Ask Colin

Why do you not advocate gearing as a wealth creation tool?

I think you are misrepresenting my views on gearing. I have never said that I do not advocate the use of borrowed money for trading or investing. What I have tried to say it two things:

Firstly, that I do not consider it appropriate for me. There are several reasons for this. One is that I am an aggressive investor. I try to time the market, which is difficult and dangerous, but can be rewarding if you are good at it. I also focus my portfolio in a few large holdings, which is also more risky than a diversified portfolio. Finally and more importantly, I focus on smaller companies which are more volatile and carry a liquidity risk. Investing is about the balance of all the risks you have to manage. Because I am taking a very risky course in my plan in these areas, I take lower risks in other areas of the plan. One of those is to not use borrowed funds.

Secondly, while not completely discounting its use by some investors and traders, I do stress that the risk in the investment or trading plan is increased by using borrowed money. Of, course, the risk level is directly related to the size of the borrowings relative to the equity. So, if you have equity of $100,000 and borrow $40,000 dollars, you have less financial risk than if you have equity of $100,000 and borrowings of another $300,000.

Using this last example, the issues become clear. If your portfolio goes up by 50% ($200,000), then your return is 200% of your equity. However, if your portfolio falls by 25% in a crash (one day in 1987) or a bad bear market, you will have a loss of 100% of your equity. This is why gearing is dangerous. It works savagely in both directions.

Another aspect I like to stress is that there is gearing at many levels and they all add to risk. It becomes clear if you take an extreme example (which is not as rare as you might think):

Your equity is $10,000. You borrow another $10,000. You use CFDs on a conservative 10% margin, so your portfolio is now $200,000. The companies you invest in are geared between 50% and 70%. You now have three levels of gearing. The big danger is that now, if your $200,000 portfolio falls by 5%, you have a 100% loss on your equity. This I find very scary. As I said, this is an extreme example, but even if you are not as aggressive as this in your gearing level, it is still very risky. Try playing with the numbers for yourself.