How to Use Gearing to Build a Diverse Investment Portfolio
Gearing, or borrowing to invest, can be a powerful strategy for building wealth and creating a diverse investment portfolio. While it comes with risks, when used wisely, gearing can accelerate your investment growth and provide opportunities for greater diversification. This article will explore how Australian investors can use gearing effectively to build a robust and diverse investment portfolio.
Understanding Gearing in the Australian Context
Gearing simply means borrowing money to invest. In Australia, it’s a common strategy used by investors to increase their exposure to various asset classes, including shares, property, and managed funds. The goal is to amplify returns by investing a larger amount than would be possible using only your own capital.
There are two main types of gearing:
- Positive gearing: When the income from your investment exceeds the costs of borrowing.
- Negative gearing: When the costs of borrowing exceed the income from your investment, resulting in a short-term loss but potential long-term capital gains.
Benefits of Using Gearing for Portfolio Diversification
- Increased Investment Capacity: Gearing allows you to invest in a broader range of assets, potentially spreading risk across different sectors and asset classes.
- Accelerated Wealth Accumulation: By investing a larger amount, you can potentially benefit from compounded returns over time.
- Tax Benefits: Interest and other borrowing costs may be tax-deductible, potentially reducing your overall tax liability.
- Access to Different Markets: Gearing can provide the capital needed to invest in markets or assets that might otherwise be out of reach, such as commercial property or international shares.
Strategies for Using Gearing to Build a Diverse Portfolio
1. Regular Gearing
Regular gearing involves combining savings with borrowed funds to invest on a monthly basis. This strategy can help smooth out market volatility through dollar-cost averaging.
Example:
Sam has $2,000 equity and wants to invest in an Australian share fund. He can afford to invest an additional $500 per month. By using regular gearing, Sam borrows an additional $500 per month, allowing him to invest $1,000 monthly. Over 10 years, this strategy could potentially yield a higher net investment value compared to investing without gearing.
2. Diversifying Across Asset Classes
Use gearing to invest in a mix of asset classes, such as:
- Australian shares
- International shares
- Property (residential and commercial)
- Fixed interest securities
- Infrastructure
This diversification can help manage risk and potentially enhance returns.
3. Utilising Different Gearing Facilities
Consider using a combination of gearing facilities to build your portfolio:
- Home Equity Loans: Often offer lower interest rates and no margin calls.
- Margin Loans: Allow you to borrow against the value of shares or managed funds.
- Investment Property Loans: Specifically designed for property investments.
4. Implementing a Core-Satellite Approach
Use gearing to create a core portfolio of low-cost, diversified investments (e.g., index funds or ETFs) supplemented by satellite investments in specific sectors or individual stocks you believe will outperform.
Managing Risks When Using Gearing
- Borrow Conservatively: Don’t borrow the maximum amount offered. Leave a buffer to manage potential market downturns.
- Maintain a Cash Reserve: Keep an emergency fund to cover unexpected expenses or margin calls.
- Regularly Review and Rebalance: Monitor your portfolio and adjust your gearing levels as needed to maintain your desired risk profile.
- Consider Income Protection: Ensure you have adequate insurance to cover loan repayments if your income is interrupted.
- Understand Margin Calls: If using margin loans, be prepared for potential margin calls during market downturns.
Case Study: Gearing in Action
Let’s consider a hypothetical example of how gearing could be used to build a diverse portfolio:
Sarah has $100,000 to invest and decides to use gearing to increase her investment capacity. She borrows an additional $100,000 through a combination of home equity and margin loans.
Sarah’s geared portfolio allocation:
- Australian shares (ASX200 ETF): 40% ($80,000)
- International shares (Global ETF): 30% ($60,000)
- Property (REIT ETF): 20% ($40,000)
- Fixed interest (Bond ETF): 10% ($20,000)
By using gearing, Sarah has doubled her investment exposure and created a diversified portfolio across multiple asset classes and geographical regions.
Gearing can be an effective tool for building a diverse investment portfolio, potentially accelerating wealth creation and providing access to a broader range of investment opportunities. However, it’s crucial to understand the risks involved and implement strategies to manage these risks effectively.
Before embarking on a geared investment strategy, consider seeking advice from a qualified financial professional who can help tailor an approach suited to your individual circumstances, risk tolerance, and financial goals. Remember, while gearing can magnify gains, it can also amplify losses, so it’s essential to approach this strategy with caution and a long-term perspective.
By using gearing wisely and in conjunction with a well-thought-out investment plan, Australian investors can potentially build more robust and diverse portfolios that stand the test of time and market volatility.