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The Mother Of All Financial Evils

  • August 24, 2006

I came across this article on SeekingAlpha by Travis Johnson discussing how he is selling positions that he had bought on margin. Margin is often referred to as a double-edged sword as it can do wonders for your portfolio in a bull market but can have disastrous effects in a bear market. Even in a flat market you continue to pay interest to your broker while your stocks are sitting around doing nothing.  I have seen many investors lose their shirts and a whole lot more thanks to margin calls from their brokers after their stocks crashed. Hence I like to call margin the mother of all financial evils as far as individual retail investors are concerned. Margin may make sense in some situations such as currency trading, which relies on a large amount of leverage and for institutional traders.

Getting back to the article by Travis, most brokerage accounts are currently charging over 10% interest on margin and his broker was charging him 11%. The historic annual return of stocks since 1925 has been a little over 10% and a significant portion of these returns come from dividends. As you can see from this excellent article in Fortune magazine, some critics argue that in the future, the rate of return from stocks is likely to be no more than 5% or 6%.

Almost 85% of mutual funds do not beat the market averages and these funds are run by professional money managers. Considering these sobering facts, can individual investors actually make more than 10% a year over the long-term? It is indeed possible as individual investors can be more nimble than mutual funds and also do not face all the restrictions that mutual fund managers face.

However, if you were to use margin at an interest rate of 10%, pay trading costs and not invest in stable dividend paying stocks (surely nobody in their right minds is using margin to buy slow growth blue-chip companies that pay a nice dividend), the odds of beating the market are definitely stacked against you. With this in mind, the decision to liquidate his margin positions at this time was a good move by Travis. The price he paid for using margin in clearly illustrated by the fact that he had to sell one of his positions, IMAX (IMAX), at a loss of 30% in his margin account. Ironically IMAX is now at a price where I am finally beginning to find the company attractive.

So are there other meaningful alternatives to using margin from your broker? I decided to find out when I came across an offer from one of my credit card companies in December 2005 that would allow me to use my entire credit line for 3.99% per year until the balance was paid in full. This meant that that my rate would not be bumped up to 16.99% or some other insane number after a period of 6 or 12 months, giving me the flexibility of holding investments for any length of time. Moreover there was an upper limit on the transaction cost, which can sometimes be as much as 3% of the full amount. To top it all, I did not have to worry about margin calls in case things did not turn out well.

With interest rates rising and an ING Direct savings account paying almost 4% per year at that point, I figured this was the best investment capital I was ever going to find. I believed that I could at least beat the rate offered by a risk free savings account. If I could not, I should seriously reconsider my decision of publishing an investment newsletter.

So how did this little experiment turn out? I split the entire amount between three stocks and one ETF. All three stocks have been featured in previous editions of InsideArbitrage and if you follow my blog, you can probably figure out what these stocks and ETFs were. My net returns from these investments is currently about 50% in little less than 9 months and I will post additional details about these investments in a follow up blog entry soon. So it is sometimes possible (though not advisable) to use leverage in your portfolio without using margin from your broker and worrying about margin calls.