You Need To Avoid This Investment Mistake: It’s Dangerous!

|

American investors owed nearly $1 trillion in margin debt at one point in 2021, leaving money expert Clark Howard shaking his head.

According to Yardeni Research, investors who borrowed on margin owed $936 billion as of early December 2021. That represents an enormous one-year increase of 40%. The number has declined in 2022 as investors take on less risk, but it’s still a really big number.

To Clark, it signifies the potential for financial devastation for many Americans, causing him to issue a stern warning. His message: Please don’t invest on margin.


Table of Contents


What Is Buying on Margin?

Buying on margin involves borrowing money from a brokerage to increase your purchasing power. It’s a leveraged bet that your investment will perform well.

If you’re right, you can earn even more money than you could with your own limited capital. But if you’re wrong and the investment tanks, it can wreck your portfolio fast.

Let’s say you have $1,000 to invest in Amazon stock, but you expect the stock to continue to rise in price. The Federal Reserve requires you to put up at least 50% of the money to buy stock. So with your $1,000, you can borrow against your investment and buy up to $2,000 in Amazon stock.

“I am not a fan of margin. Margin is when you borrow against stocks that you buy to then be able to buy more stocks,” Clark says. “You can borrow half the value of what you’re buying and double your bet. And key emphasis on ‘bet’ because you’re then going from being an investor to beyond speculator to a gambler.”

If your hypothetical $2,000 investment becomes $3,000 and you sell, you’ll owe your brokerage the original $1,000 you borrowed plus interest. But you’ll still net more profit than you would’ve on your own.

Investing on margin can amplify your gains. But it can amplify your losses just as easily. Plus, if your investment declines in price, you could be in danger of a process called a margin call.

Why Brokerage Firms Love Margin

Investing companies such as Robinhood have gotten a reputation for making it too easy for investors to buy on margin — even new, inexperienced ones.

You must apply to trade on margin, often by providing details about your employment status and income. However, getting approved can be simple.

Advertisement

Of course, lending on margin is a profit center for a brokerage firm — assuming they don’t lend to the point of putting too much risk on their books.

“They lend you money at typically seven times their cost of that money,” Clark says.


What’s a Margin Call?

If you’re investing twice the amount of money you actually have, every dollar you gain or lose essentially doubles. But if the price goes low enough, your investment company can suddenly require you to put up more money (or it can liquidate your investment).

This is considered a margin call.

Remember, buying on margin means you’re borrowing from your brokerage firm, using your investment as collateral. If your investment goes to $0, your collateral is gone. How can the investment company be sure you’ll pay it back?

If your leveraged investment declines by a certain percentage, your brokerage can demand that you deposit additional money as collateral within a short time frame. If you fail to do that, the brokerage will automatically sell your investment and use the proceeds to pay itself back.

The Financial Industry Regulatory Authority (FINRA) requires you to keep a 25% maintenance margin. So if your $2,000 investment becomes less than $500, every investment company has no choice but to issue a margin call.

Many financial companies will institute a margin call at a far higher percentage than the 25% that regulators require.

Margin calls can be terrible. You’re either forced to scramble for cash on short notice, or you may have to sell your entire position at the worst possible time.

“So margin is beautiful on the way up and beyond ugly on the way down,” Clark says.

Advertisement

Clark’s Stern Warning to Margin Investors

Clark has been one of the most consistent and passionate voices on the subject of buying on margin.

On a recent podcast, Clark referred to himself as “one-note Clark” because his public stance on investing with margin hasn’t budged for more than three decades.

However, he became increasingly concerned after reading that Americans owe nearly $1 trillion to their investment companies. He even compared his warning to what he said about the housing market from 2003-06, before the big financial crisis.

“This is a recipe for personal financial disaster. Please hear me on this,” Clark says. “Speculating or gambling is a risk level in investing that’s not worth it.”

Clark said he was particularly concerned about is the 40% year-over-year increase in buying on margin by the end of 2021 after what was essentially a 12-year bull run in the stock market. One big problem he spotted at the time: Relative to earnings, stocks were valued much higher than average at present.

Even the COVID-19-induced stock market pullback didn’t last long. After more than a decade of good returns, investors may have gotten too comfortable — or even greedy. The U.S. stock market has flirted with a 20% decline less than halfway through 2022.

It was a matter of when, not if, we’d experience a downturn in the market. And that may have turned into severe consequences for anyone buying on margin.

“What happens over time is people lose their cautiousness. The risk with margin is you don’t know when that downturn [will be]. And if you get your positions wiped out, you don’t have the money anymore for the long-term gain that the market offers,” Clark says.

“There’s another Wall Street expression: pigs get rich, hogs get slaughtered. When you get too hog wild in investing, when you take too much risk, the reward is not worth it. Because when the market does inevitably have its downturns, it’s magnified for you.”


Final Thoughts

Investing rewards patience.

Advertisement

By Clark’s definition, if your timeline isn’t at least five years, you aren’t truly investing. In fact, Clark doesn’t think you should chase outsized gains or even try to get rich quickly in the market, especially with the majority of your net worth.

Borrowing money you don’t have in hopes of squeezing out some extra profits will work sometimes for some people.

But you probably wouldn’t bet your retirement on a roulette table in Las Vegas. Buying on margin, Clark says, is not much different.


More Clark.com Content You May Like:

The Latest From The Podcast