Margin financing, also known as margin trading, is a practice where investors borrow funds to purchase stocks, leveraging their existing capital.
This approach enables investors to amplify their potential returns by using borrowed money to increase the size of their investments. However, it is essential to recognize that the same principle applies in the opposite direction – losses can also be amplified, leading to devastating financial consequences.
While margin financing can be a powerful tool for experienced investors, it comes with inherent risks that can lead to significant financial losses.
Even experienced investors and major shareholders can suffer substantially when things go wrong with margin financing – what more for retail shareholders who will be caught in the contagion effect when there is a meltdown due to margin calls.
Last month, there was a severe sell-down of 16 stocks. Many of these were triggered by their shareholders' inability to meet margin calls. Some of the stocks were subject to repeated margin calls and suffered repeated limit-downs. This means that a retail investor of those stocks may only be able to sell when the limit downs cease and by that time, the prices will be exceptionally low and heavy losses have to be incurred.
Dangers of Margin Financing:
Magnified Losses:
One of the primary dangers of margin financing is the amplification of losses. While leverage can boost gains, it can also exaggerate losses, leading to a situation where the investor owes more money than the value of their investment. If the market moves against them, the losses can accumulate rapidly, and the investor may be forced to sell assets at a loss to cover the borrowed funds.
Bear in mind the words of John Maynard Keynes - "Markets can remain irrational longer than you can remain solvent." Do not try to hold your breath. The markets downturn will outlast you.
Margin Calls:
Margin calls are demands from the financier for the investor to deposit additional funds or sell assets to cover potential losses. If the value of the stock falls below a certain level (the maintenance margin), the broker may issue a margin call. Failing to meet a margin call can result in the broker liquidating the investor's position at unfavourable prices, compounding losses.
Such liquidation leads to a flurry of other brokers making similar margin calls and liquidating positions if the margin calls are not met.
A downward spiral is set in motion. The downward spiral is further exacerbated by the introduction of 'cash upfront' requirements by brokers effectively discouraging any new investments into such stocks.
Interest Costs:
Margin financing involves paying interest on the borrowed funds. If the investment does not generate sufficient returns to cover these interest costs, the investor may find themselves in a situation where they are losing money even if the market value of their holdings remains stable.
Interest costs tend to creep up on you and whittle away your investment value. Albert Einstein said that "Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn't … pays it."
Market Volatility:
Margin financing is particularly risky in volatile markets. Sudden and unpredictable price movements can lead to significant losses or trigger margin calls. Investors must be prepared for market fluctuations and the impact they can have on leveraged positions.
Beware the collateral damage whereby even innocent stocks may suffer the wrath of the purge simply because they share some traits or connections with the affected stocks – the unintended consequences.
Limited Time Horizons:
Margin financing is often suitable for short-term trading strategies due to the associated risks. Holding leveraged positions for an extended period increases the likelihood of adverse market movements, increasing the chances of significant losses.
Use margin for a specific stock-centric time-bound purpose rather than as a general long-term investment strategy.
Psychological Stress:
Trading on margin can induce emotional stress, especially when facing substantial losses. Fear and panic may lead to impulsive decisions, exacerbating the negative impact on the investor's financial well-being.
Think also about the physical and mental turmoil that you will be subject too. Health is wealth.
Risk Mitigation Strategies:
Risk Management:
Investors should set clear risk tolerance levels and establish stop-loss orders to limit potential losses. A disciplined approach to risk management is crucial when engaging in margin financing.
Diversification:
Diversifying the investment portfolio across different asset classes can help reduce the overall risk associated with margin financing. A well-diversified portfolio is less susceptible to the impact of a single asset's price movements.
Those who invested in stocks related to a particular major shareholder may suffer the downfall of all stocks associated with that major shareholder. Do not follow shareholders. Follow fundamental companies.
Education and Research:
Before engaging in margin trading, investors should thoroughly educate themselves about the market, specific stocks, and the risks involved. Informed decision-making is a key factor in managing the dangers associated with margin financing.
Avoid stocks which are highly overvalued compared to their fundamentals. And some of such stocks are rather obvious but the possibility of making fast money seduces some investors to invest in such stocks.
Monitoring Positions:
Regularly monitoring leveraged positions and market conditions can help investors identify potential risks and take timely actions to mitigate losses.
Risks are a nano-second away and even a rumour can spook the market for a stock. If you choose to live dangerously, you have to be vigilant and keep your eyes open all the time.
Limiting Leverage:
Conservative use of leverage, such as keeping the margin levels low, can help reduce the potential for magnified losses. Investors should avoid excessive borrowing that could lead to financial instability.
When it comes to margin financing, the advice for conservative risk averse investors is - 'don't'. Adopt a path of no leverage.
While margin financing offers the potential for increased returns, it is essential for investors to approach it with caution and a thorough understanding of the associated risks.
Diligent risk management, education, and a disciplined investment approach are crucial for mitigating the dangers of margin financing and safeguarding financial well-being in the dynamic world of financial markets.
*The writer is a former chief executive officer of Minority Shareholders Watch Group and has over two decades of experience in the Malaysian capital market
