Investors are making a massive blunder. Thanks to a rising stock market and record-low interest rates, investors are piling on margin debt like never before. This could cause investors some serious pain in 2014. Here's why.
Margin amplifies more than just returns
This past November, margin debt, or money borrowed from assets in a brokerage account, hit a record of $423.7 billion. That amount exceeded the previous record set just this past October. Oddly enough, margin debt rose by 2.7% on the month, which isn't that far off the 3.5% gain achieved by the Dow Industrial Average.
That's not to say that all of the recent gains have been fueled by debt. What margin does is amplify gains. To demonstrate this, let's run through a real-life example.
Let's say an investor is very bullish on a recovery in the price of natural gas. As the nation's No. 2 natural gas producer, Chesapeake Energy Corporation (CHK +0.00%) would be an ideal target to play a rebound in natural gas. It's currently trading at around $26 per share and, for simplicity's sake, let's say that 100 shares would use up all the available cash. An investor betting on a 50% gain in shares of Chesapeake Energy in the next six months could see gains amplified to as much as a 95.8% gain by using margin.
|
Share Prices |
Shares |
Investment |
Borrowed |
Rate for 6 Months (8.44% Annual Rate) |
Profit if Up 50% |
Total Return on Investment |
|---|---|---|---|---|---|---|
|
$26.00 |
100 |
$2,600.00 |
$- |
$- |
$1,300.00 |
50% |
|
$26.00 |
133 |
$3,458.00 |
$858.00 |
$36.21 |
$1,692.79 |
65.1% |
|
$26.00 |
150 |
$3,900.00 |
$1,300.00 |
$54.86 |
$1,895.14 |
72.9% |
|
$26.00 |
200 |
$5,200.00 |
$2,600.00 |
$109.72 |
$2,490.28 |
95.8% |
NOTE: Margin rate based on E*TRADE's current margin rate.
There is, however, a dark side to using margin. Just as gains are magnified, so are losses as the following chart indicates:
|
Share Prices |
Shares |
Investment |
Borrowed |
Rate for 6 Months (8.44% Annual Rate) |
Loss if Down 50% |
Total Return on Investment |
|---|---|---|---|---|---|---|
|
$26.00 |
100 |
$2,600.00 |
$- |
$- |
$(1,300.00) |
-50% |
|
$26.00 |
133 |
$3,458.00 |
$858.00 |
$36.21 |
$(1,765.21) |
-67.9% |
|
$26.00 |
150 |
$3,900.00 |
$1,300.00 |
$54.86 |
$(2,004.86) |
-77.1% |
|
$26.00 |
200 |
$5,200.00 |
$2,600.00 |
$109.72 |
$(2,709.72) |
-104.2% |
A 50% fall in Chesapeake Energy could result in an investor losing more than 100% of his investment. The problem is that a rising market blinds investors to the real risks of these losses. Don't believe me? Check out the true story of an investor who was nearly wiped out by using margin to buy stock in Chesapeake Energy.
A case study on the dangers of margin
In the book The Frackers, Gregory Zuckerman details the rise and fall of former Chesapeake Energy CEO Aubrey McClendon. One of the contributing factors to his fall was McClendon's use of margin to buy additional shares of Chesapeake Energy. The onset of the financial crisis as well as the stunning amount of natural gas now unlocked by fracking caused shares of Chesapeake Energy to plunge. Brokers holding Chesapeake Energy stock as collateral for loans McClendon used to buy more stock, as well as other purchases, were forced to sell his shares. That selling begot more selling as the value of his collateral continued to fall. In the end, the banks sold 94% of his stake in the company, which totaled more than 31 million shares.
While many view McClendon as a risk-taking wildcatter -- and it's hard to say that didn't describe him perfectly -- when it came to margin, he was fairly conservative. Or so he thought. He's quoted in The Frackers as saying, "I honestly did not feel it was risky to have one dollar of margin for every three dollars of stock value." Yet, playing with fire even a little bit caused him to get burned. Of the whole ordeal, McClendon said that, "What I never dreamed could happen, did happen."
While McClendon was the poster boy for margin trades gone wrong, he wasn't alone. Also mentioned in The Frackers were margin calls on the CEO of XTO Energy, which is now part of ExxonMobil Corporation (XOM 4.00%) as well as forced sales by the CEO of Tesoro Corporation (TSO +0.00%). The XTO sale ended up costing its CEO 3 million shares of stock worth more than $100 million, while the Tesoro CEO was forced to shed more than 14% of his holdings.
Investor takeaway
The bottom line could not be more clear: Using margin is a ticking time bomb in a portfolio. Sure, the leveraged gains are nice when the market is riding high. However, margin-fueled losses can wipe out those gains and more when the market takes a breather. There are better ways to make money in the stock market than using margin to drive returns.
