Buying stocks on margin can seem like a great strategy -- while the market is going up. However, when stocks plunge, it can be your worst enemy. Here's why smart investors avoid debt and keep some financial flexibility.
A full transcript follows the video.
This video was recorded on Feb. 26, 2018.
Michael Douglass: Let's hop into our next commentary here. Even though he has run a conservative business, frankly, Berkshire (NYSE:BRK-A) (NYSE:BRK-B) has swung pretty widely a few times. It's had four major crashes across its history. And one of his comments there is, hey, this is a sign. Even with Berkshire, even with as big and blue-chippy and as safe a stock as Berkshire Hathaway stock has historically been, it still had some major price swings. You probably shouldn't be borrowing money to invest, because if you do, this is when really bad things can start happening.
Matt Frankel: He also said, "This will happen again." Not "this might." "This will happen again. Do not borrow money to buy stocks." The problem with borrowing money to buy stocks, generally, with margin, you can buy twice the value of stocks as you have cash in your account. So, when a stock drops by more than 50%, you could actually wind up owing money if you're leveraged to the max to buy this stock in the first place. It could literally wipe out your portfolio, whereas if you just bought what you could afford, over time, that's always come back and then some. The big problem with margin is also that you can't take advantage of opportunities as they come up. Buffett, points out, we already talked about his cash, that they like to keep at least $20 billion on hand at all times. Which to them is like you or me keeping $1,000 in the bank.
Douglass: [laughs] Right.
Frankel: [laughs] But, the reason they do that is so that when the market crashes like that, or even Berkshire stock crashes like that, they can take advantage, buying the companies they've been following at a discount, buying whole companies that, when M&A activity dries up, they're flush with money so then they get the best deals, buying their own stock back at a discount after it falls by 60% during the financial crisis. So, it's not only avoiding debt to avoid financial ruin. It's avoiding debt so you have financial flexibility when things do go bad.
Douglass: Yeah. I would double underline that. I personally have about 30%, maybe 25%, of my portfolio in cash, so far basically at all times, because I've been an investor only during this massive bull market. And at some point, things get ugly. And when that happens, those who have cash on hand can disproportionately benefit. Now, will I also probably start eating ramen during that time so I can put even more money into the market? Probably. [laughs] But, at least this guarantees at least some money that I can start with then.
Frankel: I was a little bit older than Michael -- well, I am a little bit older than Michael.
Douglass: [laughs] Still are, yeah.
Frankel: Still am. I think I started investing in '02 or '03, so I was investing well before the financial crisis, through the bubble, beforehand. So, I saw firsthand. And I can tell you firsthand, I wish, wish I'd had more money to put in the market in late 2008, early 2009. I would be in a much different financial category today if I had really known what I know today and, like Michael said, would have eaten ramen and put all my money into the market during those periods where everyone was panicking and staying on the sidelines or, even worse, selling. Thankfully, I didn't do any selling, but I was one of the unfortunate few who stayed on the sidelines. But I didn't have a ton of debt, I hadn't bought on margin so I didn't have to sell my stocks at a fire sale, which is kind of what Buffett wants people to avoid.
Douglass: And to be clear, we're not endorsing any ramen [laughs] all the time.
Frankel: No, it's not very healthy.
Douglass: But every now and then. Particularly, when I can get a dinner for $0.25, sometimes it's hard to argue with that.
Matthew Frankel owns shares of Berkshire Hathaway (B shares). Michael Douglass owns shares of Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.