Margin for leverage?

[Cool Dood]

I have a question for you financial experts here. With a young person's mostly or completely stock portfolio, is using margin for leverage over a number of years an approach that's wise, unwise, or depends on the specific situation? Are there better or preferred routes to take for gaining leverage?

I'm not sure what else I can comment on or ask about that would be helpful, but obviously I can provide more detail if you let me know what would be useful.

 

[wabmester]

Generally unwise, but that doesn't mean it can't work well.

1) Leverage works both ways: it'll amplify down-swings as well as up-swings.

2) Margin interest probably isn't the cheapest way to borrow money, so your extra returns (if any) will have a high hurdle to clear.

3) If you get a margin call, you'll be forced to sell low (and probably at a loss).

4) You can use options to give you leverage instead of margin, and your downside will be limited (of course, options are a whole 'nother can of worms).

5) If you really want leverage, go with the pros.   Buy a closed-end fund that uses leverage.   At least you'll have professional money managers who'll have access to cheaper capital than you do.

 

[scrinch]

Until earlier this year I worked for a company that, among other things, develops and operates power projects in southeast Asia. We were a stodgy company using, if you can believe it, 100% equity for these projects. That is, until the last one which came online in late 1997. You see, in 1994-1997 all the power players in SE Asia were trying to emulate the slick new kid on the block who was getting all the attention and signing some great big new power supply contracts. This slick new company was called Enron, and it was leveraging these projects to the hilt in order to maximize ROI and minimize Enron capital. So all the other companies followed suit, borrowing roughly 80% of the capital required for the power projects. Well, when the Asian crisis of 1998 hit and the bottom fell out of the Asian currencies, the bottom also fell out of the Asian power market (remember the Asian tiger economies...where has that term gone?). In Indonesia pretty much every one of these contracts was cancelled or suspended (I happened to be acting GM when we received the cancellation letter and the sh*t hit the fan), resulting in lengthy renegotiations and new, much lower pricing. The only players who made it through those renegotiations without going bankrupt were those who had resisted the temptation of high leverage (okay, those with lots of political clout made it also). We all know what happened to Enron. The company I worked for had leveraged its last ($600M) project at about 40%, and we just barely squeaked by servicing debt during the 5-6 years of renegotiation.

Okay, the US and even foreign stock markets are not subject to the same risks as a foreign power market, but my point is that, like "the force," leverage has its dark side. It all seems swell when you look at how leverage helps you on the upside, but you had better be sure that you know what a 25% market correction (even a short-term one) will do to you in a leveraged position, and that you have the stomach and the wallet for it. If you do, and if you have...go for it. I do, and I haven't.

 

[brewer12345]

I can generally turn up a half dozen bargains in the market given a month's time, regardless of whether I have cash to commit. It can be very tempting to use leverage to take advantage of those bargains. But I generally don't. Why? You would not believe the number of times I have made money by coming in after someone's leveraged great idea fell apart and assets were available at fire sale prices because someone was desperate to pya back creditors or get out of a leveraged structure.

Its probably perfectly reasonable to put on a modest amount (10 or 20%) of leverage if you have a high risk appetite. The problem is that margin is expensive. So I generally content myself with holding little cash or high grade bond exposure and leave it at that.

 

[Cool Dood]

Thank you for the very informative answers.

 

[free4now]

Another thing about margin is that the cost usually depends on your margin balance. At many brokers someone with a 1 million margin balance can pay as much as a few percent less than someone with just a few thousand. So small investors like yourself get the shaft. If you use margin it's definitely worth shopping margin rates and choosing a broker on that basis; every broker has a different scheme for determining their margin rates so you want to find the one with the best rates for your projected margin balances.

Often it seems that borrowing with say a home mortgage is cheaper than broker margin.

I used a little bit of margin (10-15%) while I was working and interest rates are low, but I will be the first to say that was risky and not for everyone or even most people.

Now that interest rates are higher I wouldn't use margin, and because I'm now living off my stash it's absolutely ruled out.