|Contributed by: martingale |
Most people believe that buying stocks on margin is a silly thing to do: Everybody knows you might get a margin call that turns your heavily margined position into pocket change. The guys who jumped off buildings in the 1929 market crash were mostly margin traders--not smart, right? You'd never do that, right? Yet many of you are closet margin traders! You've mortgaged your home to the hilt, and you've risked the borrowed money in the equity market. You pretend it isn't margin trading, but it is: You are taking on the same risks that sent people hurtling from buildings in 1929. This is a wake up call: Please understand the risks you are taking. This is an especially urgent call at a time when many suspect we're in the midsts of a real estate bubble.
Many people have heard that trading on margin is risky, but they don't understand exactly how or why. Let's work through an example, it is a fairly simple concept, and one you should understand well. Let's take the case of an investor with a net worth of $400 in three situations: without any borrowing, borrowing from a broker (margin), and borrowing from a banker (mortgage). We'll look at what happens in each case when the market suffers a downturn in which equities and homes lose 20% of their value.
$400k invested without borrowing at all:
You own a home outright for $300k and invest a further $100k in the stock market. A recession arrives, and asset values decline by 20%. Your home is now worth $240k and your market position is worth $80k. You've suffered a 20% loss of capital, but decide to sit tight and wait for asset values to recover. Que sera sera. Your net worth is $320k.
$400k leveraged, borrowing from your broker (margin):
You own a $300k home and you've got a further $100k to invest. Your broker will allow you to buy stocks with just 25% down, so you buy $400k worth of shares, borrowing $300k from your broker. When asset values decline by 20% your home falls to $240k and your equities fall to $320k. You get a margin call and your broker sells off $240k worth of your position to return you to 25% down. You now have a home worth $240k, $80k in the market, and a $60k margin loan. Your net worth is $260k.
$400k leveraged, borrowing from your banker (mortgage):
You buy a $400k home outright, but then mortgage it 75% investing the $300k proceeds the stock market. When the recession arrives your home falls to $320k while your shares decline to $240k. Your decide to hold tight, but when your mortgage comes due your banker notices you owe $300k on a $320k home. Your banker demands a minimum 25% down, or $80k, but you only have $20k in equity. You're forced to sell off $60k in stocks to come up with the cash, so you now have $180k in the stock market, a $320k home, and a $240k mortgage. Your net worth is $260k.
Actually, the mortgage and margin investors fare even worse than I have indicated above. In addition to their losses in the market, they also owe interest on their respective loans. In a year when the market goes up they can pay that interest from the proceeds of their investments; but when the market declines they've got to pay that interest out of pocket. Possibly some of it will be offset by dividend or interest income; or possibly dividends will be cut as well.
Leverage cuts both ways. If you use $100k to back a $200k investment then you double your gains if the investment rises in value: A 20% gain becomes a 40% gain. But, it works the other way too--a 20% loss becomes a 40% loss. That is why borrowing to invest is called "leverage"--the debt you take on acts like a lever, magnifying the effect of any market swing, good or bad.
Here is the fundamental point I want to make:
Taking out a mortgage loan and using the proceeds to invest in the stock market, or investing in the stock market rather than repaying a mortgage loan, is tantamount to trading on margin. You take all the same risks as a margin trader, just in slow motion. The only real difference is that you'll get the margin call in days, whereas it'll take months or years for your banker to get around to demanding an additional down payment. When you take a margin position a downturn will run over you like a high speed train. In the mortgage case, the downturn will steam roll over you in slow motion. Either way you get squished.
It is true that it is generally a bit safer to leverage with a mortgage than with a margin loan. In the above example, the margin investor was required to liquidate $240k worth of stocks, but the mortgage investor was required to liquidate just $60k. The mortgage investor stands a slightly better chance of being able to wait out the downturn, having liquidated fewer securities--the margin investor realized more of the loss up front.
It is also true that a little leverage can be a good idea. Young investors probably ought to take on a few extra risks, as they can recover from any losses. The problem I see these days is that a lot of people are doing this apparently without understanding the risks. It is never a good idea to take on a risk you do not understand---everyone should have a clear understanding of the risks inherent in their investment strategy.
From a long-term investment standpoint your net worth has fallen by the same amount in either case. The mortgage and margin investors are both worth just $260k, while the unleveraged investor who didn't borrow has retained $320k worth of capital. Sometimes you are forced to liquidate your position for unexpected reasons--you get a new job and move to a new city, or a child goes to college, or any number of unexpected life events. In the end, if your net worth is $260k it is $260k--you cannot always wait for the long term.
Whether you leverage with a margin loan or a mortgage loan the leverage you use will magnify your losses (or gains) by the same amount.