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In my Margin is a Double-Edged Sword and Investing Using Margin Debt Leaves You Vulnerable articles, I touched upon the risks of employing the use of margin debt for investment purposes.
Margin investing is the practice of borrowing money from a brokerage firm to make investments. Traders tap this to increase buying power and then repay the sum borrowed at a later date of their choosing.
I continue to believe that buying equities on margin is a terrible idea for many investors. I am, however, slowly coming around to the possibility of personally employing debt to buy equities.
Allow me to explain.
The Case for Buying Equities on Margin
I have just read Life-Cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk. This is a working paper completed for The National Bureau of Economic Research.
One author is Ian Ayres is an economist, a lawyer, and the William K. Townsend Professor at Yale Law School. The other is Barry Nalebuff is the Milton Steinbach Professor of Economics and Management at Yale School of Management.
Clearly, the authors do not reach their levels in academia by postulating ridiculous theories/concepts so I kept an open mind in reading their 2008 research paper.
In a nutshell, the findings of this study are that:
'Borrowing on margin creates a risk that the savings will be entirely lost. That risk is related to the extent of leverage. If portfolios were leveraged 20 to 1, as we do with real estate, this risk would be significant. We propose maximum leverage of 2:1. It is worth emphasizing that we are only proposing this amount of leverage at an early stage of life. Thus, investors only face the risk of wiping out their current investments when they are still young and will have a chance to rebuild. Present savings might be extinguished, but the present value of future savings will never be. Our simulations account for this possibility and even so, we find that the minimum return under the strategies with initially leveraged positions would be substantially higher compared to the minimum under traditional investment strategies.'
Interestingly, these professors propose maximum 2:1 leverage. This means you can borrow twice the amount of your investment from your broker. Let's say, for example, you want to invest $100,000 in equities but only have $50,000 in your trading account. Using leverage, you could buy on margin at 2:1 thus giving you $100,000 to invest.
Factors for Consideration
Although I agree to some extent with Professors Ayle and Nalebuff, theory and reality often collide. Buying stock on margin can work wonders but many investors contemplating the use of margin debt to buy equities might change their perspective when they consider the following.
Degree of Investment Knowledge
Know Your Client (KYC) refers to the essential requirement that an investment advisor (IA) or representative obtain information about each client that is necessary to allow them to offer financial advice and services suitable to the client's individual needs and objectives. If we do not meet the requirements for a margin account then we need to seek other sources of leverage.
Some investors drawdown on a line of credit to fund their investment accounts. There are various advantages/disadvantages to this strategy with the obvious advantage being that there will be no margin call if the value of the investments declines.
A drawback to this funding strategy is this credit facility may impact future borrowing requirements. Lenders take into consideration credit facilities already in effect when subsequent credit applications are made for a mortgage, personal loan, and small business loan purposes.
Investment Time Horizon
I think investors need to approach investing in equities from a 'business ownership' perspective. In essence, when we invest in equities we should be thinking long-term. This is even more critical when we employ the use of debt to buy equities.
Risk Tolerance
Investors need to be mentally prepared to withstand volatility. Regrettably, some investors think they can tolerate a significant reduction in the share price of their holdings when they initiate their positions. This risk tolerance level, however, miraculously changes when the 'rubber hits the road'.
I witnessed many investors panic in mid-October 1987, during the bursting of the dot.com bubble, the height of the Financial Crisis, late February/early March 2020. Rather than being in a position to buy during these periods, many investors were unloading equity positions at the worst possible time.
Quality of the Investments
Employing debt to buy equities means we are employing a more elevated level of risk than investors who acquire identical investments using no leverage. It, therefore, stands to reason that we might want to dial back the risk level of our investments. I pay particularly close attention to the credit ratings assigned to the companies in which I invest and do not invest in non-investment grade companies.
Security and Stability of Income
All goes well until it doesn't! Before we consider employing debt to buy equities we need to ask what would happen if our source of income to repay the debt were to suddenly terminate and the value of our equities plummetted. I have witnessed many people who suffered catastrophic losses because stuff went bad at the worst possible time.
Other Financial Obligations
Envision yourself employing debt to buy equities. Fast forward into the future when you want to purchase a home, start a family, start a business, etc... Will you be in a position to repay all, or at the very least, a significant percentage of the margin debt before some of these major life events occur?
Buffett and Munger on Buying Equities on Margin
At a Berkshire Hathaway AGM, Buffett and Munger explained their position on leverage and borrowed money in business and investment.
These sophisticated investors do NOT borrow on margin. They do, however, employ the use of debt where the conditions of credit do not hinge on the underlying performance of the equities they acquire.
On page 68 and 69 in Warren Buffett’s Comments on Inflation, Buffett states:
'One further aspect of our debt policy deserves comment: Unlike many in the business world, we prefer to finance in anticipation of need rather than in reaction to it. A business obtains the best financial results possible by managing both sides of its balance sheet well. This means obtaining the highest-possible return on assets and the lowest possible cost on liabilities. It would be convenient if opportunities for intelligent action on both fronts coincided. However, reason tells us that just the opposite is likely to be the case: Tight money conditions, which translate into high costs for liabilities, will create the best opportunities for acquisitions, and cheap money will cause assets to be bid to the sky. Our conclusion: Action on the liability side should sometimes be taken independent of any action on the asset side.
Alas, what is "tight" and "cheap" money is far from clear at any particular time. We have no ability to forecast interest rates and - maintaining our usual open-minded spirit - believe that no one else can. Therefore, we simply borrow when conditions seem non-oppressive and hope that we will later find intelligent expansion or acquisition opportunities, which - as we have said - are most likely to pop up when conditions in the debt market are clearly oppressive. Our basic principle is that if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun.'
Conditions I Require to Employ Debt to Buy Equities
I am receptive to employing debt to buy equities under certain conditions.
- I need to be reasonably confident the companies in which I acquire shares on margin have a very strong probability of being far more valuable in the future.
- Use debt sparingly. I would never use a 2:1 ratio as proposed in the Life-Cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk research paper.
- A 100% loss on the investments I acquire using debt would be immaterial from a 'big picture' perspective.
- The companies in which I invest must be investment grade.
- Valuation levels must be attractive.
- Investment income generated from other investments MUST be sufficient to service the interest and loan repayment obligations. I must not rely on the income generated from the equities acquired through the use of debt.
- The spread between my interest cost and the potential investment return must be very attractive.
In essence, my philosophy on the use of debt to buy equities is the same as Buffett's and Munger's.
Final Thoughts
In theory, buying stock on margin can work wonders but I think it is a terrible idea. Too many investors suffer financial losses and mental stress because of the use of margin debt.
I am, however, receptive to employing debt to buy equities but the conditions presented must be met.
I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I do not know your circumstances and am not providing individualized advice or recommendations. You should not make any investment decision without conducting your research and due diligence.
I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with the company mentioned in this article.
