Time Magazine had an article about two university economists proclaiming that young people should go on margin when investing in stocks. They came to this determination after mining the 130-year set of historical data, and taking into consideration 45-year investment periods. They suggested a 2:1 ratio.
So for example, if you had $5,000 sitting in the bank, you should go and purchase $10,000 in stocks. I would not suggest this.
David Merkel (who incidentally writes probably one of the best pages on the internet regarding real-life economics) blasts the argument for many reasons. I want to elaborate on the first counter-point, mainly that mining historical data is not sufficient to determine a future course of action.
Whenever you walk into the office of a financial adviser (salesman) person at a retail bank, the most frequent chart you will see on the back wall is the Dow Jones composite index, roughly from 1900, in non-logarithmic format (designed to make the 1929 and 1987 market crashes look like nothing). They will usually give you a pitch how the stock market, on average, has gone up 9% (in nominal, not real terms) a year since eternity and therefore, your money should be invested in some equity fund that the adviser will presumably make a healthy commission selling.
The assumption that the markets will continue going up 9% a year in the long run is incorrect. If you believe this, you will lose money.
Throughout history, markets in countries have a frequent habit of collapsing. Around 1900, the top three capitalized stock markets were in the USA, United Kingdom and Russia. Not many people would have guessed Russia, but we all know what happened after – they were utterly destroyed after the Bolshevik revolution in World War 1. In fourth place was British India, and that country looks completely different (consisting now mainly of Pakistan, India, Bangladesh) than what it was back during the dying days of colonialism.
It is very difficult to predict whether the USA will still be around in 100 years, let alone compound market gains by 9% a year.
The other comment I will make with respect to buying stocks on margin is that even if you know what you are doing, it is very psychologically difficult to watch positions go underwater when on margin. Typically you will be receiving a good (low) price during periods of very intense volatility, and it is very unlikely that you will be receiving the “best possible” price had you looked at a chart 6 months in retrospect. There are far too numerous examples of this in my own life, but one was during the middle of the financial crisis in March 2009, when ING Group’s hybrid debt was cratering:
Recall that par value on the above issue is $25, and the coupon is 6.125% given out quarterly. Looking at my own trading records, I see I purchased shares between $6.26 and $4.70, which would have equated to a 24.5% to 32.6% annual yield (assuming they do not default). The best price I could have received is $2.83, or a whopping 54% annual yield! Looking at the chart it is very easy to say “Sacha, why didn’t you put your life savings on margin into the thing at $2.83/share?” – in retrospect, I would have loved to, but there are a few complexities to take into consideration:
1. When you place your order, you implicitly acknowledge that it will likely go lower before it goes higher;
2. You have no idea how low the low will be.
3. If the issuer defaults, you are in deep do-do.
Now, I remember when placing my order that I thought I was already getting a good deal, but underestimated, by some 40%, the extent to which the market was willing to take this thing down.
Imagine if I had the snippet of knowledge that on April 16, 2010 that this would be trading at $18.91 a pop and went on 2:1 margin at a price of $4.70/share. I would have had my account liquidated on a margin call well before the bottom was reached. Even if I knew what the “true value” of something was, by using excessive margin, you are giving the market the ability to wipe out your investment before you can realize its true value. For stable asset pricing and stable yields, the argument to use margin is more coherent, but when you introduce volatility, margin will absolutely kill you.
This was a one-security case, but even when diversifying the portfolio a bit, you still would not have been able to avoid margin call issues simply because the whole market was being flushed in March 2009.
Telling young people to employ margin based on historical market data analysis is absolutely foolhardy and will only result in losses. It is difficult enough to be able to invest in equities and doing it on margin will just compound the agony even if you’ve done your research correctly and have a general idea that you are purchasing stocks below their fair value.
So for my final parting shot of the day, when a young person buys a condominium and makes a 10% down payment, and mortgages the rest, they are making a 9:1 leveraged bet on their concrete box in the sky. Does the past 10 years of Canadian real estate price history data suggest that you should be making the minimum 5% down payment and go on 19:1 margin?
The following quotation is golden advice:
One final note: when I wrote at RealMoney, I took a contrarian view that for average investors, no one should be fully invested. Even the great Ben Graham never exceeded 75% invested. My view is that average people must limit their risks or they will not be able to sustain their investment plans. A 50/50 or 60/40 balanced fund approach is best for the average person — they will never get scared enough to abandon it.
By always keeping some black powder in the keg, you will be able to pounce on opportunities that others cannot because of their leveraged circumstances. Late 2008 and early 2009 was a time to be doing this, and there will be times in the future where keeping a stack of cash will be of great benefit. I don’t sense that “now” is one of those times to be deploying cash, but certainly if we are in a 1970’s type market, we will be seeing 30-40% market gyrations both to the upside and downside.