Why Margin Isn’t Even Marginal, at Best (Part I)

I generally advise families to avoid using margin for investment purposes. This applies to the accounts I manage and to the investment vehicles I recommend in those accounts (mutual funds, ETFs, etc). There are several reasons why.

 The “L” word

First and most obvious, with the leverage that margin enables, there is a greatly increased chance that an investor will be totally wiped out by a market downturn. When a family is investing for generations, there will be many bumps in the road, some large. The key is to stay in the game, decade after decade, and avoid a situation where an investment strategy goes to zero.  An investor who used 50% margin and got the US market average returns would have at least five instances where they would have been wiped out – the crashes of 1907, 1929, 1973-74, 2000-2002 and 2008.

 But what about the market upturns? Wouldn’t an investor have made huge returns at those times? The problem is that great returns don’t help if you have lost all your money. If an investor starts in 1900 and is brought to zero by 1907, they are finished.

The perspective of a century

 Let’s look at an investor who invests in the US market in 1900 without leverage. They take a big hit in 1907, but the market eventually recovers. They take a huge hit in the Great Depression, but by 1950 they are well back into positive territory. 1973-1974 takes them down 50%, but the 1980s and 90s more than make up for that. 2000-2012 ends up being flat because of two crashes, but overall the investor has still made a huge amount of money over the 100+ years.

How about an investor that keeps a heavy margin position? As noted above, by the end of 1907 they are essentially at zero. No matter what happens for the rest of the century, they are at zero. No amount of market recovery can bring them back.

Having five bumps in the road per century that will wipe out the family is far too many if the family is investing for generations. Even one instance per century is too much. A long-term investor has to ensure that this won’t happen, and the only way to do that (among other things) is to avoid investing on margin.

 

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