In the late stages of a bull market you should be reducing leverage

Leverage

Leverage can be a glorious thing. Intelligent use of leverage enables you to massively increase your Return on Investment (ROI). The math is simple – if you don’t use leverage then doubling your money requires the underlying investment to double. If you make a $1,000 investment then the investment needs to go to $2,000 for you to make a $1,000 profit.

But if you’re able to borrow at a 50% margin then you can buy a $2,000 investment with $1,000 of your own money plus $1,000 of borrowed money. You now own a $2,000 investment and have $1,000 in debt (obviously you haven’t created any wealth here – you’ve increased both your assets and liabilities by $1,000. You still have the same $1,000 total that you had previously). If the underlying investment doubles (as in the first case above) your investment goes from $2,000 to $4,000. You sell the $4,000 investment, pay off the $1,000 loan, and you are left with $3,000. You’ve just made a 3x return on your original $1,000 through use the use of leverage.

And, of course, leverage works the same way in reverse. If we take the second example (borrow $1,000 and combine with your own $1,000 to buy a $2,000 investment) and your investment drops by 50%, suddenly you’ve lost all your money. Your investment went from $2,000 to $1,000. You sell the investment for $1,000, pay off the $1,000 loan, and you’re left with $0.

Nothing groundbreaking there – I’m sure that every reader of this blog understands how leverage works.

When to use leverage

Given that leverage amplifies your returns, both up and down, it makes sense to only use leverage when the odds of making money are in your favor. And, as I’ve written, given the current valuation of the market, the odds are NOT in your favor today.

As I mention in the article linked to above, the higher the current valuation of the market the lower the expected returns over the next 10 years. That should shock exactly nobody.

As of today (March, 2017), the Schiller P/E is around 29. Based on Vanguard’s research (linked to in the article above) this projects to a 10-year return of somewhere between 0% and 2.5%/year.

The good news is that those returns are positive. That is, the odds are that you won’t LOSE money over the next 10 years if you invest at today’s rates. You’ll likely end up somewhere between breaking even and eking out a small gain.

I guarantee that somebody out there just read the previous paragraph and thought to themselves, “Hey, with the clever application of leverage I can turn those 2.5% returns into 5% returns. BOOM!”

There are multiple problems with that approach:

  1. Leverage is not free
  2. Margin calls can wipe you out

Leverage is not free

Here’s another statement that will shock nobody: borrowing money isn’t free. This is true whether you’re borrowing money to buy a TV, a car, a house, or stocks.

Your brokerage loans you money to buy investments and you pay interest on that money. The interest rate varies by broker and the amount borrowed and varies widely from broker to broker. Just for fun I pulled rates from a few brokers:

  • Scottrade
    • $10,000 margin loan = 8.25% interest
    • $100,000 margin loan = 7.00% interest
    • $1,000,000+ margin loan = 5.75% interest
  • Vanguard
    • $10,000 margin loan = 7.75% interest
    • $100,000 margin loan = 6.00% interest
    • $1,000,000+ margin loan = 5.25% interest
  • Interactive Brokers*
    • $10,000 margin loan = 2.41% interest
    • $100,000 margin loan = 1.91% interest
    • $1,000,000+ margin loan = 1.41% interest

* – Interactive Brokers uses a tiered rate schedule. This means that if you borrow $2M then the first $100,000 will be at the 0-$100,000 rate, next $400k will be at the $100,000 – $500,000 rate, etc. This results in a blended rate that will be somewhere between the lowest and highest rates for the amount you’ve borrowed. The rates above are the marginal interest rates at that sized loan.

As you can see, of the 3 brokers I looked at, Scottrade is the most expensive and Interactive Brokers is the cheapest (by far).

For the purposes of this analysis let’s say that you decide to use Interactive Brokers (since they are the cheapest) and you decide to invest $200,000 on margin ($100,000 of your own money and $100,000 of borrowed money). As mentioned above, Interactive Brokers uses a tiered rate schedule, so the rate on a $100,000 loan will be ((10,000*2.41% + 90,000*1.91%)/100,000) = 1.96%. We’ll round this up to 2% for simplicity.

If you can borrow at 2% interest and turn around and invest for a 2.5% return you’ll pocket a .5% profit. If you borrow $100,000 you’d net $500/year with this strategy. Seems like easy money, right?

Unfortunately, there are a few problems with this approach:

  1. This assumes a 2.5% return. Historically, when the market is at today’s valuation it returns somewhere between 0% and 2.5% OVER 10 YEARS. So if the market returns the average of 1.25%/year over the next 10 years then you’ve lost .75%/year for 10 years while exposing yourself to a lot of risk
  2. The 0%-2.5% average is just that – an average. The odds that the market would return exactly somewhere between 0% and 2.5% for each of the 10  years is somewhere around zero. What’s much more likely for the market to do at this valuation is a crash followed by a slow recovery that would result in the average gains of 0-2.5%/year after 10 years. This volatility will kill you if you’ve invested on margin. Why? Margin calls.

Margin Calls

This is probably the single biggest downside to investing on margin. The idea behind a margin call is simple – the broker wants to make sure you pay your loan, including both principal and interest. Your broker does a few things to ensure this. First, they calculate and then charge you daily for the interest on the loan. On a $100,000 loan at 2% annual interest you’ll get charged $100,000 * 2%/365 = $5.48/day, everyday, for as long as you have the loan.

Second, the broker will require you to have some minimum amount of equity in your investment at all time. When you initially make the investment you might have 50% equity (assuming you’ve used 50% margin). For example – if you buy a $200,000 investment you’d put in $100,000 of your own money and you’d borrow $100,000 @ 2% interest from Interactive Brokers.

Once the initial investment is made you’ll be required to have an ongoing minimum amount of equity. This margin requirement is usually somewhere between 20% and 35%. For the purposes of this example let’s say your broker has a margin requirement of 30%.

If your $200,000 investment drops 20% the value of the investment will go to $160,000. You still have your $100,00 loan, so your equity is $60,000 (current value of $160,000 – $100,000 loan). Your percent equity is $60,000/$160,000 = 37.5%. We’d said that your broker requires 30% equity and you have 37.5%, so you’re ok.

But if your $200,000 investment drops by 30% then the value of the investment will go to $140,000. You subtract the $100,000 loan and you’re left with $40,000 of equity, or $40,000/$140,000 = 28.6% margin.

You’re now hit with a margin call. This means your broker will tell you that you have 3 days to get your margin back up to 30%, either by adding money to your account or because the stock rises in value. If you don’t have the money to increase your equity to 30% then your broker will sell your stock to repay the loan. This has the effect of locking in your loss.

Margin calls are how people get wiped out. Moderate temporary market fluctuations can lead to large permanent losses.

One solution to the prospect of getting hit with a margin call could be to keep enough cash so that you can cover a margin call. However, this strategy doesn’t make sense. After all, if you have $100,000 in cash, why would you use $50,000 in cash to buy an investment and borrow $50,000 on margin (thereby keeping $50,000 in cash to cover a margin call) when you could just buy the investment for $100,000 and not need to use leverage and expose yourself to that risk? The only time it logically makes sense to invest on margin is when you want to invest more money than you have, in which case by definition you won’t have the cash sitting around to cover a margin call.

The danger of volatility and leverage

I’ve talked before about how volatility is not the same as risk, but using margin might be the sole exception. Usually volatility doesn’t matter – the only prices that matter for your investment are the price when you buy and the price when you sell. The path between those points don’t matter. Your stock could drop by 99% the day after you buy it and as long as it has recovered by the time you want or need to sell then you’ve lost nothing.

But when you’ve bought on margin volatility DOES matter. Taking the example above, if you buy a stock and it drops 99% you’ll be hit with a margin call, the stock will be sold, and your loss is permanent. In this case, higher volatility DOES lead to higher risk.

The issue here is that margin loans are callable. If the loans weren’t callable then the problem would largely go away. In fact, if margin loans weren’t callable they would be a fantastic way to massive increase your wealth.

And, in fact, margin loans CAN be a great way to make money…under the right circumstances.

When and how to use margin

The wrong way to use margin loans is to increase leverage when the odds are low that your returns over the next 3-5 years will be higher than the cost of margin.

The right way to use margin loans is to increase leverage when the odds are high that your returns over the next 3-5 years will be higher than the cost of margin.

As I mentioned previously, with the market’s current valuation (Schiller 10-year PE of approximately 29) the expected return over the next 10 years is somewhere between 0% and 2.5% per year. Let’s assume the return over the next 3-5 years will also be in the same range (although I think the reality is that the short-term return will be negative).

That means that, even with the cheapest possible margin interest of 2%, your results will be somewhere between -2%/year to +.5%/year.

This is a terrible time to leverage your investments.

So when SHOULD you use leverage?

Simple – you should use leverage when the market’s valuation is low enough that the odds are high that returns will be positive over the next 3-5 years. Referencing the same Vanguard study we find that when the Schiller 10-year PE is 10 the average returns over the next 10 years are around 10%/year.

I like those odds.

If you can borrow at 2% and invest at something that should average somewhere around 10% for 10 years then you have a way to create wealth.

Conclusion

Given the market’s current valuation, you should be reducing (or preferably eliminating!) any market leverage you currently have. At this point in the market cycle any leverage you’re using will likely lead to lower returns and potentially catastrophic losses.

Reduce your leverage and build a cash reserve so you’re ready to take maximum advantage of future lower valuations. Then, when valuations are low and expected returns are higher you can get aggressive by using leverage to amplify returns.

 

Readers: Are you using leverage in today’s market? Do you have experience with buying on margin in the past? What are your expectation for market returns in the next 5-10 years?

 

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