Image of gears

This article on gearing is by Planalyst from Team Monevator. Every Monday brings more fresh perspectives from the Team.

Borrowing to invest – or ‘gearing’, as seasoned investors call it – is as simple as it sounds to get started.

You take out a loan. Then you invest it as you would your own capital for potential growth. 

However the journey and outcome you’ll get from gearing is much more complicated and uncertain from there.

What a difference a decade makes

The Investor explained in a mini-series a decade ago why borrowing to invest is usually a bad idea.

Just as he was writing coming out of a recession, so I am with this article. 

Gearing is common practice for businesses, investment trusts, and fund managers. And it has been steadily increasing to the point that margin debt – gearing directly applied to an investment portfolio – is at its highest level in the US for more than 10 years. 

But a big difference between now and back then when a younger, better-looking Investor was sharing his thoughts is that personal loan interest rates are much lower today.

Best Buy personal loan rates are below 3% APR. That’s a far cry from the 10% The Investor talked about in the aftermath of the financial crisis. 

Still, with the post-pandemic economy recovery we’re already hearing talk of central banks pushing up base rates to combat higher inflation.

Does that make it a good time to gear up your portfolio by fixing a low interest rate loan for long-term investment? 

The good, the bad, and the gearing

I recently explained gearing to Mr Planalyst. He wondered why I didn’t use gearing for my investments to try to ratchet my returns even higher?

Particularly, he noted, because my investments have made an average 11% return a year. (Thank you, bull market!)

Mr Planalyst saw it in simple terms. Why not use someone else’s money to make us more money? 

So we sat down to planalyse this idea. And I created the tables below to explore the following ‘what if’ scenario.

Say we borrowed £30,000 to invest, at a 3% annual interest rate over a 10-year term.

For simplicity, we’ll assume the compounded debt interest is rolled up to be repaid at the end of the term, with the original capital. (Personal loans are usually repaid over time, but this makes the maths very complicated).

A calculator tells us that this borrowing and interest totals £40,317.

We’ll also assume the borrowing is all invested in a single passive tracker fund. And we’ll model returns according to two example scenarios.

Gearing scenario 1: good times

The UK market tends to see at least one steep decline every ten years or so. Typically stocks will fall 20% or more during these drawdowns. 

Our first table therefore shows the potential position of a borrowed £30,000 after ten years that suffers one such crash. (All numbers rounded to the nearest pound.)

In this (fictitious!) example we see an average annual return of around 4% overall. But there’s a fall of -20% in one grim year halfway through:

Year Portfolio value Annual return % Annual return £
1 £30,000 9% £2,700
2 £32,700 8% £2,616
3 £35,316 9% £3,178
4 £38,494 7% £2,695
5 £41,189 -20% -£8,238
6 £32,951 2% £659
7 £33,610 4% £1,344
8 £34,955 5% £1,748
9 £36,702 7% £2,569
10 £39,272 9% £3,534
End total / average return £42,806 4%  

In this first scenario, using gearing worked out positively – although the end result was only a little ahead of the cost of borrowing (£40,317).

Remember: market volatility means you can’t guarantee any returns.

There’s no certainty of a gain at the end of the borrowing period to repay the debt and the interest accrued. Never mind enough to deliver a profit for going to all this trouble in the first place!

Even if you come good in the end, seeing your total invested assets that you bought with gearing go below the amount at stake during the term won’t be easy. It could be emotionally upsetting.

Obviously it’ll be even worse if you come up short at the end of the term.

Talking of which…

Gearing scenario 2: bad times

In this scenario our returns are almost as before – except for the last two years.

This time the market’s recovery from its decline is very sluggish, rather than it bouncing back to pre-downturn levels as in the first scenario.

And again, after ten years your term is up and your debt must be repaid:

Year Portfolio value Annual return % Annual return £
1 £30,000 9% £2,700
2 £32,700 8% £2,616
3 £35,316 9% £3,178
4 £38,494 7% £2,695
5 £41,189 -20% -£8,238
6 £32,951 2% £659
7 £33,610 4% £1,344
8 £34,955 5% £1,748
9 £36,702 4% £1,468
10 £38,171 2% £763
End total / average return £38,934 3%  

After ten years you don’t have enough to repay the loan plus its interest – £40,317 – let alone seen a profit.

This example demonstrates the risk of having to sell when your capital is down to repay your debt. You are forced to realize a loss.

You might have fretted about this outcome for half the loan term – from year six onward. And the risk would have come true.

Maybe you’ll have greyer hair, too.

Debts must be repaid. You would have to dip into other savings or income to repay the bank what you owe. Assuming that was even an option for you.

Outcome

Here’s how the numbers work out from these two scenarios after ten years:

Scenario Debt and interest Portfolio Balance
1 £40,317 £42,806 £2,489
2 £40,317 £38,934 -£1,384

In the second example, we see how interest – the cost of debt – has amplified the losses compared to just investing £30,000 of your own money.

Of course you might see far higher average annual gains than 3% or 4% over ten years. That would make borrowing to invest very lucrative.

But you could also see lower returns, too.

This unpredictability of future market moves is why I wouldn’t consider gearing to invest. The risk of volatility and market falls at the worst time are too great to ignore – even for that chance to make a healthy profit.

Historically, stock market returns have been far higher than today’s low cost of debt, which might make the odds seem pretty good.

But personally I don’t have the stomach for it.

Gearing up for a fall

You say you’re willing to accept the market’s ups and downs? There are other factors and caveats to consider before you gear up. 

More risks to think about

In the above examples, I kept the structure of the loan very simple.

You could use monthly or annual interest repayments instead to take the pain away from repaying a lump sum at the end. The exact loan structure chosen upfront could even make or break the eventual returns. This adds extra risk – it could turn out to be wrong for your future circumstances. 

With such an arrangement you’d also need to keep up regular repayments, adding to your household expenditure. This would reduce your disposable income for any other investment opportunities that may arise over the fixed term of the loan. 

In the event of a market crash – perhaps with a recession – having to make regular repayments could prove tough if you faced job insecurity. 

And don’t forget investment costs along the way. These haven’t been explicitly broken out in my examples above. They will eat into any growth. 

You may also have taxes to pay on your gains when it comes time to repay, though this depends on how you invest.

Investing in an ISA can take away the tax pain, as a Monevator article by Finumus recently stressed

Risk reducers

You might be attracted to variable interest rates loans, particularly if they start off lower than a fixed rate option.

But variable rates add extra interest rate risk. Locking in a fixed rate now makes future budgeting certain, even if your investment returns are not.

Taking out a long-term loan for investment can soften the blow of short-term market volatility. Investing is a long-term game. Securing returns is more about time in the market than trying to time the market.

In contrast, you’re likely to risk making even greater losses by gambling to chase returns to repay a debt over a short timescale. 

This is why The Investor suggested in his series that a mortgage is the only debt that’s prudent for most people to consider while also investing in risky assets like shares.

Finally, you may choose to diversify across different asset classes and funds, rather than rely on one tracker.

Properly diversified investments would mitigate the downside risk, at least to some extent, but it could also curb your expected returns. 

Changing gear

Even if gearing is not for you when it comes to your portfolio, knowledge of how it works might still prove useful.

Case in point: there exists a financial calculation called the gearing ratio, which analysts use when assessing companies.

Companies typically take out debt to invest in their own businesses. 

The gearing ratio is a company’s total debt divided by its total equity.

If the gearing ratio is: 

  • Over 50% – The company is highly geared, so future downturns and high interest rates could put the company in trouble.
  • 25%-50% – Considered normal for most large companies.
  • Under 25% – Probably a lower-risk investment, but potentially also a slower growing business

Gearing ratios need to be considered in the context of a company’s sector/specific industry.

For example, utility companies have strong recurring cash flows. Their higher levels of gearing might therefore be considered less risky than for instance a manufacturer borrowing to build a factory.

Gear for you

The gearing ratio might also be applied to your personal finances.

The ratio could give clues as to how much debt a household could comfortably carry before things get risky. Not only when taking out a loan for investing, but also when deciding to take on a mortgage or car loan.

To work out your personal gearing ratio, you’d divide the total level of actual or proposed debt by your total net assets.

Note: as far as I know there are no hard-and-fast rules here.

If we took the thresholds I gave for companies, for example, then having more than 50% of your personal assets in debt would seem very unwise.

However, this is typically what happens when buying a house, with today’s high prices. Many young buyers have very little elsewhere in the way of assets after scraping together the deposit for a 90% loan-to-value mortgage.

At least your home’s value won’t fluctuate like the stock market. (Which is exactly why borrowing to invest in a house is a mainstream activity.)

Reverse gear

If you’re thinking of gearing to invest, do your homework and thoroughly consider all the costs and the additional risks.

Some sophisticated investors could make it work for them.

But for a typical individual, gearing explicitly to invest in the stock market is not a risk worth taking. Better to get rich slowly!

See all Planalyst’s articles in her dedicated archive.

The post Is there a case for gearing up your investments? appeared first on Monevator.

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