

To help protect against small market fluctuations, there is usually a 'buffer' (typically 5% of your total portfolio value) within which a margin call may not be made.

Find out more