The Beta Post

Passive income, personal finance and fintech.

Why I use gearing

Why I use gearing

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.


Gearing points

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

Portfolio example

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.

Comments

Gravatar
Mr. ATM
November 3rd, 2017 19:26

Hi,

When you say "you use gearing", you really mean margin? In other words, you are borrowing from your broker (as in using a margin account) to get an additional return on your investments. Did I get this right?

Sorry, the gearing terminology was a bit confusing to me at first, but when I read a bit more, it occurred to me that you are actually referring to buying stocks on margin.

In mechanics, gearing is great for amplification or attenuation of a force, I learned that in a Dynamics class when I was in college.

Therefore, if the additional capital from your broker (in the form of gearing) provides amplification of your returns minus the friction (interest rate), it can also attenuate your returns if it is applied to a wrong type of investment.

I don't know, I'm not a big fan of investing with borrowed money, it never made sense to me to borrow to invest. Sorry, if I completely misunderstood your gearing concept.

Take care

Gravatar
The Beta Post
November 5th, 2017 05:29

Hi ATM,

No, you understood it right: I'm borrowing money from my broker to increase my positions.

You're also completely right about the risks involved, and it is therefor vital that I keep my debt-to-equity ratio low enough so that I can handle any black swans that might occur in the market.

As we previously discussed CBL: bying that kind of stock on margin would be completely wrong. Stocks that might loose 20% of it's market value on one day is not the kind you would like to have bought on a margin. I's mentioned in my other comment, I'm writing a entry about CBL, and why I will sell it off the next week.

Thank you for your comment!

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