Gearing (also known as Leverage) is the practice of using borrowed capital to finance an investment, with the goal of amplifying the potential returns on your own money. Think of it like using a physical lever to lift a heavy object – a small amount of effort (your own capital) can move a much larger weight (the total investment). When an investment's return is higher than the interest rate on the borrowed funds, the investor's profit is magnified. However, this financial magic comes with a serious warning label. Just as gearing can magnify gains, it can equally magnify losses. If the investment sours, the borrower is still on the hook for the entire debt, plus interest. This can lead to a complete wipeout of the initial capital and even leave the investor owing more than they started with. For this reason, gearing is a powerful tool that must be handled with extreme caution.
To truly understand gearing, let's look at a simple example in two acts: one a comedy, the other a tragedy.
Imagine you have €10,000 to invest. You buy shares in a solid company, and after a year, their value increases by 20%. Your investment is now worth €12,000, giving you a tidy profit of €2,000. That's a 20% return on your capital. Now, let's add gearing. You take your €10,000 and borrow an additional €90,000 from your broker, giving you a total of €100,000 to invest in the same company. The shares again increase by 20%, so your investment is now worth €120,000. You repay the €90,000 loan (we'll ignore interest costs for simplicity), leaving you with €30,000. Your initial €10,000 stake has generated a €20,000 profit. That’s a staggering 200% return on your own money. This is the seductive allure of gearing.
Let's rewind the geared-up scenario, but this time, the market turns. Your €100,000 investment falls by 20%, and it's now worth only €80,000. Here’s the problem: you still have to repay the €90,000 loan. To do so, you are forced to sell your entire holding for €80,000. Not only have you lost your initial €10,000, but you are now €10,000 in debt. A 20% investment loss resulted in a personal loss far greater than 100%. This is the brutal, unforgiving risk of gearing.
Gearing appears in many forms, for both large corporations and individual investors.
Companies often use gearing by taking on Debt to fund expansion, research, or acquisitions. As an investor, you can gauge a company's risk level by looking at its gearing. The most common metric is the Debt-to-Equity Ratio, which compares a company's total liabilities to its shareholder equity.
Another useful measure is the Debt-to-Asset Ratio, which shows what proportion of a company's assets are financed through debt.
Many people use gearing, sometimes without realizing the technical term for it.
Legendary investors like Benjamin Graham and Warren Buffett have long preached the virtues of a conservative approach to debt. Buffett famously quipped, “If you're smart, you don't need it. If you're dumb, you have no business using it.” The core philosophy of value investing is to buy wonderful companies at fair prices and hold them for the long term. A key characteristic of a “wonderful company” is a strong Balance Sheet with little to no debt. Why?
Value investors hunt for resilience and a margin of safety. Gearing is the enemy of both. It introduces a point of catastrophic failure and removes the cushion that protects an investor from mistakes or bad luck. While others chase spectacular returns using borrowed money, the value investor prefers to sleep well at night, knowing their companies are built on a rock-solid financial foundation.