Gearing, also known as leverage, is the use of borrowed funds to increase the potential return on an investment. It involves borrowing money to invest in an asset, such as stocks, with the aim of generating higher returns than would be possible with the investor’s own capital alone.
For example, if an investor has $1,000 to invest and uses gearing to borrow an additional $4,000, they will have a total of $5,000 to invest. If the investment generates a return of 10%, the investor will earn $500. However, because they used gearing, their actual return will be higher than if they had invested only their own capital, as the additional $4,000 borrowed also earned a return.
While gearing can amplify potential returns, it also increases the risk of losses, as losses will also be magnified. Therefore, investors should carefully consider their risk tolerance and financial goals before using gearing as a strategy.