In pursuit of excessive returns I use gearing. In this post I will explain why I believe this is rational, and calculate the effect this can have on my portfolio. But keep in mind that the calculations are heavily influenced by the expected long term return of the market, which I base on historical returns.
To illustrate the benefits of gearing I will quantify the expected excess return due to gearing using a simple model. In this model we will assign gearing points to the portfolio, which combined with the expected yield will show the total expected return using gearing.
My broker lets investor gear up their holdings for certain stocks. The level of gearing varies among the stocks. To get the lowest interest rate (currently at 1.69% pre-tax) you can only use 40% of that level of gearing. Due to this, the maximum amount of gearing can be expressed using the following equation:
Max gearing = Market value * possible gearing from broker * 40%
The expected return due to gearing is then found by multiplying the maximum gearing by the difference between expected return of the portfolio (E(rp)) and the interest rate of debt (rd):
Expected return due to gearing = Max gearing * (E(rp) - rd)
We now have a numeric value for the expected return due to gearing, and by dividing that with the market value of the portfolio we have expressed this as a percentage. This can then be combined with the expected return of the portfolio.
Gearing points = Expected return due to gearing / market value of portfolio
As you can see in my portfolio I assign gearing points to each individual stock, which can be grossed up for the entire portfolio.
At the time of this writing my portfolio has a market value of $38,000, and an annual expected return of 7.5%.
The maximum gearing of the portfolio is found by summarising all possible gearing of the stocks, and is at this time of writing found to be $6,800.
The expected yield of 7.5% is post-tax, so we therefore need to express the interest rate of debt in post-tax as well:
rd = 1.65% * (1 - 0.25) = 1.27%
The expected return due to gearing is then found as following:
Expected return due to gearing = $6,800 * (7.5% - 1.27%) = $423
With the given expected return due to gearing we can calculate the gearing points for the entire portfolio:
Gearing points = $423 / $38,000 = 1.1%
Now, 1.1% may not seem that much at first, but with the power of compounding interest, that annual excessive 1.1% return increases my expected returns for my portfolio by $90,685 over a period of 20 years.
NB: I find it most important to address that gearing is not for everyone, and that I need to have a positive cash flow and a low gearing ratio to keep the
risk at an managable level. I will discuss how I handle the different risks in a later post.
We are also in a bull-market at the moment, and it is argued that the long term expected return of 7.5% may be too optimistic.