"Mortgage the house on this one, folks."
That was a post on the Yahoo! message boards from Aug. 10, 2006. The stock referenced had dropped nearly 50% since the beginning of the year, yet it had more than tripled its revenue year over year and looked to be on the verge of dominating its only competitor.
A seemingly enticing situation, we agree. And our poster was ready to go whole hog.
Bait ... and switch!
Plain and simple, there are no stocks worth betting the house on. If anyone tells you that, run in the opposite direction. That's because even "seemingly enticing situations" can turn out to be not so enticing after all. The stock in question with our Yahoo! poster was Sirius Satellite Radio, and along with those growing revenues, it had massive debt obligations, more than $1 billion in losses over the past year, and a troubling addiction to shareholder dilution.
So what has Sirius done since Aug. 10, 2006? Well, for one, it's merged with its close competitor to become Sirius XM Radio. It's also -- we hope you're sitting down for this -- dropped 97%. In other words, we're hoping our poster was speaking in hyperbole and isn't currently servicing the debt he took on to buy Sirius shares.
You guys are too much
We're not speaking in hyperbole here. More Americans are playing the market without realizing that they're assuming risks that can decimate their brokerage accounts, their savings accounts, and, yes, even their homes. According to recent NYSE data, margin debt stands near $200 billion -- off the all-time high it hit in the go-go times of summer 2007, but still quite high.
You can see the disaster lying in wait here. When folks are margined out, they get hit hard when the market sours -- particularly if they own stocks with triple-digit price-to-earnings ratios, or worse, triple-digit price-to-sales ratios.
Seriously, it happened
Recently, we happened on a painful post on our Motley Fool message boards written by a gentleman who maxed out his margin account in 2000 to buy shares of Celera as it fell.
Like our Sirius poster, he had the right idea. He wanted to make a big bet on a stock that he thought the market was treating unfairly.
Unfortunately, Celera also shared another trait with Sirius: It was losing more than $100 million each year.
That did not stop investors from buying big into Celera's plans to map the human genome. Optimism for the company was so great that, at its peak, shares sold for 263 times sales.
That's right: 263 times sales. For context, even a fast grower such as VMWare
We probably don't need to tell you how it ended for our poster or for anyone else who went whole hog on Celera in 2000. The company's stock chart tells the whole story.
You're better than that
While the Celera tale may be extreme, it's certainly not the only anecdote of its kind. That's why we advise you to adhere strictly to an investing philosophy that suits your goals, risk tolerance, and time frame -- even if you've happened across a so-called stock to bet the house on.
Because big margin bets one year ago on seemingly better-priced stocks such as Harley-Davidson
For example, here's what Fool co-founders and Stock Advisor analysts David and Tom Gardner recommend for any investor who is less than an expert:
- Diversify broadly.
- Invest new money on a regular basis.
- Wipe emotion from your decision-making.
- Expect mistakes.
- Scale back any individual position, or your overall exposure to stocks, if you're fretting about volatility.
Supercharge your returns
The easiest way to crush the market over the next few decades is to be the patient, long-term owner of great companies. And if you can do that and be disciplined in your stock picking, you'll never have to bet the house in order to help you buy a house ... or two.
But if you decide margin has a place in your portfolio, we're not here to tell you that you're wrong. Margin can enhance your returns. But if you use too much and don't know what you're doing, it can wipe out your life's savings. That's why we recommend that:
- Unless you are 100% comfortable and have read (at least twice) the margin agreement with your broker, stay away altogether. It's not worth the hassle.
- If you decide to use margin, keep it at 20% or less of your total portfolio's worth.
- Never use leverage if the worst-case scenario would cause you financial ruin. Never.
Of course, if you ask us, patient, long-term investors in great companies don't need margin. After all, that's the tack we take at Stock Advisor, where our picks are ahead of the market by 30 percentage points on average. You can see all of those picks, as well as our top five for new money, with a no-obligation 30-day free trial. Click here for more information.
This article was first published March 20, 2007. It has been updated.
Tim Hanson and Brian Richards heartily recommend chocolate chunk cookies as a midafternoon snack. Neither Tim nor Brian owns any company mentioned. T. Rowe Price Growth Stock fund is a Champion Funds recommendation. VMware and Google are Motley Fool Rule Breakers selections. The Fool's disclosure policy, while satisfying, is not quite as satisfying as a midafternoon chocolate chunk cookie.