The Wise Investor
Kate was looking very excited now.
John's tone became cautionary as he continued. "We
have not allowed for expenses or interest on the mortgage,
so remember that in practice it would take a much larger
increase to return the same profit. Still, the principle always
applies. Now for the bad news."
Kate's excitement faded a little.
"Just as the gearing multiplies your profit, it also multiplies
your loss if things go badly. Imagine that the house declines
in value from 100,000 to 90,000 dollars. If you were to sell at
this time, and pay off the mortgage, you would not have a
single cent left to yourself.
Although the house has gone down in value by only 10
percent, quite a modest and possible decline, you would have
lost the entire total of your money.
Your loss in this example would be 100 percent.
Things can become even worse, however. Should the
value of the house fall by another 10 percent, then not only
have you lost all your own money, but you are actually have
negative net assets of 10,000 dollars!
It is important keep this in mind, Kate. This is why you
should never gear highly if there is a chance that you could
be forced to sell within a few years."
Kate pondered John's words solemnly. He had illustrated
the concept clearly, and the potential for profits or loss was
"I have used an example of a house, as this is the most
common example of gearing, and one that most people could
relate to. Properly used, gearing can improve your profits for
a modest increase in risk. The critical factor is the amount of
borrowings. The higher the borrowings, the higher the risk
and the higher the potential for profit.
As I have already said many times, though, we are not in
the business of taking large risks. The wise investor takes
modest, well-planned risks for a consistent increase in
wealth, and avoids large risks altogether.