This article explains how gearing works in Australia, the mechanics of margin lending and margin calls, the mathematics of amplified returns, tax considerations, and why many investment policy statements (IPS) restrict or prohibit borrowing to invest.
Key takeaway
Gearing amplifies both gains and losses, and the mathematics of leverage mean that losses can exceed the original equity invested.
What Gearing Means#
Gearing is the use of borrowed money to increase the size of an investment position. If an investor has $50,000 of their own capital and borrows an additional $50,000 to invest, they now control $100,000 of assets. The $50,000 of borrowed funds is the "gear." The ratio of total investment to personal equity describes the level of leverage.
The key concept is that investment returns (positive or negative) apply to the full $100,000, but the investor's own money at stake is only $50,000. This magnification effect is the entire purpose of gearing, and the entire source of its risk.
In Australian financial language, "gearing" is the most common term. In global markets, "leverage" is used interchangeably. Both describe the same mechanic: using debt to amplify investment exposure.
How Margin Lending Works in Australia#
A margin loan is the most direct form of gearing for listed securities. In Australia, margin lending facilities are offered by major banks and specialist providers.¹ The investor deposits securities (and sometimes cash) as collateral, and the lender provides additional funds to purchase more securities.
Loan-to-Value Ratio (LVR)#
The central concept in margin lending is the loan-to-value ratio, or LVR. This is the proportion of the total portfolio value that is funded by the loan.
| Component | Amount |
|---|---|
| Investor's equity | $50,000 |
| Margin loan | $50,000 |
| Total portfolio value | $100,000 |
| LVR | 50% |
Different securities are assigned different maximum LVRs by the lender. Blue-chip ASX 200 stocks and broad ETFs typically attract higher LVRs (up to 70% or 75%), while smaller or more volatile securities attract lower LVRs or may not be accepted as collateral at all.² The lender sets these limits based on the liquidity and volatility of each security.
Interest Rates and Costs#
Margin loan interest rates in Australia are typically variable and sit above standard home loan rates. The interest is charged on the borrowed amount, regardless of whether the portfolio rises or falls. This means the investment needs to generate returns above the interest rate just to break even on the borrowed portion.
The Mathematics of Leverage#
The amplification effect of gearing is best understood through worked examples.
When Markets Rise#
An investor has $50,000 of equity and borrows $50,000 at 50% LVR, creating a $100,000 portfolio. The market rises 20%.
| Without gearing | With gearing (50% LVR) | |
|---|---|---|
| Starting equity | $50,000 | $50,000 |
| Total invested | $50,000 | $100,000 |
| Market return (20%) | +$10,000 | +$20,000 |
| Portfolio value after | $60,000 | $120,000 |
| Less loan | $0 | $50,000 |
| Equity after | $60,000 | $70,000 |
| Return on equity | 20% | 40% |
The 20% market gain becomes a 40% gain on the investor's own equity. This is the appeal of gearing.
When Markets Fall#
The same investor faces a 20% market decline.
| Without gearing | With gearing (50% LVR) | |
|---|---|---|
| Starting equity | $50,000 | $50,000 |
| Total invested | $50,000 | $100,000 |
| Market return (-20%) | -$10,000 | -$20,000 |
| Portfolio value after | $40,000 | $80,000 |
| Less loan | $0 | $50,000 |
| Equity after | $40,000 | $30,000 |
| Return on equity | -20% | -40% |
The 20% market decline becomes a 40% loss of equity. The loan amount does not shrink when the portfolio falls. It stays fixed, which means the full weight of the decline falls on the investor's equity alone.
The Asymmetry Deepens With Larger Declines#
At higher levels of gearing or larger market declines, the mathematics become more severe. With 70% LVR (borrowing $70,000 against $30,000 of equity to hold $100,000), a 30% market decline would reduce the portfolio to $70,000. After subtracting the $70,000 loan, the investor's equity is zero. A further decline would mean the investor owes more than the portfolio is worth.
This is the asymmetry of leverage: gains are pleasant, but losses can consume the entire original investment, and in extreme cases, extend beyond it.
Margin Calls Explained#
A margin call is the mechanism lenders use to protect themselves when a leveraged portfolio declines.
When the portfolio's LVR rises above the lender's maximum (because falling prices have eroded the equity), the lender issues a margin call. This is a demand that the investor restore the LVR to an acceptable level, typically within 24 to 48 hours.³
The investor has limited options when a margin call is received:
- Deposit additional cash into the margin loan account
- Deposit additional securities as collateral
- Sell existing holdings to reduce the loan balance
If the investor does not act within the required timeframe, the lender has the right to sell securities in the portfolio to bring the LVR back within limits. The lender chooses which securities to sell, and the timing is dictated by urgency, not by market conditions.
Why Margin Calls Are Particularly Damaging#
Margin calls tend to arrive at the worst possible moment. They are triggered by market declines, which means the investor is forced to sell (or inject cash) precisely when prices are low. This converts temporary paper losses into permanent realised losses.
There is a quiet cruelty to this mechanism: the investor who most needs time for the market to recover is the one least able to wait.
Forced selling during a downturn is one of the most reliable paths to permanent capital loss. It removes the possibility of recovery, which is the very thing that makes equity investing viable over long time horizons.
Other Forms of Gearing#
Margin lending is the most visible form of investment leverage, but it is not the only one.
Investment Property Loans#
Property investment in Australia commonly involves gearing. A borrower who purchases a $600,000 investment property with a $120,000 deposit and a $480,000 mortgage is geared at 80% LVR. The mechanics are similar to margin lending, though the absence of daily mark-to-market pricing and margin calls makes property gearing feel less volatile. The underlying leverage risk, however, is real: if the property falls in value, the borrower still owes the full loan amount.⁴
Internally Geared Managed Funds#
Some managed funds use internal leverage, borrowing within the fund structure to increase exposure. The investor buys units in the fund, and the fund itself holds the debt. These products are sometimes marketed as a simpler alternative to margin lending because the investor does not personally manage the loan. However, the amplification of returns (in both directions) still applies, and the fund's unit price will reflect the leveraged exposure.
Structured Lending Facilities#
Products like the NAB Equity Builder (and similar facilities from other providers) offer a form of investment lending without traditional margin calls. These are typically structured as fixed-term loans secured against a portfolio of approved investments. The absence of margin calls removes the forced-selling risk during downturns, but the loan still needs to be repaid, and the investor still bears the full amplified loss on their equity.⁵
Tax Deductibility and Negative Gearing#
In Australia, interest paid on money borrowed for income-producing investments is generally tax-deductible.⁶ This applies to margin loans, investment property loans, and other borrowing arrangements where the purpose is to produce assessable income (such as dividends, distributions, or rent).
When the cost of the loan (interest and other expenses) exceeds the income generated by the investment, the result is a net loss. This is negative gearing: the investment costs more to hold than it produces in income. Under Australian tax law, that net loss can typically be offset against other income, reducing the investor's overall tax liability.
Why Tax Benefits Do Not Eliminate Risk#
The tax deductibility of interest reduces the after-tax cost of borrowing, but it does not change the fundamental mathematics of leverage. A tax deduction at a 37% marginal rate means the government effectively shares 37 cents of every dollar of interest cost. The investor still bears the other 63 cents, plus the full exposure to capital losses.
| Scenario | Pre-tax loss | Tax benefit (37% rate) | After-tax loss |
|---|---|---|---|
| $5,000 interest, no capital gain | -$5,000 | +$1,850 | -$3,150 |
| $5,000 interest, $20,000 capital loss | -$25,000 | +$1,850 | -$23,150 |
The tax benefit is modest relative to the potential capital losses. Negative gearing reduces the cost of holding a geared position, but it does not protect against the scenario that matters most: a significant decline in the value of the underlying investment.
Why IPS Documents Often Restrict Gearing#
An investment policy statement is a written set of rules that governs how a portfolio is managed. Many IPS documents restrict or prohibit gearing, and there are several reasons this is common.
Amplified downside risk. As the worked examples above illustrate, gearing magnifies losses. A portfolio designed to achieve long-term goals can be derailed by a leveraged loss that would have been survivable without borrowing.
Forced selling at the worst time. Margin calls remove the investor's ability to choose when to sell. In a standard portfolio, an investor can wait for recovery. In a geared portfolio, the lender may force a sale during the trough. This is the opposite of what long-term investing requires.
Increased complexity. Gearing introduces interest costs, LVR monitoring, tax implications, and lender relationships into portfolio management. Each adds a layer of decision-making and potential error.
Behavioural pressure. Watching a leveraged portfolio decline is psychologically different from watching an unleveraged one. The knowledge that losses are amplified and that a margin call may arrive creates anxiety that can lead to poor decision-making, including panic selling before a margin call even occurs.
Incompatibility with long-term discipline. Most evidence-based investment approaches rely on staying invested through downturns. Gearing introduces a mechanism (margin calls) that can forcibly override that discipline. The IPS exists to protect an investor from impulsive decisions, and gearing introduces a structural force that can override the IPS itself.
Gearing and Inexperienced Investors#
The combination of leverage and limited experience is notable because it compounds multiple risks simultaneously.
An investor who is new to markets may not have experienced a significant downturn. They may understand the concept of a 30% decline intellectually without understanding what it feels like to watch $30,000 of a $100,000 portfolio disappear, or what it feels like to receive a margin call demanding $15,000 within 48 hours during a period when their own financial situation may also be under pressure (since market downturns often coincide with economic stress).
Most people discover their true risk tolerance not during calm markets, but during the first serious decline they experience while holding real money.
Experienced investors who use gearing typically do so with a clear understanding of the specific risks, sufficient liquid reserves to meet margin calls without forced selling, and a predetermined plan for various decline scenarios. These are not qualities that develop quickly.
Summary#
Gearing means borrowing money to invest, amplifying both gains and losses relative to the investor's own equity. Margin lending in Australia operates through loan-to-value ratios, and when portfolios decline, margin calls can force the sale of assets at the worst possible time. The tax deductibility of investment interest reduces borrowing costs but does not offset capital losses. Investment policy statements frequently restrict gearing because it introduces amplified downside risk, forced selling, and behavioural pressure that can undermine a long-term investment plan.
Sources#
- Australian Securities and Investments Commission. (2023). Margin lending. Moneysmart. https://moneysmart.gov.au/investments-paying-off/margin-loans
- ASX. (2023). Understanding margin lending. ASX Investor Education. https://www.asx.com.au/investors/investment-tools-and-resources/calculators-and-tools
- Australian Securities and Investments Commission. (2023). Margin calls. Moneysmart. https://moneysmart.gov.au/investments-paying-off/margin-loans
- Reserve Bank of Australia. (2023). Financial stability review: Household and business finances. Financial Stability Review, October 2023. https://www.rba.gov.au/publications/fsr/
- National Australia Bank. (2023). NAB Equity Builder: Product information. https://www.nab.com.au/personal/investments/nab-equity-builder
- Australian Taxation Office. (2023). Interest, dividend and other investment income deductions. https://www.ato.gov.au/individuals/income-and-deductions/deductions-you-can-claim/interest-dividend-and-other-investment-income-deductions/