Double Gearing Explained: Risks & Rewards of Leveraged Stock Investing

Double gearing refers to the practice of borrowing money against an asset, with the money being used to buy shares of stock. Then, more money is borrowed against the shares to establish a margin loan that can be used to purchase even more shares. In short, double gearing is a form of leveraged investing.

Basically, it means the investor burdens himself with a significant amount of debt. The risk? The best case scenario is the investor recovers more than enough to pay back the borrowed funds. In the worst case situation, the investor loses, can’t repay his debts, and ends up underwater.

Summary

• Double gearing is a high risk, high reward strategy
• Double-geared investors set themselves up to become overburdened by debt that they cannot pay back unless they generate optimum returns
• Double gearing is best suited to experienced investors

Responsibility of Lenders

It is widely believed that double gearing can be eliminated, or, at least, the danger to investors limited if lenders do their due diligence and don’t over-supply investors with loans.

If lenders let their clients take on too much risk, it’s irresponsible for the sake of the client but also for the lender. A client who becomes overburdened by borrowing may end up being unable to pay back the lender in a timely way. In some cases, they may never be able to pay the lender back.

Therefore, it’s critical that lenders do their due diligenceDue DiligenceDue diligence is a process of verification, investigation, or audit of a potential deal or investment opportunity to confirm all relevant facts and financial information, and to verify anything else that was brought up during an M&A deal or investment process.  Due diligence is completed before a deal closes.. Double check a client’s credit, how many loans they’ve taken out in the past, how quickly they’ve paid those loans back, and how many loans they already have at the time they attempt to take out another. Double geared loans can be dangerous for the client and to the lender.

Double Gearing Between Companies

Between companies, double gearing looks slightly different. At least two companies pool their capitalCapitalCapital is anything that increases one’s ability to generate value. It can be used to increase value across a wide range of categories, such as financial, social, physical, intellectual, etc. In business and economics, the two most common types of capital are financial and human. in order to mitigate risk. The companies often loan money to one another to fund different investment projects, purchases, and the like. It can cause a shift in the perception of the health of said companies because it skews their accounts and tends to make them look more profitable or financially sound than they actually are.

The practice is common among complexly structured corporations. Often, it involves a parent company and its subsidiaries, each with their own balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting., but often funding one another’s purchases and investments. The loaning between such companies can result in the borrowing company becoming overly burdened with debt.

Major Risks of Double Gearing

The two primary risks related to double gearing are the following:

1. Double gearing is a high-risk strategy with the goal of gaining a still higher reward. More investments mean the potential for greater returns. However, as with any leveraged sort of investment, it also magnifies the potential for serious losses.
2. If the anticipated returns are not generated, the double-geared investor won’t make any profit on his investments, and he may not be able to repay his loan.

Double gearing is an incredibly risky strategy of borrowing to make purchases that can be borrowed against or used as collateralCollateralCollateral is an asset or property that an individual or entity offers to a lender as security for a loan. It is used as a way to obtain a loan, acting as a protection against potential loss for the lender should the borrower default in his payments. to borrow even more. The potential for higher than normal returns is present; however, the borrower can become overburdened by his debt. It is a strategy best used sparingly and only by experienced investors.

Related Readings

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• BankruptcyBankruptcyBankruptcy is the legal status of a human or a non-human entity (a firm or a government agency) that is unable to repay its outstanding debts
• Credit EventCredit EventA credit event refers to a negative change in the credit standing of a borrower that triggers a contingent payment in a credit default swap (CDS). It occurs when an individual or organization defaults on its debt and is unable to comply with the terms of the contract entered, triggering a credit derivative such as a credit default swap.
• Revolving DebtRevolving DebtA revolving debt (a "revolver", also sometimes known as a line of credit, or LOC) does not feature fixed monthly payments. It differs from a fixed payment or term loan that has a guaranteed balance and payment structure. Instead, the payments of revolving debt are based on the balance of credit every month.
• Stockholders EquityStockholders EquityStockholders Equity (also known as Shareholders Equity) is an account on a company's balance sheet that consists of share capital plus