During the past nine years of a rising stock market, investors have juiced their gains by buying on margin. Buyer beware, those gains could be wiped out in an instant.
The amount of money at risk is staggering. Retail and institutional investors have borrowed a record $642.8 billion against their portfolios as they try to pocket bigger gains by ramping up exposure to stocks, according to a recent alert from the Financial Industry Regulatory Authority, or FINRA.
Unfortunately, those investors were left wide open and exposed when the Dow tumbled more than 1,000 points during two separate sessions. A slew of margin calls by brokerage firms erased years of gains and then some.
Here’s why borrowing on margin can be so dangerous, according to a recent scenario in the Wall Street Journal.
When using a margin loan, an investor would pledge all or part of a portfolio of stocks and bonds as collateral to buy other securities. If the value of the collateral shrinks enough, which tends to depend on the mix of investments that are pledged, the bank can demand repayment. If the margin call isn’t met, the securities backing the loan are sold and the borrower is responsible for any remaining balance.
The so-called net margin debt was worth 1.31% of the total value of the New York Stock Exchange last year, according to Goldman Sachs data stretching back to 1980, eclipsing the previous peak of 1.27% reached in the buildup to the tech bubble in 2000.
The Journal also noted that lending against securities is a key profit center for brokerage firms. They charge interest on the margin loans and can also factor into brokers’ compensation, incentivizing many to extend money to clients regardless of whether they need it or not.
An important area of easy profits for securities houses? Brokers being incentivized by cash to make risky bets for clients? What could go wrong?
After the total value of margin loans broke $600 billion for the first time, FINRA issued a warning saying that “investors may be underestimating the risks of trading on margin and may not understand how margin calls work.”
FINRA also expressed concern that “many investors may misunderstand the operation of, and reason for, margin calls. Investors who cannot satisfy margin calls can have large portions of their accounts liquidated under unfavorable market conditions. These liquidations can create substantial losses for investors.”
A similar warning was issued by famed investor Warren Buffett in his latest letter to Berkshire Hathaway shareholders.
Buffett warned his disciples that using borrowed cash to buy stocks, or buying on margin, is a risky proposition for individual investors. Why? It can amplify losses when stocks plunge and cause you to panic.
“There is simply no telling how far stocks can fall in a short period,” Buffett reasoned. “Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.”
Investors are learning that the law of gravity indeed applies to their stock portfolios and that the use of leverage can accelerate declines. Take Warren Buffett’s advice. It’s sheer folly to borrow money to buy stocks.
Zamansky LLC is a New York law firm which represents investors in court and arbitration cases against securities brokerage firms and issuers. The firm may represent investors in cases against companies mentioned in this blog.
Zamansky LLC also represents investors in arbitration cases against UBS and other brokerage firms regarding Puerto Rico bonds and UBS closed end bond funds and other investments.