Best of the Week
Most Popular
1.The Brexit War! EU Fearing Collapse Set to Stoke Scottish Independence Proxy War - Nadeem_Walayat
2.London Terror Attack Red Herring, Real Issue is Age of Reason vs Religion - Nadeem_Walayat
3.The BrExit War, Game Theory Strategy for What UK Should Do to Win - Nadeem_Walayat
4.Goldman Sachs Backing A Copper Boom In 2017 - OilPrice_Com
5.Trump to Fire 50 US Cruise Missiles To Erase Syrian Chemical Attack Air Base, China Next? - Nadeem_Walayat
6.US Stock Market Consolidation Time - Rambus_Chartology
7.Stock Market Investors Stupid is as Stupid Goes - James_Quinn
8.Gold in Fed Interest Rate Hike Cycles- Zeal_LLC
9.The BrExit War - Britain Intelligence Super Power Covert War With the EU - Nadeem_Walayat
10.Marc Faber: Euro to Strengthen, Dollar to Weaken, Gold and Emerging Markets to Outperform - MoneyMetals
Last 7 days
Google Panics and KILLS YouTube to Appease Mainstream Media and Corporate Advertisers - 25th Apr 17
Gold Price Is 1% Shy of Ripping Higher - 25th Apr 17
Exchange-Traded Funds Make Decisions Easy - 25th Apr 17
Trump Is Among The Institutionally Weakest National Leaders In The World - 25th Apr 17
3 Maps That Explain the Geopolitics of Nuclear Weapons - 25th Apr 17
Risk on Stock Market French Election Euphoria - 24th Apr 17
Fear Campaign Against Americans Continues Nuclear Attack Drills in New York City - 24th Apr 17
Is the Stock Market Bounce Over? - 24th Apr 17
This Could Be One Of the Biggest Winners Of The Electric Car Boom - 24th Apr 17
Le Pen Shifts Political Landscape- The Rise of New French Gaullism  - 24th Apr 17
IMF Says Austerity Is Over - Surplus or Stimulus - 24th Apr 17
EURUSD at a Critical Point in Wave Structure - 23rd Apr 17
Stock Market Grand Super Cycle Overview While SPX Correction Continues - 23rd Apr 17
Robert Prechter Talks About Elliott Waves and His New Book - 23rd Apr 17
Le Pen, Melenchon French Election Stock, Bond and Euro Markets Crash - 22nd Apr 17
Why You Are Not An Investor - 22nd Apr 17
Gold Price Upleg Momentum Building - 22nd Apr 17
Why Now Gold and Silver Precious Metals? - 22nd Apr 17
4 Maps That Signal Central Asia Is at Risk of War - 22nd Apr 17
5 Key Steps For A Comfortable Retirement From Former Wall Street Trader - 22nd Apr 17
Can Marine Le Pen Win? French Presidential Election Forecast 2017 - 21st Apr 17
Why Stock Market Investors May Soon Be In For A Rude Awakening - 21st Apr 17
Median US Household’s Wealth Has Declined by 40% Since 2007 - 21st Apr 17
Silver, Platinum and Palladium as Investments – Research Shows Diversification Benefit - 21st Apr 17
U.S. Stock Market and Gold, Post Tomahawks and MOAB - 21st Apr 17
An In Depth Look at the Precious Metals Complex - 20th Apr 17
The Real Story of China’s Strong First-Quarter Growth - 20th Apr 17
3 Types Of Life-Changing Crisis That Make You Wish You Had Some Gold - 20th Apr 17
The Truth is a Dangerous Thing - 20th Apr 17
2 Choke Points That Threaten Oil Trade Between Persian Gulf And East Asia - 20th Apr 17
Gold’s Next Downside Target Is Around $700… Even if It Breaks Up First - 19th Apr 17
SPX May be Completing its Corrective Pattern - 19th Apr 17
Silver Production Has “Huge Decline” In 2nd Largest Producer Peru - 19th Apr 17
Soothing East Asia's Nerves as Trump's Administration Reaffirms US Power in Asia-Pacific - 19th Apr 17
The Brexit War - Article 50 Triggered, General Election 2017 Called - Let the Games Begin! - 19th Apr 17

Market Oracle FREE Newsletter

Why 95% of Traders Fail

Should You Invest with Borrowed Money?

InvestorEducation / Learning to Invest Jul 23, 2013 - 03:39 PM GMT

By: Don_Miller

InvestorEducation

It’s high time investors heed the yellow caution flags waving in front of their margin accounts. Much like the NASCAR driver who pumps his brakes to avoid disaster when he sees the caution flag, it's time for us to slow down. My friend and colleague Ed Steer, editor of Ed Steer's Gold & Silver Daily, recently highlighted a must-read Wall Street Journal blog post focusing on the record-high levels of margin debt, and it sure made me pause to think.


For those unfamiliar with margin accounts, here's an explanation in a nutshell: margin debt is money you borrow from your brokerage based on your investments and the balance in your account. In the US, one can legally only borrow up to a 50% margin. For the sake of illustration, assume a hypothetical investor (let's call him "John") buys $100,000 of a stock. If John has a signed margin agreement with his broker, he can borrow 50% of that amount from the brokerage. That means that John only needs $50,000 to purchase the full $100,000 of stock. Of course, he also pays interest on his loan.

If the stock increases 10%, John has $110,000, earning a $10,000 profit. Based on his original balance of $50,000, that's a 20% return on his initial capital. This is the way in which margin leverages an account. Furthermore, John could use his new equity to leverage himself even more – the more the stock increases, the more debt he can pile on for yet more risk and leverage.

But what happens when the price of one of John's stocks drops? The losses are similarly doubled as well. Furthermore, if John's equity reaches the maintenance margin, his broker will issue a margin call, and he will have to come up with the cash immediately to meet the minimum level of the maintenance margin. The maintenance margin is also a percentage and varies from broker to broker. If John can't come up with the money, his broker has the right to sell part or all of his stock at its current price to bring his account back within the margin requirements.

Margin debt is a unique sort of loan:

  • The interest rate is changed by the lender (in this case the broker), and fluctuates with the current cost of money.
  • The amount one can borrow fluctuates minute by minute as stock prices rise and fall.
  • The broker can take an investor out of his equity position at its discretion, and sell his stock at the worst possible time if he goes outside of the agreed-upon margin requirements.
  • The Securities and Exchange Commission sets the maximum margin requirements and can change them at will. Brokers and their customers must comply immediately.
  • Investors can pay off the loan by selling their stock. Their broker will deduct whatever amount was owed at the time of sale.

Now, why are more investors borrowing increasing amounts against their investment accounts? The author of the WSJ post had one suggestion: "Some see the increase as a sign of speculation, particularly if the borrowed money is reinvested in stocks."

If investing in stocks is not speculative enough for you, you can add to the excitement (and your blood pressure) by speculating with borrowed money. The time to do that is when you have a "sure thing" – an investment that you just know is going to skyrocket. I've been there before and learned my lesson the hard way.

The Sure Thing: Don't Bet the Farm

In 1977, I moved to Atlanta. One of the coaches of my son's baseball team worked for Scientific Atlanta, a hot new technology company at the time. He kept touting the company's stock, and we watched it go from $16 to $32 per share and split twice in a fairly short time period. He convinced me it was a great opportunity.

I took out a second mortgage on my house, borrowed $32,000, and bought 1,000 shares. I figured it would split and double, and I could quickly pay off the mortgage. I would be playing on the house's money, so to speak.

I was right about one thing: the stock was soon selling for $16 per share, but not because it had split. The price dropped in half because they were having serious production problems with one of their main products. Eventually, I sold it off, paid off part of the second mortgage, and cussed at myself for being greedy and stupid for the next several years as I wrote checks to pay off the balance of the loan. I was playing on the house's money all right – my house!

I'm sure we have all heard the stock market described as a house of cards. The increasing level of margin debt is certainly a prime example. Retirees are pouring money into the market because really, there are few other options left for finding decent yield. Now we're learning that the number of stocks bought on margin is at a record high, meaning a lot of those stocks were purchased with borrowed money. In turn, this has helped push the stock market to all-time highs.

Hello! Does anyone remember the Internet boom… and bust? How about the market crash when real estate prices plummeted?

A sudden dip in the stock market would mean an awful lot of margin calls. More than likely, few folks would have enough spare cash to put up the additional capital requirements. Brokerage firms would then enter sell orders, at market price, to bring their clients' accounts back in balance. Those massive sell orders would drive prices down further, causing more sell orders, and soon it would be a full-blown crash. Boom! Just like a house of cards tumbling to the ground.

And what happens to the retiree who had invested his life savings, hoping to watch it appreciate while collecting dividends in the process? You know, we old people who bought our stocks with real money, the kind we earned and saved – not the borrowed kind. Our account balances will plummet right along with those of the market speculators. The only difference is that we won't have the opportunity to recover.

The Solution for Conservative Investors

Retirees and other conservative investors can protect themselves with a multipronged approach. First, diversification – a topic Vedran Vuk, senior analyst, and I covered at length in the April 2013 issue of Miller's Money Forever – will help prevent a total wipeout. And while the market may crash, there are still many solid companies making plenty of money and paying fine dividends. Those companies usually rebound much more quickly from a crash or downturn than speculative investments do.

Second, stop losses can limit the damage. Stocks don't all fall at the same rate when the market drops. Many big-name companies owned by pension funds pay good dividends and are less likely to be sold, even in a rapid down cycle.

In addition, the Money Forever team also recommends having at least 30-35% of your portfolio in cash and short-term, near-cash instruments. Those contrarians with the courage to buy good companies when others are selling may find themselves in the buying opportunity of a lifetime. If you're one of these folks and you have the cash to buy, you can profit in a down market.

In short, survival comes down to limiting exposure, allocating capital properly, and controlling our emotions. Panic is our worst enemy when times get tough.

I was 37 when I gambled with that second mortgage, and I have had 35 years to recover from it. Investors near the retirement cusp cannot afford to borrow money to speculate; the risks are just too high. At this point in life, we have learned the hard lessons. For seniors and folks approaching retirement, preservation and return of capital always trumps return on capital.

At Money Forever, we cover almost every topic under the sun when it comes to the financial risks facing retirees and those planning for retirement. Whether it's margin debt, annuities, reverse mortgages, peer-to-peer lending, under-the-radar income investments, or just finding some good, high-dividend-paying stocks, we leave no stone unturned. Our unique monthly income strategy is being used by thousands of investors and is a good way to start adding to your income stream almost immediately. Click here to find out how you can start it today with as little or as much as you want to put into it.

© 2013 Copyright Casey Research - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

Casey Research Archive

© 2005-2016 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife