mardi 4 octobre 2022

The dangers of margin

Since the last 3 or 4 years, I've been a great fan of margin. In an environment of very low interest rates, why not borrowing lots of money and investing on the stock market with an almost guaranteed return of 9-10% every year (when you invest in the S&P500 on the long run). 

It looked so simple and easy. 

But a lot of us tended to forget that the PE of market was high these last years and interest rates where very low. Two abnormal situations at the same time. 

Recently, interest rates went up quite a lot and the PE of the market went down quite a lot. It was the perfect recipe for a financial suicide or a real suicide for those who were all in on margin. 

Imagine that scenario:

Your portfolio has a value of one million dollars. The PE of your portfolio is about 25. About 50% of your portfolio includes stocks bought with margin. The interest rate of your margin is 3%. 

A few months later, the PE of the market goes to 18 (28% reduction). Interest rates go to 6% (100% increase). Normally, you won't experience a margin call but it always depends on the kind of stocks you own. At the same time, you have to pay much higher interest rate on your margin (which is a debt). That's a substantial financial stress. Plus the stress of a potential margin call. 

If you owned a lot of super expensive stocks, the contraction of the PE was probably much worse. For instance, if you own Block (Square), the value of a current share is about 25% of what it was at the beginning of 2022. 

A lot of gamblers and bitcoin lovers may find current times very difficult. 

The lesson is that margin may be interesting but only for a small percentage of your portfolio. In my opinion,  a margin over 10% for a large portfolio may be dangerous. 

My margin represents about 3% of my total portfolio and I feel that interest rates are much less pleasing to pay now than they were 6 months ago. 

Try to remember that during the next bull market. 

1 commentaire:

  1. Investors tend to forget everything they learned deep into a bull market.