With the rise of hedge funds, quantitative trading models and engineered financial products, using margin to buy or sell stocks has become common practice.
However, it takes a market crash to realize the risks of using leverage to enhance investment returns. Since February, the media has reported many instances in which retail investors were burned as a result of excessive leverage in their investment portfolios.
Because the recovery of the global economy is still a distant reality, stock prices are likely to remain highly volatile. Amid this challenging outlook, finetuning the investment process is critical to avoid catastrophic losses that could arise as a result of short-term market movements.
The first step is to avoid using borrowed funds to invest in stocks altogether, or to reduce leverage in case an investor has already committed the mistake.
"My partner Charlie Munger (Trades, Portfolio) says there are only three ways a smart person can go broke: liquor, ladies, and leverage. Now the truth is - the first two he just added because they started with L - it's leverage."
This is not the first time the guru warned retail investors to avoid leverage to improve the odds of winning in the long run. A careful study of recent events and historical market performance data suggests that investors should avoid borrowing money to buy stocks.
Investors can lose money with safe investments because of leverage
Berkshire Hathaway Inc. (NYSE:BRK.A) (BRK.B) is considered to be one of the safest investments because of its consistent track record of delivering stellar returns to investors. The likes of Buffett and Munger, who manage the conglomerate, are arguably the best brains the industry has ever seen, which adds another degree of safety to investing in Berkshire.
The market, however, does not accurately represent the economic reality of a company all the time. Short-term market gyrations could lead to irrevocable losses for investors who are betting on safe and sound companies with borrowed money. In his annual letter to shareholders in 2017, Warren Buffett (Trades, Portfolio) warned investors of this possibility and presented the below table that lists down the biggest ever drops in the company's share price.
Percentage decrease in the stock price
1973 to 1975
1998 to 2000
2008 to 2009
Source: Berkshire Hathaway 2017 annual letter to shareholders
Commenting on the data in this table, Buffett wrote:
"This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren't immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions."
There's a popular belief that the chances of losing money by investing in a mature, well-run company are slim. Even though there is some truth to it, the odds change drastically when leverage is involved, which becomes clear when Berkshire's substantial price drops are studied carefully.
Not only stocks, but treasury yields could also become volatile as a result of an external market development, even though these instruments are considered to be the benchmark for the risk-free rate. Below is an illustration of the historic spike in the volatility of U.S. Treasury yields.
Source: Bloomberg / Financial Times
The Financial Times reported in May that many leveraged hedge funds had lost millions of dollars in the first quarter as a result of this spike in volatility that could never have been predicted at the time of entering their high-risk positions.
The unpleasant reality
Despite the abundance of real-life examples available to avoid using borrowed funds to invest in the market, retail investors are continuing to get it wrong. According to Google Trends, internet users searching for the term "margin trading" has seen a spike since March, along with the millions of new trader accounts that were opened with smartphone-oriented brokers such as Robinhood.
Source: Google Trends
This sudden spike suggests inexperienced traders are trying to double-down on the bull run by borrowing money to buy stocks, which could end up in substantial losses. In the last few months, Bloomberg reported in several instances the agony of unassuming retail investors who had lost most of their invested money as a result of using leverage without properly understanding what they are getting into.
A research paper prepared by the Boston College in collaboration with The Massachusetts Institute Of Technology in 2018 concluded that the leverage available to retail investors should be limited by regulatory authorities to curb speculative trading that leads to undesirable circumstances to all parties involved. The below is an excerpt from this paper.
"We have shown that leverage restrictions can reduce speculation without imposing costs (in fact, according to Brunnermeier et al.'s definition, the restrictions actually increase welfare). In addition to this belief-neutral welfare improvement, regulators might have other motivations for curbing speculation. The financial sector has recently experienced extraordinary growth, and this growth might in part reflect activities that do not benefit society (Zingales, 2015). Our evidence suggests that the growth of the forex brokerage market has been excessive, and a leverage-constraint policy is an effective tool to reduce this excess. More broadly, trading volumes have ballooned in recent decades, largely as a result of speculative trading, as evidenced by the recent trading frenzies in cryptocurrencies and retail structured products. Our results suggest that speculative trading could have inefficiently increased the size of the financial sector, and policies that target speculative trading can address this inefficiency without hurting market liquidity."
This study goes on to conclude that using leverage is likely to lead to disappointing returns in the long run, but many investors seem to be oblivious to this reality.
Leveraged trading is for professionals
There are many reports of well-known hedge funds using leverage to deliver promised returns to investors. This, however, should not be replicated by retail investors due to two primary reasons.
First, these investors are professionals and have extensive experience in using borrowed funds tactically to enhance returns. This is not the same as funding every transaction with leverage, and a clear set of guidelines are in place to help fund managers mitigate the risks of using margin trading facilities.
Second, most of the institutional investors hedge their positions to minimize the downside risk of investing in stocks or any other asset class. Therefore, the losses are often limited and are known in advance to placing a trade with leverage. Novice investors, however, have little to no understanding about such techniques and it's common to see a few unsuccessful trades wiping out the entire portfolio value in a few market sessions.
It is important to draw a line between professional and retail investors to determine which type of strategies are suitable for investors falling into these two broad categories. Empirical evidence and the advice given by many renowned investors suggest odds are stacked against individual investors using leverage to enhance returns.
When the market is on a roll, investors might be enticed to borrow money in the hopes of generating alpha returns. As long as the investor is wining, the true nature of this exercise will not be revealed. Many retail investors around the world received a rude awakening when the market crashed in March in response to the global lockdown that saw economic growth coming to a standstill. Not even the smartest investors would be able to predict exactly when a downturn would occur, and recessions often catch every investor by surprise. In light of this unpredictable nature of the market, the best course of action for a retail investor would be to avoid using leverage altogether even though margin rates could drop substantially in the future due to the low-interest-rate environment.
Disclosure: I do not own any stocks mentioned in this article.
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This article first appeared on GuruFocus.