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Strategy 2 – A geared investment portfolio
With this strategy, you take the savings plan just mentioned, then add ‘fuel’ to it through a strategy called gearing.
What is gearing?
Gearing is where you borrow money to add to what you are already saved or in the process of saving—it’s borrowing more money to invest. This strategy is for those who have been a little ‘delayed’ in saving for their child’s eduction. It can also be referred to as a ‘catch up strategy’. I’m sure there are many of us that this applies to.
Gearing has become popular in Australia over the past 15 years. When the share market is soaring ahead as it has been over the past 3 to 4 years then all goes well. On the flip side when the stock market is moving downwards, and/or interest rates are rising, then losses may occur can accelerate as well . So beware! Gearing means you have borrowed money to invest and you need to pay it back. This type of borrowing or loan may not be suitable for everyone.
You may need to contact your sharebroker or financial planner to set up a geared portfolio. Nothing changes as discussed in Strategy One—you have a choice of investing directly in shares or managed funds.
Gearing can take three different forms: positive, neutral, or negative.
Positive gearing – the income you receive from the total investment is greater than the cost of borrowing the funds.
Neutral gearing – the income you receive from the investment is equal to the cost of borrowing the funds.
Negative gearing – You have more leverage, however the cost of borrowing outweighs the income received, ie., overall there is a loss of income in this strategy.
To begin
To begin a gearing strategy, you need to borrow money to invest from a financial institution (the lender). First you will need to have an existing asset such as available equity in your home—that is, is the difference between the market price of the property and your mortgage debt—an existing portfolio of direct shares or managed funds, and/or simply cash. With some lenders you can also start a regular gearing/savings plan with as little as $250.
There are risks as you are borrowing money to put into an investment. To reduce this risk (known as market risk) and play safe, do not overcommit yourself with borrowing money.
If you decide to invest directly, you will need to choose a sharebroker or online sharebroker to execute the trades for shares or managed funds.
For objective information and comparisons on financial and investment services see www.infochoice.com.au
With any investment, mentally prepare yourself for a long timeframe and remain patient. To gain the most from this strategy, an investment period of no less than seven years is required.
You and your adviser will need to monitor the geared portfolio amount of funds you borrow against your existing asset to ensure you have not over extended when the markets become unstable.
Margin calls
If you have used an existing share portfolio, cash or a mixture of both as equity for the margin loan (this doesn’t apply if you used your home), there is a risk that market fluctuations will reduce your portfolio’s value to a level where it no longer provides adequate security for the loan. Once proces have fallen far enough so that the ratio of the loan to the portfolio value exceeds the maximum set by the lender, the lender will step in and make a margin call.