Most people simply think of investing on margin as increased risk for the potential of increased return. But under the surface it is a lot more illogical than a shift in the trade-off between risk and return.
When you buy stocks on margin you are taking over the role of corporate CFO. Most people don’t think about it this way, but it is true. With a margin purchase, an investor is effectively stating, “I can make better financing decisions for this company that its CFO.”
Leveraging at the company level
One of the primary jobs of a CFO is to decide how much a company should be financed by equity vs. borrowing. More equity means less risk but stock returns are more diluted. More borrowing means more risk. It is easier for the company to go bust, but if events go well, then the positive shareholder returns are more concentrated.
Leverage in your account vs. leverage by the company
A company CFO might recommend and subsequently execute a stock buyback play. This means the company will purchase back shares from the public, leaving the remaining shareholders with a more concentrated stake in the company’s value. To raise the money for this buyback plan, the company could borrow money. The net effect of these transactions is that the remaining shareholders are more leveraged – they will do better if the company does well, but are in a riskier position if the company does poorly.
Sound at all like investing on margin in an investment account? You borrow money in order to buy more shares of stock. If the company does well, your returns are even more concentrated. If the stock does poorly, you are wiped out much quicker because you have to pay back the loan.
So a corporate CFO of a company can decide to take a leveraged position by borrowing money inside the company, or you can effectively accomplish the same thing by leveraging the stock on margin in your brokerage account. But if you own the stock using your own leverage, doesn’t that mean you thought the corporate CFO chose the wrong balance within the company?
When looked at this way, margin just doesn’t make logical sense — unless you don’t like the equity vs. borrowing position of corporate leverage that the company CFO has chosen. Well, maybe you understand all of this and invest on margin because you legitimately don’t agree with the position of leverage that the CFO has chosen. But that raises an even more troubling question — If you don’t trust the CFO of this company to make smart decisions, why are you buying an extra-concentrated, high risk position in the stock in the first place?
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