I would like to spend a bit of time discussing the use of margin for investment, especially considering the dearth of discussions on this. I’m a great believer of using other people’s money to our advantage, but how can we use debt safely and effectively?
First, a basic understanding of how margin works. Margin is a fancy word for borrowed money, allowing you to increase your returns. Most stock brokerages allow you to leverage up to 3.5x if using cash as collateral and 2.5x if you are using shares. For example, if you have cash of $100,000, you can borrow up to $250,000, for a total value of $350,000. This example from DBS shows how returns can be magnified.
In the same manner, margin also exposes you to greater losses if your bet turns against you. Besides the losses I illustrate below, you are still liable for the interest on the financing amount.
|Loss of 6%||$21,000|
|Return of investment using leverage||-21% on initial $100,000 capital|
Not all stocks can be bought on margin or are considered equal. Generally only high quality stocks are allowed to be leveraged, and the interest rate increases with a lower quality (grade) of the underlying security. My view is to only use Grade A securities for borrowing and collateral, especially if you are a beginner. This risks and returns for Grade B and below don’t seem to be worth it, and these securities will experience greater swings too.
Brokerages or Privileged Banking?
Both brokerages and privileged banking (PB) services offer loans for investment. But there are significant differences in how they provide loans and their interest rates.
Margin through brokerages is far more immediate and flexible. Once you set up a margin account, you are more or less good to go. PBs have much more paperwork to do for each investment and you need to wait for approval.
Brokerages also don’t require you to be a PB client, and hold a certain amount of assets in the bank. This is at least $250,000 of liquid assets for banks in Singapore. Finally, brokerages allow you to use margin on shares, something I don’t believe is often done at PBs, if at all.
The advantage for PBs is that their margin has lower interest rates, about 1%-1.5% cheaper than what you can find from brokerages. So PB is better for long-term holdings like bonds, insurance, and mutual funds. Not so much shares.
In the end, brokerages and privileged banking services cater to different products, and its not quite fair to compare them directly. PB loans are more suitable for fixed income products, while brokerages cater for shares. What I’m doing myself is that my bonds and insurance are at my PB enjoying lower interest rates, while my shares are on margin at my brokerage with greater flexibility.
This is what most people worry about. A margin call is when a margin valuation falls below 140%. This is calculated by the total value of marginable shares divided by the amount financed. So let’s say that your marginable shares is $100,000, and the amount financed is $70,000. This leads to a margin maintenance level of 143%, which is barely above the 140% needed to avoid a margin call. Once it falls below 140%, the investor would receive call from the brokerage or bank, requesting for new collateral within a few days.
My view is that investors using Grade A shares as collateral should keep a maintenance margin of about 250%. This allows for at least a 40% decline in the value of your marginable shares. To put it in another way, if your marginable shares are at $100,000, you should not borrow more than $40,000. The table below shows how a decline in assets would affect the maintenance margin.
|Starting value||10% drop||20% drop||30% drop||40% drop|
|Marginable shares ($60,000 capital)||$100,000||$90,000||$80,000||$70,000||$60,000|
How much buffer do you need?
The buffer needed for margin depends on the underlying asset. If the margin is on stocks, I had recommended a much higher margin at 250%. This is enough buffer for two bear markets (decline of at least 20%). Bear markets, on average, happen every 5 years. So it has to be a truly cataclysmic event for a margin call to happen when you use margin moderately.
If the underlying asset is high-yield bonds (my definition is around the 6% yield range), I think its prudent to hold enough cash to cover a 30% drop. High-yield bonds fluctuate far less than stocks, and a drop is nearly always less sudden and steep as stocks. For lower risk bonds, a lower buffer is possible.
If the underlying asset is insurance, there is a minimal need to have a buffer, as the danger of margin calls is negligible. As far as I know, margin on insurance policies is closer to the risks of a home loan, which is low risk.
It really makes very little sense to go all in on margin with no buffer. You might make good money for a while, but it just takes one black swan event to wipe you out. You can be right a 100 times, but you just need to get it wrong one time to lose it all.
Margin is tricky and adds risk. It’s not possible to generalise telling an individual how much and where to use margin in his/her portfolio, as everyone’s risk appetite and portfolio are unique.
An important thing I have learned about margin is that it can prevent you from seizing opportunities. During a crash and when everything is down, you get worried whether your collateral will keep falling. You tend to hoard cash, and not buy anything. But these are precisely the best times to be investing. Missing out on fire-sale prices can be painful, as I found out myself during Mar this year. Margin should be reduced during the good times, and be more than average during a crisis.
Use margin moderately and prudently, and it will serve you very well. Chances are you are already using debt, through credit cards and home loans. Pretty much all millionaires and billionaires have made use of debt and other people’s money to become successful.
It is why the rich stay and get rich.