Now, before I jump into several reasons for why I'm not a fan of margin anymore, I'd like to offer an interesting counter opinion from the poster child of long-term investing in stocks: Wharton professor Jeremy Siegel.
In his must-read book, Stocks for the Long Run, Siegel's chapter on risk and return includes a section (pp. 36-37 in the second edition) in which he searches for the optimal portfolio allocation between stocks and bonds based on nearly 200 years of historical data, running all the way from 1802 to 1996. Within that analysis, he breaks down investor temperaments among the following four categories of risk tolerance:
- Ultra-conservative -- demands maximum safety regardless of returns
- Conservative -- accepts small risks to achieve extra return
- Moderate -- accepts moderate risk in search of extra returns
- Aggressive -- accepts substantial risks in search of extra returns
What follows are Siegel's conclusions summarized in tabular form along with his commentary:
Portfolio Allocation -- Percentage of Portfolio in Stocks Based on All Historical Data:
Risk Holding Period Tolerance 1 year 5 years 10 years 30 years Ultra-conservative 7.0% 25.0% 40.6% 71.3% Conservative 25.0% 42.4% 61.3% 89.7% Moderate 50.0% 62.7% 86.0% 112.9% Aggressive 75.0% 77.0% 104.3% 131.5%"The recommended equity allocation increases dramatically as the holding period lengthens. The analysis indicates that, based on the historical returns on stocks and bonds, ultra-conservative investors should hold nearly three-quarters of their portfolio in stocks over 30-year holding periods. This allocation is justified since stocks are safer than bonds in terms of purchasing power over long periods of time. Conservative investors should have nearly 90% of their portfolio in stocks, while moderate and aggressive investors should have over 100 percent in equity. This allocation can be achieved by borrowing or leveraging an all-stock portfolio."
Looking back at the above table for a moment, I've bolded the three instances where 200 years of history says that an investor is best served by using margin to at least some extent. The conclusion I draw from the professor's data is that if you are: a) under 40 years of age; and b) enough of a risk-taker that you can tolerate a portfolio of individual stocks (as opposed to funds), then you most definitely should use a moderate degree of margin for your retirement savings. Agreed?
While I don't at all doubt the authenticity of Siegel's data, I actually disagree with the usefulness of his recommendations for the majority of investors. Here are my five reasons for why I won't ever again use margin:
1. Except for high net worth individuals, margin is typically too expensive.
Siegel's argument for the valid use of margin rests upon an unstated (as best as I could find in the text) interest cost. Regardless of his exact method of determining this cost, it surely doesn't match up with the real world, where margin lending rates vary widely. For small investors such as myself, the margin rate is usually the prime rate plus 1% or thereabouts. Here, for example, are the margin lending rates at the Rule Maker Portfolio's new home, American Express Brokerage:
With an average Rate as of debt balance of: 11/18/99 $0-$24,999 9.00% $25,000-$49,999 8.50% $50,000-$99,999 8.00% $100,000-above 7.50%On the whole, stocks have achieved an average annual return of 10.6% since 1926. If margin costs a minimum of 7.5%, the likely profit spread doesn't amount to much when you consider the risk incurred. And if you (like me) have to pay 9% for your margin dollars, then the deck is very much stacked in the broker's favor. Now, some of you out there might be thinking that 8 or 9% is small price to pay if you can get 20 or 30% returns on top of that. Hey, if you can pull it off, more power to you, but over an extended period time that strategy is likely to backfire.
The typically high cost of margin is my only quantitative rationale against its use. My other reasons are of a more psychological and practical nature.
2. Using margin tends to reduce investing discipline.
In many aspects of life, I find that we as people are more similar than not. And if you're anything like me, then margin turns your brokerage account into a game of Monopoly money. In contrast, a pure cash account only holds dollars that were earned through sweat, blood, and tears. The difficulty of attaining those precious savings helps an investor exercise scrupulous due diligence when choosing stocks. When it's real cash on the line -- cash that could be used for a new car, a home theater system, a weekend trip to someplace sunny and warm -- you're much more likely to only put that cash into the very best companies, those that represent a compelling long-term investment.
3. Margin can reduce an investor's fortitude to hold, hold, hold.
If you use margin very long, you'll undoubtedly learn that margin giveth, and margin taketh away -- in equal measure. In a bull market such as we have right now, using a little margin to juice returns seems like a pretty smart idea. But even in this bull run, I can vouch personally for margin's sting when there's a major sell-off, a la the corrections of October '97 and '98. Too much margin can force you to sell at the least opportune times, the times when you should be buying! Of course, Siegel only promotes the responsible use of a moderate amount of leverage. Even so, margin tends to be a slippery slope where a little margin here, a little there, and next thing you know, you're in the danger zone. Outside margin's noose, it's a heckuva lot easier to ride the ups and downs of long-term stock ownership.
4. You don't need margin!
Obviously, the attraction of using margin is its get-rich-quick appeal. But the oft-forgotten truth is that you don't need leverage to get rich with stocks. Just look at the Rule Breaker Portfolio and its 68% compounded annual return since mid-1994 -- without a lick of margin. Through a few good stock picks, the RB Port has turned $50,000 into more than $800,000. A less dramatic example would be the aforementioned 10.6% average annual return that U.S. stocks have amassed since 1926. That rate is good enough to turn $10,000 into $75,000 over 20 years. Again, margin is just one of the public markets' many seemingly tasty treats -- along with futures, options, and penny stocks -- that appeal to our sweet tooth of greed. But in the end, their taste proves bitter as gall.
5. The past is the past.
Even Siegel admits that his 200 years of historical evidence is just that -- history. Siegel quotes Nobel laureate and famous economist Paul Samuelson who said, "We have but one sample of history." Considering the weight of arguments against margin's use, I think Siegel's case for a leveraged portfolio is unconvincing. I'll sleep well at night with my retirement savings invested in a plain ol' unleveraged but fully-invested portfolio of well-selected stocks.
For more on the ins and outs of margin, check out our Fool FAQ on Margin.
One final note: If you're interested in participating on this week's Motley Fool Radio show, see this link and contact Mac Greer at email@example.com.
Good night and Fool on!
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