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 multi-pronged 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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.