Investment Strategies: Consider Gearing Up - dummies

By David Stevenson

A small but growing band of investors in the UK has taken a stand against the noise of the markets, deliberately eschewing their frenetic hyperactivity. These investors don’t sit tight and ignore the markets, as many long-term buy-and-hold investors do, but choose instead to make big, leveraged moves on key trends.

Gearing isn’t a complex investing idea: you borrow money from someone else and then bet that money on a key trend. Gearing has the effect of leveraging your potential returns, which means that instead of making, say, a 1 per cent gain on every 1 per cent increase in the value of an underlying financial asset, you make 2 per cent or perhaps even 10 per cent.

Most of the time these so-called macro-orientated investors retain a core of cash or very liquid investments, conserving their capital, not doing very much, because they don’t have much conviction in any big trend.

But when they spot a key trend (such as an economy entering a recession) they spring to life and start using that mountain of cash. Instead of betting all that money on a key investment idea, however, they use gearing to increase their returns.

These investors cleverly invest only a small portion of their cash in any trade. For example, they may stay 95 per cent in cash and only invest 5 per cent in a big investment idea, but with leverage. If their gearing is, say, 10-fold, a small 10 per cent move in the underlying asset may produce a doubling in their investment.

At this point the investors may sell their positions and bank the 5 per cent gain overall (the 5 per cent portfolio position has doubled in price to 10 per cent). If the trade goes wrong and the asset falls by 10 per cent, however, they’ve probably lost their entire investment, but remember that they bet only 5 per cent of their portfolio on the trade!

Many investors aren’t quite as canny and insist on leveraging up their returns throughout their portfolios, turning into highly geared day-traders. Sadly most of these investors eventually come unstuck as leverage destroys their wealth; that is, all those costs from trading and borrowing eat away whatever gains have been made in the past, which is made worse by a run of poorly conceived trade ideas.

If you use some form of borrowing, or margin, to increase exponentially your returns from a more tactical strategy, you’re also exponentially increasing your risk profile. Gearing can be useful if you have a strong conviction trade and can even be used by cautious investors who want to retain liquidity within their portfolio.

But you need to use gearing with great care and only sparingly. (A conviction trade is a trade based on an investment principle your research has indicated will hold sway in the market. For example, if your research tells you that in the coming year a funding crisis will cause inflation to increase and the dollar to fall, your conviction trade may be to invest in gold and gold stocks.)