It is a well-known fact that professional traders use the leveraged money to invest in the ETF market, as well as other stocks. This practice that has been going on for decades can be ruinous in the long run, especially for the average individual investor.
Evidence suggests that trades on margin are increasing on a global level, as the stock market continues on a bullish recovery, demonstrating investor confidence.
Reports indicate that there was a total of $652 Million of margin debt as indicated by the FINRA Statistics this August. This is a steep rise, compared to last year’s figure of $596 million.
It was 1991, when Warren Buffet offered a speech at the University of Notre Dame, now widely regarded as some of his wisest words; “I’ve seen more people fail because of liquor and leverage — leverage being borrowed money.”
The Berkshire Hathaway CEO has also indicated to the audience that they could make a lot of money themselves, without using other people’s funds.
However, the temptation continues to linger within investor communities, who now look to use the historically low-interest money, acquired through mortgages, personal credit lines and 401(k) to invest in the stock market. The idea can be successful, especially in times when the Dow is reaching historic heights of more than 26,000, a milestone which looked far-fetched during the great recession of 2009.
Using the Leveraged Money for Investing
As mentioned before, professional traders have leveraged money primarily from brokers and lenders, in turn investing it into exchange-traded funds, as well as other stock options. This tactic, although practiced for decades can be dangerous for the unsuspecting individual investor if they are not careful. It should be noted that for an investment or financial expert who borrows on margin, is not the same as an ordinary trader borrowing against his/her mortgage to buy stocks. The latter is considered a very risky and uninformed decision.
When taking the decision of whether or not to invest with borrowed money, it eventually boils down to comparing the cost of borrowing the money with the expected investment returns. In this case, if the returns outweigh the cost, then the transaction is deemed to be economically viable.
Things have dramatically changed in today’s world, with the spread between the two becoming very wide. It can still work, however if the trader properly diversifies his/her trading portfolio. This formula is not fool-proof however, because stock market gains can be variable while the borrowing costs remain fixed.
To better understand this, let’s take an investment with an expected return of 15 percent as an example. Although the investment guarantees a return of 15 percent, the actual figure might range somewhere between 15 to 30 percent. Even in cases where the cost of borrowing is as low as 4%, the transaction is still considered to be risky business.
On the other side of the spectrum, if a collection of diversified investments in a portfolio offers a 10% rate of return, the risk of the transaction is reduced by a great margin. This is because the narrower range of the transaction can be only 9-11 percent.
How to Calculate Leveraged Return
In 2010, Warren Buffet actually acknowledged in a letter to Berkshire Hathaway Shareholders, about how some people become rich through the use of borrowed money, while others become poorer. According to him, “When leverage works, it magnifies your gains … but leverage is addictive,” and “Once having profited from its wonders, very few people retreat to more conservative practices.”
This can be further explained by the following example.
If a stock originally purchased with cash, rises about 10% in value from an original $10 value, the trader has made a $1 profit. In the reverse scenario, if the stock loses 10%, the trader loses an equivalent amount. Things are different with leveraged stock, however.
For instance, a $10 stock which is leveraged with a 2-to-1 margin trade would achieve a much higher profit of $2. However, the scenario becomes bleak when the stock experiences losses. If the stock loses value by 10%, the trader gas to pay back the marginal costs of about 5% of the stock. The trader will now lose $2.50 or 25% as opposed to much lesser in normal trading circumstances. The situation can worsen even further if the stock declines further. A trader could be subject to a margin call, forcing them to sell the stock at a loss.
A similar scenario can be seen on a consumer level, with the following example.
If a trader has borrowed $10000 leveraged by a home-equity loan, with a 5% margin, the trader can make a $1000 profit if the stock appreciates by 10%. After paying the borrowing costs, the trader makes a flat profit of $500 in this case. However, if the stock declines in value by 10 percent, the trader lose $1500 as opposed to $1000 had he paid in cash?
Thus it is always advised that only those with a concrete track record should deal with leveraged debt to buy investments. In other words, if a trader thoroughly understands his/her industry and trading something of value, they should know how to properly use debt to trade more.
Increasing Amount of Margin Debt
Recent evidence has emerged that trades on margins are increasing with the stock market’s bullish ascent. Investor confidence is at a high as prices go up. Margin debt amounted to a total of around $561 million as reported by the New York Stock Exchange. This is a major increase from the $471 million reported last year. Compare that to about $236 million in margin debt recorded in 2010 and we can see the increase.
Factors that dictate whether an individual should borrow from one asset to invest in another, depends largely on variables such as the individual’s financial condition, age, and financial goals. Taking advantage of short-term loan with historically low rates is recommended, using consumer debt to pay down slowly, while investing in cash savings.
The above types of “good debt” provide a much lower interest rate for people with good credit scores, than the broker offered margin rates. A high degree of speculation comes in when a trader uses leverage to invest in stocks or other marketable securities. Consistent investments and retraining from timing the markets are considered the key to building wealth.
Thus it is advised for a trader’s investment choices to be long term. This is because the stock market becomes less risky for traders with a 30-year plan.
List of Conditions before Borrowing
After the above discussion, if an individual still considers getting a personal loan for trading and investing, the following points can be considered.
Examining Loan Rates
Having a good idea about the interest rate a particular lender is offering is the first step to seek a loan. Earning high returns would not make much of a difference if the bank gets a chunk of the profit.
Weighing the Payments
Before applying for a loan it is advised that the applicant makes sure that he/she can afford the loan payments over the period of the loans. [Regular returns rolling in are considered ideal].
Studying Investment Performance
Market research can be considered one of the most important facets of stock trading, especially if it is done using the leveraged money. This includes historical price rates and trends since the stock’s inception. A trader has to stay on top of updated information in this case because of the volatile stock trading environment.
Assessing Control with Risk
Because of the volatile nature of such markets, traders should always measure the maximum risk they can incur for the possibility of earning bigger rewards.
Reviewing the Fees
Along with the changing interest rates, different expenses such as lender’s fees, brokerage fees, trade commission’s etc are also added to a transaction. All these expenses should be pre-calculated before applying for the loan.
Getting a personal loan to use it as a vehicle to invest in the stock market is a risky gamble and not meant for everyone. Thus it is always best to analyze the pros and cons from every angle before making the final decisions. If one is still unsure of what decision to take, they should consider hiring a professional financial advisor to guide them.
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