You Don’t Want to Make This Devastating Investing Mistake in 2014

Investors in the USA are making a massive blunder. Thanks to a rising stock market there and record-low interest rates, investors are piling on margin debt like never before. This could cause investors some serious pain in 2014 and is something us investors in Singapore can draw lessons from.

Margin amplifies more than just returns

This past November, margin debt, or money borrowed from assets in a brokerage account, hit a record of US$423.7b in the USA. That amount exceeded the previous record set just this past October. Oddly enough, margin debt rose by 2.7% on the month, which isn’t that far off the 3.5% gain achieved by the Dow Jones Industrial Average, one of the oldest American stock market indices.

That’s not to say that all of the recent gains have been fuelled by debt. What margin does is amplify gains. To demonstrate this, let’s run through a hypothetical example.

Let’s say an investor is very bullish on the future economic prospects of Indonesia. In such an instance, shares with huge exposure to the Indonesia economy, such as Jardine Cycle & Carriage (SGX: C07), Golden Agri-Resources (SGX: E5H), First REIT (SGX: AW9U), and Lippo Malls Indonesia Retail Trust (SGX: D5IU), might make ideal targets for such a play.

Let’s focus on, say, oil palm producer Golden Agri-Resources. It’s currently trading at around S$0.52 per share and for simplicity’s sake, let’s say that 2,000 shares would use up all the available cash. An investor betting on a 50% gain in shares of Golden Agri-Resources in the next six months could see gains amplified greatly by using margin.

Share Prices Shares Investment Borrowed Rate for 6 months (6% annual rate) Profit if up 50% Total Return on Investment
S$0.52 2,000 S$1,040 S$- S$- S$520 50%
S$0.52 2,500 S$1,300 S$260 S$7.80 S$642.20 61.8%
S$0.52 3,000 S$1,560 S$520 S$15.60 S$764.40 73.5%
S$0.52 3,500 S$1,820 S$780 S$23.40 S$886.60 85.3%

Source: Margin rate based on Phillip Securities’ current margin financing

There is, however, a dark side to using margin. Just as gains are magnified, so are losses as the following chart indicates:

Share Prices Shares Investment Borrowed Rate for 6 months (6% annual rate) Loss if down 50% Total Return on Investment
S$0.52 2,000 S$1,040 S$- S$- (S$520) -50%
S$0.52 2,500 S$1,300 S$260 S$7.80 (S$657.80) -63.3%
S$0.52 3,000 S$1,560 S$520 S$15.60 (S$795.60) -76.5%
S$0.52 3,500 S$1,820 S$780 S$23.40 (S$933.40) -89.8%

Source: Margin rate based on Phillip Securities’ current margin financing

A 50% fall in Golden-Agri could result in an investor losing a lot more. While Singapore’s stock market, as represented by the Straits Times Index (SGX: ^STI), did not exactly have a stellar year, there’s always the possibility that investors become blinded to the risks of margin-related-losses if the markets start rising.

If you think that’s not possible, just check out the true story below of an investor who was nearly wiped out by using margin to buy stock in American natural gas producer Chesapeake Energy.

A case study on the dangers of margin

In the book The Frackers, Gregory Zuckerman details the rise and fall of former Chesapeake Energy chief executive Aubrey McClendon. One of the contributing factors to his fall was McClendon’s use of margin to buy additional shares of Chesapeake Energy.

The onset of the financial crisis in 2008 as well as the stunning amount of natural gas now unlocked in the USA by fracking caused shares of Chesapeake Energy to plunge. Brokers holding Chesapeake Energy stock as collateral for loans McClendon used to buy more stock, as well as other purchases, were forced to sell his shares.

That selling begot more selling as the value of his collateral continued to fall. In the end, the banks sold 94% of his stake in the company, which totalled more than 31 million shares.

While many view McClendon as a risk-taking wildcatter — and it’s hard to say that didn’t describe him perfectly — when it came to margin, he was fairly conservative. Or so he thought. He’s quoted in The Frackers as saying, “I honestly did not feel it was risky to have one dollar of margin for every three dollars of stock value.” Yet, playing with fire even a little bit caused him to get burned. Of the whole ordeal, McClendon said that, “What I never dreamed could happen, did happen.”

While McClendon was the poster boy for margin trades gone wrong, he wasn’t alone. Also mentioned in The Frackers were margin calls on the CEO of XTO Energy, which is now part of oil and gas giant ExxonMobil Corporation, as well as forced sales by the CEO of American petroleum refiner Tesoro Corporation. The XTO sale ended up costing its CEO 3 million shares of stock worth more than US$100 million, while the Tesoro CEO was forced to shed more than 14% of his holdings.

Foolish bottom line

The bottom line could not be more clear: Using margin is a ticking time bomb in a portfolio. Sure, the leveraged gains are nice when the market is riding high. However, margin-fuelled losses can wipe out those gains and more when the market takes a breather. There are better ways to make money in the stock market than using margin to drive returns.