Urgent: Investors Must Avoid Margin Ditch
Below is a recent article published by Securities Attorney Jake Zamansky on Forbes.com - 09/27/12
As the stock market has risen from the depths of the financial crisis, only after destroying the retirement savings of countless Americans, so has a potential scourge: margin borrowing.
Margin loans at brokerage firms have risen to $162 billion, the highest level since the 2008 collapse of Lehman Brothers, as Jason Zweig pointed out last week in the WSJ. Investors on margin at that time were wiped out at the bottom of the market and didn’t share in the recent recovery.
Come to think of it, the same thing happened in 2000 when a flood of investors borrowed on their tech stock paper profits, only to see their portfolios melt when the tech bubble burst.
Zweig noted: “When you use margin, you merely appear to be borrowing from yourself. Instead, you are borrowing from one of the most unstable and unreliable lenders imaginable: Mr. Market, that personification of investors everywhere, sometimes euphoric, sometimes miserable, never predictable.”
Maybe he should have said never, ever in a thousand years predictable.
Zweig continued, detailing the perils of borrowing on margin: “If Mr. Market trashes your investments in a sudden panic, your margin debts may be ‘called,’ forcing you to sell some of your assets to sustain the minimum account values you committed to under the terms of the loan. By definition, margin calls are most likely to come just as the prices of the holdings you borrowed against are in free-fall.”
This is an ominous warning from one of the most respected financial writers in the country. And, on top of the spike in margin debt by investors, new research by market participants highlights the dangers of playing the market with borrowed money.
According to Mr. Zweig, the hazards of investing with borrowed money are spelled out by two investment advisors, Bruce Jacobs and Kenneth Levy.
Modern portfolio theory-the formula for diversification developed in the 1950s by economist Harry Markowitz, who later won the Nobel Prize for his breakthrough-needs an urgent updating to account for the devastation that can be wrought by borrowed money, according to Zweig. And the great majority of investment advisers claim they base decisions on this theory, which falls short when it comes to accounting for the risk of borrowed money.
“Conventional portfolio theory says not to hold all your eggs in one basket,” Jacobs told Zweig. What that misses, according to Jacobs, is that “using leverage is like piling baskets of eggs on top of one another until the pile becomes unsteady. Borrowed money can make even an optimally diversified-and theoretically ’safe’-portfolio risky.”
Is this another instance of history repeating itself?
The similarity to 2000 is unmistakable. Unfortunately, there’s a horde of hungry stockbrokers pushing their clients to double down, shouting to buy twice as much Apple or Google stock, or to take money out of their accounts and treat themselves. Apparently they think this is a reasonable substitute for home equity lines of credit, since investors can no longer take equity out of their homes for cars, trips, and the like.
Investors need to resist this pitch lest they end up in the ditch again.
Disclosure: Zamansky & Associates are securities attorneys representing investors in federal and state litigation and arbitration against financial institutions, including brokerages.
Read article by New York Securities Attorney Jake Zamansky on Forbes.com