On September 21, Jason Zweig wrote an interesting article in the Wall Street Journal about the risks of borrowing funds against your investment portfolio. In spite of interest rates being at historic lows, these types of loans known as “margin loans” expose the investor to significant risks. The amount that can be borrowed is determined based on the value of the underlying assets (stocks, bonds, or mutual funds).
As we have experienced in the past few years, stocks’ and bonds’ value can be extremely volatile. This volatility can be catastrophic if an investor has a margin loan secured by these investments and the loan is “called” due to an unexpected plunge in the underlying assets. If a loan is called, an investor is required to pay back a portion of the loan or he could be forced to sell some of the underlying securities in order to maintain the agreed loan to value ratio. Of course being forced to sell assets when the market is down is the exact wrong time to sell.
Modern Portfolio Theory (MPT) argues that investment risk can be reduced by diversifying assets in a portfolio. MPT refers to risk as volatility in the market and the effect volatility has on investment returns. However adding margin loans to a portfolio adds another type of risk that can adversely impact investment results. Being patient is a key component of sound investing. If a portfolio is leveraged, an investor runs the risk of being forced to sell in the short run and not being able to hold on for the long run. This is a point many of us have personally experienced with the stock market meltdown in 2008. An investor with significant leverage on their portfolio in 2008 may not have been able to hold on and stay invested in order to enjoy the recovery over the next four years.